A recession is coming. Stock markets will decline, possibly a great deal.
Investors that sit tight and don’t sell their investments will have temporary losses as markets will eventually recover. The astute will capitalize on the carnage and enhance their long-term returns thanks to purchases made during the market decline. That is, post-recession trailing multi-year returns will be higher than otherwise for the opportunistic investor due to an upgraded collection of individual investments. And then, countless other investors all over the world will lose a lot of money. That much is certain.
What isn’t certain, is when any of that will happen.
A recession could start in six months, or next year, or in 2030. Do you remember the constant calls for a new recession and bear market from 2009 all the way to 2020? It took a pandemic to finally end the last decade-long economic cycle.
There are helpful indications of a topping economy and the potential for a bear market. But even if all the historically leading economic indicators were pointing to recession today (and they’re not), the duration from signal to a recession has varied considerably, from months to multiple years. When the risk of recession rises considerably, our best bet is to go on ‘recession watch’ and to handle ourselves with an extra bit of care. But there can be no all-or-nothing approach.
Howard Marks in his book Mastering the Market Cycle puts it like this:
“In my view, the greatest way to optimize the positioning of a portfolio at a given point in time is through deciding what balance it should strike between aggressiveness and defensiveness. And I believe the aggressiveness/defensiveness balance should be adjusted over time in response to changes in the state of the investment environment and where a number of elements stand in their cycle.”
Perfect reasonableness from a world-class investor.
Over the last couple of months, I’ve seen a surprising number of headlines suggesting an imminent recession and bear market. I’m fielding more questions about it too, so I thought I’d spend a little bit of time sharing my thoughts on the aggressiveness/defensiveness posture we have today and why.
To be clear though, I am not an economist. I am not running a macro fund. I am a long-term investor looking for the best individual companies that we can own over the next five, ten, and twenty years.
To start, I’m not even on recession watch. And it wouldn’t matter much if I were unless the world were one big economic bubble, overproducing and substantially overvalued. Below, I’ll show you why I don’t think that’s the case. So, while a typical recession–and the bear market that typically accompanies them–could be on the way, I view it at worst as an unfortunate, but totally compulsory stop on the road to above-average returns. Fear them? No. Capitalize on them.
The View From 30,000 Feet – The U.S. Economy Today
Really bad recessions and bear markets are due in large part to oversupply and unsustainable demand that comes crashing back to earth. As the table above shows, we’re not building too many houses, selling too many cars, spending too much on capital investments, and overearning profits. Which means, when a recession eventually does happen, it’ll probably be mild. So that’s good news.
Some will argue that stock markets are expensive when compared to historical valuations. On the surface that appears true, as valuation ratios on expected earnings (which might be too high anyway) are above long-term averages.
But if we dig a little deeper, there are plenty of attractive opportunities outside speculative tech. For instance, I’ve found very good value in industrial distribution, banking, home improvement, and advertising.
Also, statistical measures of valuation like the P/E ratio should be expected to vary over time. Some still anchor to averages from 50 or more years ago. Think about that. Should stocks trade at the same valuation as they did in 1980?
Are we really supposed to believe that businesses like Google or Facebook, which turn 20% to 30% of every dollar of revenue into free cash flow, should trade at the same P/E as the typical company from the 1980s? I don’t think so. It is a different ballgame for these businesses. And today those two and others like them make up a pretty large percentage of the U.S. stock market.
Broad market P/Es should therefore be expected to be different from the 1980s. I still think U.S. stock markets are likely to deliver below-average returns over the next decade. But the situation isn’t as dire as some would have us believe.
Even so, it doesn’t matter all that much to us. We don’t own the stock market.
On the Ground Assessment – Our Portfolio
Right now, about 85% of our portfolio is in our top 10 holdings. While the stock market’s direction acts like gravity on our portfolio over the short-term, given enough time, our returns will eventually mirror the internal compounding of the business value of our holdings.
I expect several of our top positions to have returns upwards of 30% per year over the next three to five years. In aggregate, our portfolio has an expected annual return of over 20%. I’ve been very bullish since the worst of the pandemic. I remain so, despite the many challenges our world is facing (war, supply chain shortages, disease, inflation, pivoting monetary and fiscal policy). Why?
We own essential businesses with secular growth opportunities, good returns on capital, the potential for high free cash flow, at valuations that fail to flatter. Why would we sell these, in my view–high probability investments–at the first sign of the potential for an eventual likely-mild recession? A recession would only delay the inevitable, a mere speed bump on the road to high long-term returns.
To sum up, at this point, a recession starting in the next year isn’t that high a probability. Most leading indicators are still generally positive. Parts of the yield curve have inverted, but many other parts of the curve that are arguably more important haven’t. For some reason the more important and still-highly-positive portion of the curve fails to get much media attention.
The economy isn’t overearning and overproducing and is instead generally strong but dealing with supply chain issues and war that are exacerbating inflation. That should improve in the months and years ahead.
We’ll have to see how the economy takes rate increases and how inflation responds to tightening monetary policy while at the same time supply chain issues improve. Just maybe, the Federal Reserve can pull off a soft landing. Who knows?
But in the meantime, we have in my view a world-class portfolio with very high expected returns. A recession would certainty negatively impact us. But I think I’d also find enough to do within a major market decline that we’d come out of it with an even higher long-term return than if recession is delayed. So, I’m at peace with whatever may come. My hope is that you are too.
Thank you for your continued trust.
EMERGING MANAGER OF THE YEAR
Just this month, Black Cypress won Emerging Manager Monthly’s 2022 Emerging Manager of the Year Award for U.S. large-cap equities. Over 400 manager strategies were considered. The top three managers in each category were reviewed by a committee of industry experts that evaluated the merits of each firm based on quantitative and qualitative measures. And we won!
Emerging Manager Monthly, owned by FIN News, is a publication that focuses solely on the emerging manager space (managers with less than $2 billion in assets under management). The publication makes this award annually. EMM has over 7,000 readers, including other managers, allocators, and institutional investors.