Why the Markets have not Bottomed

 

All experienced investors can recite a number of valid market "rules":

1. The market will rally when there is "blood in the streets" and all optimism is wrung out.  (courtesy Warren Buffett). 

2. The market discounts the future; when the market has discounted the recession (priced the impact into stock prices), the market will rally.

3. The market will rally when investors least expect it.  (Bearish sentiment is a contrary indicator)

[Feel free to add your own to my list]

As i write this on May 26, 2022, for YTD, the NASDAQ  Composite is down 28.9% and SPX is down -16.3% (Bloomberg), many analysts are tempted to say that the markets are close to the bottom.  

The problem facing investors is that there is too much uncertainty to make any useful prediction of future market dynamics.  

Inflation is the major financial/economic issue facing both the financial markets and the Federal Reserve.  At this point, we know one thing for certain.  The Fed is focused on crushing inflation and bringing it back to within range of its 2% target.  To do that, the Fed MUST slow US economic growth.  At the neutral rate, somewhere around 2.5%, by definition, rates will NOT slow economic growth.  The Fed will have to raise interest rates above the neutral point, to some higher rate AND convince the market that rates will move even higher until inflationary expectations are wrung out of the consumer's psyche.  The "market" consensus, that 3% would be an appropriate end point is much too optimistic.  It is easily possible that the Fed will have to raise rates well past 3%, possibly to 5% to both reduce demand and really change inflationary perceptions. 

As Chairman Powell has repeatedly pointed out, the Fed can only deal with the demand side of the inflation equation.  Demand will not slow until there is a slowdown in the general US economy, including job growth (and the resulting wage growth).  Of course, the Fed has a dual mandate, but job growth is much too hot, and as a result wage growth is too hot.  The Fed aspires to bring down the job vacancy ratio from 2:1 to a more normal 1:1 and asserts that by doing so, it will temper inflationary pressures.  This would be the "soft landing" that would temper inflationary pressures without increasing unemployment.  Regrettably, that is not consistent with human behavior.  Wage pressures will not abate until there is some fear of losing a job and possible unemployment (i.e., some equilibrium is restored between labor and capital).  In today's environment, employees can demand higher wages, without any penalty for pushing too hard.  Another job is around the corner, AND savings accounts are high so some time off does not seem so bad.  The hallmark of the US labor market is that employees are able to transition between jobs relatively easily (very different from he Euro markets), but this feature has gotten out of balance in the current environment. 

Interest rates are not the only story; external inflationary pressures also have to be considered, although these are more supply side driven.  The war in Ukraine will  have its own inflationary pressures due to the impact on Ukraine (food prices) and the sanctions on Russia (gas and Nat Gas prices).  These are long term impacts.  Over the course of time, the markets and the global economy will adjust to these factors, but the point of equilibrium is likely to be well beyond 2022. We must also add the impact of other inflationary forces to this tasty stew.  Supply chain disruptions are clearly resulting in inflationary pressures due to the fitful and incomplete restart of the global economy after the pandemic.  As of today, China is clearly not in restart mode, and clearing the bottleneck will take some even after it reaches full restart.  It seems fanciful to think that this aspect of "return to normal" will occur in 2022. 

Some other factors for investors to consider independent of the above analysis.  (1) the impact of the War in the Ukraine, (2) the impact of the shift to QT from QE, and (3) the impact of the end of TINA. I could write a separate column on each of these factors.  For the moment, I will only point out that all of these will tend to lead to higher interest rates across the yield curve, and lower stock prices. 

If my analysis is correct, what are the implications? 

The market has exhibited an inability to discount the impact of inflation (rising input costs; rising inventory costs) combined with the initial indications of a slowdown in spending, at least is some sectors.  Good example (of many) is the reaction to Target's earnings release.  This a premier company with excellent management and a long track record of success.  Nevertheless, Target was unable to simply pass through higher labor and inventory costs.  It also implies that consumer demand was not sufficient to allow the firm to raise prices.  The result was that its stock price declined nearly 25% in one day. 

My conclusion from this analysis, despite being a true believer in market's efficiency, is that there is simply too much uncertainty for the moment to reach any conclusions about the future course of market movements.  We will not be able to rationally forecast a market bottom until the market has a much better idea of (1) the end point in the interest rate cycle; (2) the long term impact of QT; (3) the depth of the economic slowdown necessary to tame inflation, and finally and most importantly, the impact of this end state on individual companies and the demand for their products and services.

Market Efficiency

The theory of Market Efficiency is that all available information that might affect stock prices, whether company-specific, macroeconomic or other, are incorporated into stock prices immediately and accurately.  Behavioral Finance is a conflicting theory that asserts that market prices are driven in great respect by emotional factors (such as FOMO), biases, and cognitive errors.  This conflict has been contested for many decades. Both theories are confirmed by the award of Nobel Prizes to their adherents.  

What do we make of market dynamics today (April 2022)?  I am an advocate that the market is mostly efficient.  My evidence is that few professional investment managers beat the market in any year, much less over a period of years.   Nevertheless there are instances of clear mispricing that can be detected ex ante.  In 2021, profitless growth was priced on the basis of historically high P/S ratios ranging up to 100x.  Many of us argued at the time that these were unsustainable over even the medium term.  This is the best evidence supporting Behavioral Finance.  These valuations were clearly affected, in very large part by the ZIRP interest rate policy of the Federal Reserve, and stimulus of all the major governments in the world.  This resulted in a historically low discount rate.  Since these companies were not projecting earnings for many years, the discount rate applied to distant cash flows and earnings was a critical factor in valuation. However even at the time, it was clear that these factors were coming to an end.   Nevertheless, high valuation persisted for a long time.  

Another factor in stock prices over the last two years has been the impact of the Covid Pandemic.  Since its onset in March 2020, consumer behavior shifted dramatically to WFH, Play at Home and Shop at Home as consumers endured government mandated lockdowns in many jurisdictions. The Covid Pandemic is not over, but clearly in the US, it is on the wane and return to normal is taking hold not just in work, but also in Entertainment (full sports stadia) and Travel.  Until recently, little attention was paid to the Pandemic Darlings; those companies that benefited from Covid.  The poster children for this phenomenon are Peloton and Zoom Video. But there were many others including Apple, Microsoft, Facebook, NFLX, Amazon, and Roku.  .  

Here is where market efficiency should have kicked in.  By January 2022, it was clear that the largest pandemic impacts were dissipating in the US.  Mask mandates were being phased out: vaccine cards were no longer being required in indoor places and testing sites were empty.  Also, by this time, the Federal Reserve's intention to being to increase interest rates to more "normal" levels was well understood although the path was uncertain.  The market should have been able to incorporate the loss of the pandemic benefit into stock prices.  This is not complex.  Take earnings from 2019, pre-pandemic, add a little for permanent growth, and you have a reasonable forecast for post pandemic.  Yet in the past two weeks, the market has been surprised by the loss of pandemic benefit in two high profile stocks:  NFLX and AMZN.  Yesterday, AMZN reported earnings, and the stock price is -9% today despite continued high growth in its AWS business.  NFLX reported last week, and was down over 30%.  Yes, there are company-specific issues and macroeconomic issues (supply chain, energy  and Ukraine War) that affect many stocks but clearly the market did not correctly anticipate the Pandemic benefit.  

In the age of the Internet, Market Efficiency should apply regardless of  the size of the company involved. However there is an argument that small companies with limited analyst following are more prone to inefficient prices due to lack of information and the inability of arbitrage to correct mispricing.   I mention NFLX and AMZN because they are widely followed by Wall Street Analysts.  There is no argument that the stock dynamics are a function of lack of information or arbitrage.  I acknowledge that we can see larger evidence of inefficiency in smaller stocks in which there is less information available (fewer analysts) and arbitrage is more difficult.  The poster child for this argument might be TDOC which reported its earnings this week and sank more than 30% from an already near 52-week low.  Similarly, after reporting declining active users, HOOD suffered a decline of 10% as its users begin to leave their comfortable couch and return to work. 

We are living through a market period that is not only volatile but also topsy-turvy.  Profitless Growth is no longer being rewarded with huge valuations.  (Plus for Efficiency).  However, yesterday's price action reminds us that the market has still not adjusted for the pandemic benefit received by many companies. This is negative for the market efficiency advocates. 

Powell votes for more inflation

Yesterday, April 22, Chairman Powell reiterated his increasing concern with rising inflation, but again his actions belie his words.  He allowed that the FOMC "could consider an increase of 50 bps at the May meeting (May 2-3), but that decisions are made at the meeting, and meeting by meeting."  Once again, Powell failed to deliver a clear roadmap to the market of the Fed's interest rate policy.   

As an economic fact, the Fed remains in a stimulating posture until the short term rate reaches the "neutral" rate, assumed to be over 2%.  At the moment, the rate stands at 0.5% and even with a 50 bps increase will still be only 1%.  The result is further simulation of inflation perhaps through the summer.  Even after reaching neutral, presumably, the Fed will have to at least gently restrain the economic in order to restrain inflation (the "soft landing").  If this is to be achieved, the Fed Funds rate would have to reach closer to the neighborhood of 3%.  Again, when will the Fed get to that point?  If it is not until late 2023, as indicated in the last Fed minutes, inflation can be expected to gain force through all of 2022 and most of 2023.  I am not an economist but this seems unwise. 

Further, the FOMC and Powell have not made any definitive statement about Quantitative Tightening.  The minutes suggest 90B per month will be allowed to roll off the Fed's balance sheet.  While one could debate the apprpriate size of the Fed's balance sheet, clearly $9T is too high.  At the rate of $90B per month or a little over $1T per year, it would take 7 years to reduce the Fed's balance sheet to the pre-pandemic level.  

Another economic fact: the markets will do some/all  of the work of the Fed and increase rates through the yield curve IF (note the capital letters) the path, and ideally, the destination, is communicated clearly.  However, we have had a complete absence of clarity.  As a result, the market remains highly volatile surging in one direction or the other based on threads of perceived information. 

 Netflix has reached maturity

Neflix reported Q1 financial results last night (April 19); the company reported a loss of 200,000 subs for the quarter but guided to a future loss of 2 m subs in Q2.  The market's verdict was swift and harsh, with the stock down by 36% to $222 late in the day on April 20.  The one-year decline is worse, down nearly 60%.  Despite the sharp declines, it is probably not the time to buy the stock.  Compare the stock performance of Meta (FB) since its "adjustment" in Feb 2022 when it reported its Q4 results.  The stock cratered a massive 31%, but since that date has dropped a further 10%. 

During its conference call after the release, the Company flagged 2 interesting issues.  First, its shutdown in Russia cost 700,000 subscribers.  Excluding these subscribers, the Company would have gained 500,000 subs, but still far below the 2.5m that it had guided to.  The second point was that password sharing might account for 100m additional shadow subs.  Of course, it would be great for the Company to find a way to curtail this, but it does not change the fundamental narrative of low future growth.  

These results signal that NFLX has reached maturity.  The days of large subscriber growth are over.  Perhaps this is a result of saturation of its TAM, or perhaps influenced by increasing competition.  One response from the Company was to suggest that it might add an ad-supported subscription to its offerings.  However, this would also come with competition from other streaming services such as DIS and HBO Max.  

As a mature company, the Company needs to change the narrative and focus investors on another metric: either Revenue growth or a profit metric.  The Company has more flexibility with profits since its content spending in 2021 amounted to $17B.  Apple had the same transition when it stopped releasing data about unit sales and focused on Revenues.  NFLX has reached the same point.   

Elon's Next Move

Confidence is the key to takeover battles.  Any Raider needs to project confidence to the "market" in order to muster investor support.  Generally, tender offers are about dollars and cents, but proxy fights, which generally accompany the tender offer and give it more teeth in the face of a poison pill, are about creating a sense of confidence.   

Apparently, Mr. Musk plans to obtain financing commitments and use these to support his bid, either in the tender offer or in negotiations with management.  But to succeed, he must become the "serious" Musk not the flaky "Musk".  This is as much about PR as it is about Finance.  Musk struggles to raise funds

What Will Elon Do Next: a case study in Current Takeover tactics

 

In early April, Elon Musk announced by filing a 13G that he owned 9.2% of Twitter inc (Ticker: TWTR).  On the same day, he accepted a seat on the Board of of Twitter and entered into an Standstill Agreements. Shortly thereafter, on April 9, he terminated the agreement and announced that he would not be joining the Board.

On April 14, Musk announced a proposal to buy the remaining shares of TWTR for $54.20 per share or $43B, a premium of 18% over the closing price of the stock on the day before, but 45% over the unaffected price prior to the announcement of his share stake.

On April 15^th, the Board announced that it would consider Muck’s offer but also announced that it had adopted a poison pill that would, among other things, prevent Musk from acquiring more than 15% of the firm without the Board’s approval. 

Twitter is a Delaware Corporation with a staggered Board of Directors divided into 3 classes with only 2 Directors standing for election in 2022.  Twitter has distributed Notice of its Annual Meeting of shareholders for May 25^th.  Nominations to the Board of Directors are closed (as of Feb 2022)

What will/can Musk do next?

Musk faces some significant obstacles but ultimately should be able to prevail if he is determined to own the company. 

Twitter is a Delaware Corporation.  Delaware is the most popular state for corporate charters in part due to the Delaware Chancery Court which is experienced in resolving issues of corporate law and has a well-developed law governing corporate takeover battles. 

Nominally the two major obstacles facing Musk are the Poison Pill and the fact that Twitter has already filed notice of its annual meeting to elect directors for May 25^th, and other nominations for Director are now closed.

Musk’s options include the following, which could be taken simultaneously or separately:

1.       File suit in Delaware Chancery Court asking that the Pill be redeemed by the Board or be declared invalid. Under Delaware law, the court will apply the standard of “enhanced judicial review” from Unocal.  Unless the Board is prepared to announce an acceptable price as required under the Airgas case, it is likely that Musk will eventually prevail. 

2.       Make a Tender Offer for any or all shares with a 51% minimum condition, although this would have to be subject to redemption of the pill.  To do so, Musk would not have to have procured financing but only a “highly confident” letter from a credible investment bank.

3.       Launch a proxy fight in the election of the two directors standing for election and ask shareholders to cast a NO vote on those directors.  This is unusual since Musk could not nominate his own Directors, but by obtaining a majority of the votes, he would force the Nominees to resign, which is required under Twitter’s Bylaws and market practice.  This would not directly gain control of the firm but would send a strong message to the Board and would most likely decide the battle.

Musk’s best option is #3.  To give his proxy fight more credibility, Musk should take actions designed to reinforce the view that he is fully prepared and able to buy the company either alone or in conjunction with a financing partner.  Given Musk’s personal wealth, management credibility and obvious connections in the financial community, this should be achievable.