To clients and friends of The London Company:
The occasional reset is healthy and a normal part of life, but it’s also central to the statistical concept of mean reversion. Reversion to the mean assumes that a level that strays far from the long-term norm will converge to its secular trend or average state over time. For the notion to hold true, inevitably there need to be resets along the way. Our economy and the equity markets have strayed in both directions these past two years, and now we are living through a reset. Thus far, it has been quite painful as evidenced by the S&P 500’s -20.6% first half decline—its largest price decline to start to the year since 1970. The question investors are grappling with now is: how much of a reset is required before the pain is over and the market reaches a bottom? Importantly, you cannot time mean reversion, and you can only truly assess the degree of reset required after the fact. Relying on historical averages as part of an investment strategy can be problematic over short periods of time, but that still doesn’t stop many investors from looking to the past for answers about the future. Having said that, the current investment landscape presents some compelling opportunities for fundamental active management and disciplined long-term investors.
Concerns over inflation and expectations for aggressive monetary policy spilled over into the second quarter, but the addition of slowing global growth fears resulted in a broad risk-off atmosphere. To combat historic and persistently high inflation, central banks across the globe are now reversing 10+ years’ worth of accommodative monetary policy. In effect, they are soaking up liquidity, which is having a destabilizing impact on capital markets. Domestically, the Federal Reserve’s outsized focus on inflation led to a more aggressive pace of rate hikes following the liftoff in March. The specter of aggressive monetary policy, the broadening of tighter financial conditions and growth concerns weighed on sentiment and exacerbated volatility in the second quarter. The S&P 500 declined -16.1%, and officially entered bear market territory. It was the S&P 500’s largest quarterly decline since the height of the pandemic fears in early 2020. There were few places to hide, but Value stocks held up better than Growth stocks and defensive sectors largely outperformed the more cyclical sectors. At the market cap level, the correction wasn’t very discriminating, with shares of Large Cap companies slightly outpacing Small Caps. Looking at market factors, Yield, Value and Quality led while Volatility and Growth factors were the biggest detractors.
Living Through a Reset
Market Highlights
- S&P 500 experienced its first prolonged, 5+ consecutive weekly sell-off since 2011.
- Despite low sentiment, steep drawdown and collapse of valuation multiples, the coast isn’t necessarily clear.
- Even though recession odds have increased, corporate earnings estimates have yet to deteriorate. If this cycle follows the roadmap of history, the tightening of financial conditions is poised to catch up to profits.
Unlike the COVID crash of early 2020, which lasted just 23 trading days, investors are weathering a more prolonged selloff that could worsen as recession risks grow. At one point, the S&P 500 experienced a seven-week losing streak. This is the first sustained period of consecutive weekly sell-offs in equity markets since 2011. While uncomfortable, it’s worth acknowledging that sustained drawdowns such as these are actually common throughout history. The dearth of down markets over the past decade is actually the exception and not the norm. Regretfully, 10+ years of accommodative monetary policy has conditioned many market participants to think of everything in V-shaped terms. Those hoping for a sustained ricochet bounce like we’ve grown accustomed to seeing may be in for a rude awakening.
Source: Deutsche Bank, Strategas
There are no bells rung at market tops or bottoms. Likewise, there is no magic percent decline or valuation multiple that signals we have reached a bottom. Given how complex and unprecedented the current macroeconomic backdrop is, we’re reminded of a quote by the Nobel Prize winning psychologist and economist Daniel Kahneman, “The idea that the future is unpredictable is undermined every day by the ease with which the past is explained.” While historical averages are informative, it’s also important to acknowledge the coast isn’t necessarily clear just because we reach a historical threshold. If we look back through history, on average, bear markets last 20 months and the market declines roughly -40%. But, the duration has ranged from 1 to 62 months, and the worst bear market decline in history was over -86%, between 1929-1932. Looking at valuations, you get a similar story. Valuation multiples at prior bear market bottoms are quite varied overtime, and the absolute figures don’t necessarily capture the respective interest rate backdrop at the time. Over the past two years, historically low rates helped reduce risk and boost valuations; meanwhile, earnings benefited from stimulus and pent up demand. With such uncertainty around the outlook for rates and earnings, the utility of valuation metrics based on near-term profits is limited. Even though multiples have collapsed, the market is down nearly 20% year-to-date, and sentiment is historically low, these signals do not cause bottoms.
So, why do markets bottom? Looking back at every major S&P 500 sell-off since the 1950s, the notable catalyst for every bottom was either a turning point in the economy (e.g. bottoming of PMIs, leading economic indicators) or a dovish policy shift from the Fed. Applying that lens to the current backdrop, it appears unlikely we’ll see a Fed pivot any time soon. The Fed has just begun its tightening campaign and it has already indicated it is prepared to accept a recession if it means getting inflation under control. Turning to PMIs, and the outlook for a bottom in the near term isn’t much better. The Purchasing Managers’ Index or PMI measures the prevailing direction of economic trends in the manufacturing and service sectors. PMIs are important because they lead the business cycle, which leads profit cycles, which leads the economy. Business cycles go up and down over time due largely to easing and tightening of financial conditions. Historically, broader tightening cycles lead to broader economic slowdowns, but it can take months for the full impact of tightening to be realized. Current PMI readings are still in expansionary territory, but they are trending lower. Separately, we have seen rapid declines in other economic data from autos, to housing, to rail volumes and more. The S&P 500’s decline year-to-date has been completely driven by multiple compression—not earnings. Even though recession odds have increased, corporate earnings estimates have yet to deteriorate. If this cycle follows the roadmap of history, the tightening of financial conditions is poised to catch up to profits. Historically, when profits get hit and earnings estimates get cut, volatility increases, credit spreads widen and valuation multiples typically compress further. No two slowdowns are the same; but, according to Strategas Research Partners, earnings fell by an average of ~30% in the prior 15 recessions, with a range of -3% to -92%. As we get further into the second half of 2022, the earnings landscape will be a key area of focus for market participants.
A Strategy Recap
Turning to our performance, The London Company’s portfolios performed as they’re designed to do and held up well against the market turmoil. Each of our portfolios outperformed its primary benchmark in Q2. Thus far, in 2022, it has been tale of two quarters. During the atypical, valuation-driven sell off in Q1, we received limited benefit from our Quality orientation. Fast forward to the risk-off atmosphere of Q2, and we benefited from the market’s increased attention to profitability, leverage levels, and credit risk. Our Small, SMID and Mid Cap portfolios meaningfully exceeded our 75% downside capture target for the quarter, which has helped them each outperform year-to-date. Solid downside protection from our Large Cap portfolio during the quarter more than offset weakness in Q1, leading to year-to-date outperformance. Our Income Equity strategy is the only portfolio trailing its primary benchmark the Russell 1000 Value year-to-date, due largely to having less energy exposure. Fortunately, it has continued to exceed our downside protection expectations versus its secondary benchmark, the S&P 500. As we have highlighted in prior letters, our adherence to quality has hurt us at times on the way up, especially when speculation was rampant. We also warned that some of the lower quality leadership we witnessed was not sustainable. In recent months, we’ve seen a reckoning of that leadership dynamic. Periods like the second quarter help validate our approach and highlight the benefits of protecting capital when it matters most.
Periods like the second quarter help validate our approach and highlight the benefits of protecting capital when it matters most.
Looking Ahead
As we said at the outset, our economy and equity markets are living through a reset. The Fed has just started its journey to reach price stability. Monetary policy is a blunt instrument and the Fed can only really try to tackle the demand side of the inflation problem. Unfortunately, the Fed can’t fix the situation in Ukraine, the oil crisis, supply chain bottlenecks, or the pandemic. Even as some transitory pricing pressures are set to abate, stickier inflation and structural issues in energy markets will likely make fighting inflation a process rather than an event. Over the past year, we’ve expressed concern over the rising risk backdrop. In our outlook earlier this year, we pointed out how the treasury yield curve had inverted. Since then, the curve has inverted twice more. Curve inversions are notorious for predicting recessions, and typically signal concerns over future growth or a monetary policy misstep. If we do enter a recession, the sort out process could take even longer—both for the economy and equity markets.
While our general assessment of the current backdrop is a sobering one, these views should be taken as preparatory and not predictive. As natural contrarians, we’re loathe to consensus thinking. We recognize that the herd mentality is increasingly bearish, which means we should probably be on the lookout for what could go right. Even though the Fed has just started its tightening campaign, it also has a reputation for fighting the last battle and often being late. Frankly, the market has been doing the Fed’s job for it since late 2021. Broader financial conditions have already excessively tightened in anticipation of the Fed’s moves. If inflation rolls over faster than expected, that may encourage the Fed to ‘pause’ its campaign, which could be received by the market just as positively as a ‘pivot.’ We should also note that tighter financial conditions have already caused tremendous carnage beneath the surface, particularly in the lower quality growth segments of the market. Many of the micro-bubbles that existed (e.g. Meme stocks, SPACs, cryptocurrencies, etc…) have already popped in spectacular fashion. Moreover, corporate balance sheets are the cleanest they’ve been in decades, with records amount of cash. And while the odds of a recession have increased in recent months, the resiliency of the US consumer should not be underestimated. Labor markets are historically tight and household balance sheets remain strong—powerful forces that can ballast the US economy. We do not attempt to forecast the future and cannot offer any insight about the market’s likely course in the weeks and months ahead, but we remain confident in the long-term outlook for the equity markets. Further, we believe our adherence to taking this long view will continue to serve our clients well. We know that owning high-quality businesses can provide a measurable advantage over full market cycles. We also know from history that time in the market beats timing the market. As depicted in the chart, even missing out on a couple of days in the market can reduce an investor’s realized portfolio growth in a meaningful way.
Source: Strategas
As a manager focused primarily on downside protection, we know that quality and valuation matter. We had great confidence in the quality of our companies going into 2022. After six months of market tumult and volatility, we have even greater conviction in our positioning. Many of our business have experienced drawdowns that are incongruent with their fundamentals, which we feel are now trading at significant discounts to their intrinsic values. Such divergences between short-term share price movements and long-term earnings power are rare, especially for such high quality business. We believe the companies we own have greater control over their own destiny. These are businesses that are not dependent on access to cheap capital, artificially low interest rates, lofty growth expectations, unpredictable cyclical dynamics or emergency stimulus. In recent years, companies with a high story-to-substance ratio were rewarded. Going forward, we believe attributes like a strong balance sheet and the ability to self-finance operations are poised to stand out as competitive advantages in a higher cost of capital environment. Moreover, we believe total shareholder yield (dividends + net buybacks) will become an increasingly important component of investors’ total returns going forward. Going back to the 1930s, dividends’ contribution to the S&P 500’s total return averaged roughly 60%. In the past decade, however, that has fallen to less than 25%. Market appreciation was the primary source of return for investors following the Great Recession, supported by historically low interest rates and stable inflation. Now, investors are faced with persistently high inflation and tighter monetary policy. Given this backdrop, equity returns going forward may be more modest and multiple expansion more challenged. Should that play out, stable earnings growth and the return of shareholder capital will be key. Many of the businesses we own are under-levered, have excellent credit quality, hold record cash balances and generate high free cash flow yields. We believe these are additional advantages that could translate to an accelerated return of capital through larger repurchases and dividend payouts.
In recent years, companies with a high story-to-substance ratio were rewarded. Going forward, we believe attributes like a strong balance sheet and the ability to self-finance operations are poised to stand out as competitive advantages in a higher cost of capital environment.
In summary, rapid market declines can be stressful and nerve-wracking, but we hope our approach to capital preservation mitigates some of that fear. As we assess the depth of this downturn, we also hope to be opportunistic to take advantage of great bargains presented to us. Resets work in both directions, and often the pendulum swings too far. Capitalizing on mean reversion can be part of a successful long-term investing strategy, but in order to reap the full benefits of compounding, “the eighth wonder of the world” it’s important to remain disciplined and stay the course.
We want you to know that we remain fully committed to you and are available to discuss questions and concerns you may have. As part of that commitment to client service, we embarked on a rebranding project in 2021. We have been busy behind the scenes orchestrating an upgrade that modernizes our materials and website. Additionally, we’ve made enhancements which should improve the delivery of our messaging and informational content that our clients and partners depend on. We look forward to sharing our refreshed materials in the weeks ahead, but we also invite you to continuing exploring our newly designed website as well.
As always, we appreciate and value highly the trust you have placed in us.
View Strategies
For more information