Dec 11, 2022·edited Dec 11, 2022Liked by Alfonso Peccatiello (Alf)
this seems very much to be the case.
everyone is bearish, but everyone is long. they think the bottom is near, which is why the bottom is not. bottoms are made in fear, not in ennui. portfolios (esp in big cap tech) reflect a lack of understanding of what "recession" means. (meanwhile, a lot of microcap is down 70-90% and trading deeply cheap)
i suspect we see that space pop as tax loss selling ends and that next year will be a pain tolerance test for big cap tech until it breaks and ends in rout. the big, bellwether names have massive downside still and therefore so do the indexes. 2023 going to be a rotten year there, but a good one for smaller cap stockpickers.
We just haven't seen true capitulation, have we? People still like stocks, they still believe in the bull case. There has not be true pain. If the bottom was really already in, that would just be too easy imo.
A friend based in Switzerland working in finance with American millionaires for clients told me the other day that the recession is already priced in and the best option is sticking your money in an index ETF as the stock market always go up...
You assume a 20% EPS drop - is there further justification why this recession will be the shallowest for 40 years (based on your table, although that includes some unique circumstances)?
Earnings have risen on the back of recent stimulus spending. Non-financial corporates are more leveraged than 15 years ago and with a recession coming, they are probably just getting started. Housing has been roaring away for a couple of years and the job market looks less robust than at this stage in the past.
Would a 40% drop be surprising or inconsistent with where we are starting from?
What drop would be implausible - i.e. what is a credible range?
One question on signals from the bond market: have you ever explored the correlation between yield curve inversion, recessions, and earnings drawdowns? Meaning, does deeper yield curve inversions (whether we're talking 10-yr/2-yr or 10-yr/3-mo Treasury curves) correlate to either more severe recessions and a corresponding corporate earnings decline?
I'm curious on your thoughts on that area of the bond market, and the implications for the type of recession/earnings decline. Thanks!
This is the most anticipated recession ever. What is so puzzling is how orderly declines have been in both stock and bond markets. As an aside I find symmetry between your view and Felix Zulauf (one of his few interviews). He sees a roller-coaster decade but the chance for growth to shine, though perhaps briefly, when those rate cuts finally occur. However, for a generation, the easy money has probably been made.
150bps of cuts would take us from what the fed sees as an restrictive, inflation combating rate at c.5% to 3.5%, which would be consistent with PCE between 2.5% and 4% based on the long run reaction function. To me that's a normalisation rather than definitely pricing in a recession (where policy would likely get easier than 'normal')
Here's the bigger question....one that you likely don't have the data to answer but would be a telltale for where we're going in 2023.
The yield curve is DEEPLY negative, and a negative YC has been a 100% telltale to a 'proper recession' ahead. Where were your probabilities priced-in before each of these recessions compared to our <20% probability today? My bet is that it was significantly higher, and that the 'smart money' bond market had it right well ahead of the lagging stock market indices. KB
Investing is about thought control & your own ego more than anything else..or so I believe. You seek out those who share your own self-reinforcing opinions (I'm with you, Alf, on a big recession starting in 2023) but I'm also mindful to read opposing opinions in case we're wrong. However, this latest newsletter is probably the best thing I've read so far in support of the 'prosecution' case. I've not read anything compelling from the 'defense' side other than the usual hope & pray stuff. On a lighter note, I was going to offer you, @Alf, my consolations, as an Englishman, for the Dutch football loss. I then remembered that your birth country is Italy....
I think your estimates are very conservative given the amount of debt in the public and private sector. Unless fed pivots. However even that may not have a sustaining effect when it happens.
Good point Ryan. My concern is whether the 'amount of debt in the public and private sector' is accurately recorded. Public debt: a lot of it is 'off balance sheet' eg. read Alf's newsletter from last week (ok-netting) but what about other things that are not recorded in the way a company would under GAAP? Private: The regulation on the banks have increased a lot since the 2008 GFC but it's the non-banks we need to watch. How many of these non-banks even report to a country regulator? I still get daily emails from all & sundry offering me & my company lines of credit. FTX is just the top of the pile -we are seeing everything slowly unwind as more hedge funds etc. can't meet margin calls and mark to market assets. It reminds me of the 1720 South Sea Bubble story about a promoter who encouraged investment into “an undertaking of great advantage, but nobody to know what it is.”
what happens if a fed forced pivot in less than 6 months causes us dollar down hard, commodities up hard, inflation returning, and bond yields up? Do we have a renewed recession?
early FED pivot and inflation returning would mean we essentially start over and recession would be delayed. the cycle goes 1. inflation, 2. stagflation, 3. recession. We are currently at step 2, about to head into step 3. that's why Alf's portfolio is talking about "pricing in recession" because we are not yet there, but the markets are going to look ahead at what's coming and act accordingly.
so what happened in 2021? everything went up as a result of FED easy policy. if FED pivoted early in 2023 and we started that cycle over again, we would simply go back to what happened in 2021. we would get another boom cycle in 2023, followed by another stagflation cycle in 2024 as the easy money wears off, followed by a recession afterwards in 2025.
that would be my guess anyway, just going off of what has happened in the past few years.
If I remeber correctly, the Fed "pivoted much too soon back in the Paul Volker era and had a big jump back up in inflation before Volker finally pushed rates to the moon. Money made by those who had some, but the lower 50% of our US citizens with virtually zero savings will once again be the sufferers.
yes, as i understand it, the 70's was not 1 period of continuous inflation, but a series of ups and downs in inflation (as a result of FED tightening, then pivoting too soon, having to tighten again, etc...) that taken overall resulted in an inflationary decade
it wasn't until after multiple cycles of this up and down inflation that Paul Voelker finally put an end to it by raising the FED funds rate to 20% in June of 1981.
that then set up the ability for the FED to continually lower rates until 2020, resulting in literally a 40 year bull market in stocks and bonds. what a time to be a money manager - you could have had a monkey manage your money and you would have done well.
Dec 11, 2022·edited Dec 11, 2022Liked by Alfonso Peccatiello (Alf)
Alf's macro portfolio has been pricing in this recession for a while now, since basically january 2022. He's been long TLT (long duration bonds) and shorting the Russell 2k.
"For portfolios, that means that the ‘‘easy money’’ has been made: as markets quickly repriced ‘‘a recession’’ as their base case, bonds rallied aggressively while stocks didn’t follow suit as it should be."
translation - the easy/sure gains from pricing in the recession have already happened. TLT (long duration bonds) had big gains ever since the October's CPI report showed lower inflation. Russell 2k has fallen a lot as well since the beginning of 2022.
"But given ‘‘a proper recession’’ remains only mildly priced in, a macro portfolio construction that benefits from these relative mispricings can be still achieved."
translation - gains derived from pricing in a recession are not finished yet, there's still room for further gains. TLT (long duration bonds) still have further gains to make as the market continues to further price in recession. Russell 2k still has further to fall ahead of this recession fully setting in.
He also said at the end that "new ETF portfolios" would be discussed in 2023, so perhaps he will be changing/adding to his 2022 portfolio that was long TLT and short Russell2k in the weeks and months ahead.
Thanks Alf (for the article) & Jonathan (for additional explanation & context). Really appreciate it!
Hoping for more content & community support like this to make it more accessible for less sophisticated investors (like myself!) who're trying to catch up & be better positioned 2023 onwards.
Nice understandable response. I am long a combo of EDV/TLT and in the green by about 10%. I am looking to double my position on any pullback to circa 100 on TLT so as not to meaningfully increase my average cost basis. This pull back may not happen. My base case is that TLT gets to a minimum of 115 and a bull case is 130+ in the next 12 to 18 months.
I guess you are looking at the BS delta of the 3200 strike to approximate the probability of SnP trading below that level in 1 year. I would add that the implied probability of it touching that level at any point in that period should be 2* delta so around 32%
To be clear, you mentioned implied probability of SnP trading at or below that level BY eoy… If you look at the delta of the strike, then that’s the probability of trading at or below that level AT eoy. You can think of it intuitively.. let’s say the SNP has 32% probability of touching 3200, and from there equal probability of finishing the year above or below that level -> so in total indeed 16% implied probability of finishing the year below 3200 but 32% probability of touching the level “by” EOY
this seems very much to be the case.
everyone is bearish, but everyone is long. they think the bottom is near, which is why the bottom is not. bottoms are made in fear, not in ennui. portfolios (esp in big cap tech) reflect a lack of understanding of what "recession" means. (meanwhile, a lot of microcap is down 70-90% and trading deeply cheap)
i suspect we see that space pop as tax loss selling ends and that next year will be a pain tolerance test for big cap tech until it breaks and ends in rout. the big, bellwether names have massive downside still and therefore so do the indexes. 2023 going to be a rotten year there, but a good one for smaller cap stockpickers.
Excellent comments, thanks!
We just haven't seen true capitulation, have we? People still like stocks, they still believe in the bull case. There has not be true pain. If the bottom was really already in, that would just be too easy imo.
Great article, many thanks.
A friend based in Switzerland working in finance with American millionaires for clients told me the other day that the recession is already priced in and the best option is sticking your money in an index ETF as the stock market always go up...
He's obviously not a reader of the Macro Compass!
He's had a tough 2022 if this is his approach :)
hahaha
Thanks for another great article, Alf.
You assume a 20% EPS drop - is there further justification why this recession will be the shallowest for 40 years (based on your table, although that includes some unique circumstances)?
Earnings have risen on the back of recent stimulus spending. Non-financial corporates are more leveraged than 15 years ago and with a recession coming, they are probably just getting started. Housing has been roaring away for a couple of years and the job market looks less robust than at this stage in the past.
Would a 40% drop be surprising or inconsistent with where we are starting from?
What drop would be implausible - i.e. what is a credible range?
20% EPS drop in 2023, I didn't say earnings will stop dropping there :)
Peak to through I assume 30-35%
Thanks for this great article.
Welcome!
Great post and analysis!
One question on signals from the bond market: have you ever explored the correlation between yield curve inversion, recessions, and earnings drawdowns? Meaning, does deeper yield curve inversions (whether we're talking 10-yr/2-yr or 10-yr/3-mo Treasury curves) correlate to either more severe recessions and a corresponding corporate earnings decline?
I'm curious on your thoughts on that area of the bond market, and the implications for the type of recession/earnings decline. Thanks!
Great question, I'll spend time on this!
Thank you Alf!
Welcome, Chris!
This is the most anticipated recession ever. What is so puzzling is how orderly declines have been in both stock and bond markets. As an aside I find symmetry between your view and Felix Zulauf (one of his few interviews). He sees a roller-coaster decade but the chance for growth to shine, though perhaps briefly, when those rate cuts finally occur. However, for a generation, the easy money has probably been made.
''However, for a generation, the easy money has probably been made.''
Correct!
150bps of cuts would take us from what the fed sees as an restrictive, inflation combating rate at c.5% to 3.5%, which would be consistent with PCE between 2.5% and 4% based on the long run reaction function. To me that's a normalisation rather than definitely pricing in a recession (where policy would likely get easier than 'normal')
Absolutely James, and that was the point of the piece :)
Thanks Alf, always love your post and looking forward to the new year, subscribed!
Thanks for becoming a subscriber, Joe!
Here's the bigger question....one that you likely don't have the data to answer but would be a telltale for where we're going in 2023.
The yield curve is DEEPLY negative, and a negative YC has been a 100% telltale to a 'proper recession' ahead. Where were your probabilities priced-in before each of these recessions compared to our <20% probability today? My bet is that it was significantly higher, and that the 'smart money' bond market had it right well ahead of the lagging stock market indices. KB
I can do some work on that, Kirk.
Thanks for the hint!
Investing is about thought control & your own ego more than anything else..or so I believe. You seek out those who share your own self-reinforcing opinions (I'm with you, Alf, on a big recession starting in 2023) but I'm also mindful to read opposing opinions in case we're wrong. However, this latest newsletter is probably the best thing I've read so far in support of the 'prosecution' case. I've not read anything compelling from the 'defense' side other than the usual hope & pray stuff. On a lighter note, I was going to offer you, @Alf, my consolations, as an Englishman, for the Dutch football loss. I then remembered that your birth country is Italy....
I am definitely Italian at heart, not Dutch :)
I think your estimates are very conservative given the amount of debt in the public and private sector. Unless fed pivots. However even that may not have a sustaining effect when it happens.
Totally agree
Good point Ryan. My concern is whether the 'amount of debt in the public and private sector' is accurately recorded. Public debt: a lot of it is 'off balance sheet' eg. read Alf's newsletter from last week (ok-netting) but what about other things that are not recorded in the way a company would under GAAP? Private: The regulation on the banks have increased a lot since the 2008 GFC but it's the non-banks we need to watch. How many of these non-banks even report to a country regulator? I still get daily emails from all & sundry offering me & my company lines of credit. FTX is just the top of the pile -we are seeing everything slowly unwind as more hedge funds etc. can't meet margin calls and mark to market assets. It reminds me of the 1720 South Sea Bubble story about a promoter who encouraged investment into “an undertaking of great advantage, but nobody to know what it is.”
what happens if a fed forced pivot in less than 6 months causes us dollar down hard, commodities up hard, inflation returning, and bond yields up? Do we have a renewed recession?
That'd be the mistake of the 70s when the Fed pivoted too early.
This time Powell won't make this mistake, but he'll make another one.
He'll keep policy super tight even as it's clear we walk into a recession.
early FED pivot and inflation returning would mean we essentially start over and recession would be delayed. the cycle goes 1. inflation, 2. stagflation, 3. recession. We are currently at step 2, about to head into step 3. that's why Alf's portfolio is talking about "pricing in recession" because we are not yet there, but the markets are going to look ahead at what's coming and act accordingly.
so what happened in 2021? everything went up as a result of FED easy policy. if FED pivoted early in 2023 and we started that cycle over again, we would simply go back to what happened in 2021. we would get another boom cycle in 2023, followed by another stagflation cycle in 2024 as the easy money wears off, followed by a recession afterwards in 2025.
that would be my guess anyway, just going off of what has happened in the past few years.
If I remeber correctly, the Fed "pivoted much too soon back in the Paul Volker era and had a big jump back up in inflation before Volker finally pushed rates to the moon. Money made by those who had some, but the lower 50% of our US citizens with virtually zero savings will once again be the sufferers.
yes, as i understand it, the 70's was not 1 period of continuous inflation, but a series of ups and downs in inflation (as a result of FED tightening, then pivoting too soon, having to tighten again, etc...) that taken overall resulted in an inflationary decade
it wasn't until after multiple cycles of this up and down inflation that Paul Voelker finally put an end to it by raising the FED funds rate to 20% in June of 1981.
that then set up the ability for the FED to continually lower rates until 2020, resulting in literally a 40 year bull market in stocks and bonds. what a time to be a money manager - you could have had a monkey manage your money and you would have done well.
I would imagine its only "fully priced in" when the stock market bottoms (?)
What does "a macro portfolio construction that benefits from these relative mispricings" mean exactly?
Alf's macro portfolio has been pricing in this recession for a while now, since basically january 2022. He's been long TLT (long duration bonds) and shorting the Russell 2k.
"For portfolios, that means that the ‘‘easy money’’ has been made: as markets quickly repriced ‘‘a recession’’ as their base case, bonds rallied aggressively while stocks didn’t follow suit as it should be."
translation - the easy/sure gains from pricing in the recession have already happened. TLT (long duration bonds) had big gains ever since the October's CPI report showed lower inflation. Russell 2k has fallen a lot as well since the beginning of 2022.
"But given ‘‘a proper recession’’ remains only mildly priced in, a macro portfolio construction that benefits from these relative mispricings can be still achieved."
translation - gains derived from pricing in a recession are not finished yet, there's still room for further gains. TLT (long duration bonds) still have further gains to make as the market continues to further price in recession. Russell 2k still has further to fall ahead of this recession fully setting in.
He also said at the end that "new ETF portfolios" would be discussed in 2023, so perhaps he will be changing/adding to his 2022 portfolio that was long TLT and short Russell2k in the weeks and months ahead.
Thanks Alf (for the article) & Jonathan (for additional explanation & context). Really appreciate it!
Hoping for more content & community support like this to make it more accessible for less sophisticated investors (like myself!) who're trying to catch up & be better positioned 2023 onwards.
Julian, that's exactly what The Long Term Investor subscription tier is going to be all about :)
Nice understandable response. I am long a combo of EDV/TLT and in the green by about 10%. I am looking to double my position on any pullback to circa 100 on TLT so as not to meaningfully increase my average cost basis. This pull back may not happen. My base case is that TLT gets to a minimum of 115 and a bull case is 130+ in the next 12 to 18 months.
Wow Jonathan, quite a translation! :)
I am going to release my ETF portfolio and tactical trades on Jan 2nd for subscribers of The Macro Compass premium products.
Naive question - is there an etf to short Russell 2k ?
RWM.
TZA
Johnathan, thank you. I appreciate your "translation". That's the kind of clarification I was looking for.
I guess you are looking at the BS delta of the 3200 strike to approximate the probability of SnP trading below that level in 1 year. I would add that the implied probability of it touching that level at any point in that period should be 2* delta so around 32%
To be clear, you mentioned implied probability of SnP trading at or below that level BY eoy… If you look at the delta of the strike, then that’s the probability of trading at or below that level AT eoy. You can think of it intuitively.. let’s say the SNP has 32% probability of touching 3200, and from there equal probability of finishing the year above or below that level -> so in total indeed 16% implied probability of finishing the year below 3200 but 32% probability of touching the level “by” EOY
Indeed I discussed about the probability of the SPX trading at 3200 or below at the end of 2023, not throughout (single touch) only