There is a saying on Wall Street, “There is a bull market somewhere go find it.” This year it’s
hard to find one. Stocks are down, bonds are down, cryptos are down, gold is down and that
leaves oil and grains as the only bright spots. We own a lot of commodities so that has helped,
but it didn’t offset the other groups’ decline. We will elaborate on that in this letter.
After three good years in the market, our accounts were due for a decline, and we got one. This
year will be the fifth worst market for a combination of bonds and stocks since 1900. This will
be the worst year for U.S. Treasuries on record. The S&P 500 will finish down around 20%,
which puts it squarely in the bear market category. The Nasdaq will finish down over 30% this
year. As we wrote in our last letter, we think a fair value for the S&P 500 is 3600. We are
trading at 3800 now. That implies our risk from here is 5% if everything goes according to plan,
which as we all know never does. Could we go lower? Sure. Will it stay below that level? We
don’t think so.
The Federal Reserve will continue to raise interest rates until something breaks in the economy.
With rates on the short end now at 4.5% we think that we are close to the breaking point.
Housing has slowed down. Layoffs have begun particularly in tech companies and job openings
nationwide have started to decline. At some point this will stop the rate rises of the Fed and the
markets will respond positively. We don’t expect rates to suddenly drop on the short end, just
stopping going up will do the trick. We think rates at 5 to 5.5% are the top in this cycle. If that
number is reached, we think it will be in the first half of this year, assuming we have that right,
then what?
There have been 11 years since 1900 where the market for both stocks and U.S. Treasury Bonds
have been like this year. The average decline was -17% (this year we are at -14%) in those 11
years. The next year the average rally was plus 13% with only one year being a down year. That
year was 1931 when bonds and stocks lost -31%. The most recent years like this one were 2002
and 2008. In those two years a 60/40 stock bond portfolio lost 8% and 17% respectively. In the
following years of 2003 and 2009 those portfolios were up 17% and 11%. Our base case for
2023 is an up year for the markets. What about our stocks?
Let’s start with the biggest losers for this year in our accounts. Tesla is down over 70% this year.
Most of that occurred in the last eight weeks of the year. It’s hard to talk about Tesla being a
loser for us when we took profits on it in 2020 and 21 but 2022 was a mess. Operationally the
first three quarters of this year were good. We think Q4 will indicate a slowdown in demand in
China. This is going to affect them, but we don’t think it’s their biggest problem. When Elon
Musk bought Twitter, he had to sell some Tesla stock to finance it. The markets are trying to
figure out if he will be forced to sell more Tesla to fund those operations or not. The stock has
cratered 45% in the last six weeks to make it harder to fund Twitter. Hedge funds are also
shorting the stock to see if they can possibly trigger a margin call for him if the stock goes below
$100. We don’t think Musk’s tweets on non-car issues are helping people want to buy a Tesla.
We are hoping he gets a new CEO at Twitter and spends most of his time at Tesla. Until that
happens this stock is going to be very volatile and unpredictable. We continue to hold the stock
and have been buying some in this decline.
Lumen eliminated its dividend this quarter. We thought they would cut it in half (pay one billion
a year) but they didn’t do that. Instead, they announced they will buy back $1.5 billion in stock
over the next two years, which would shrink the float of the company by 25% to 30% at today’s
prices. We will see what their guidance is for the year when they report in February before
commenting further. We have them with free cash flow in 2023 of $500 million to $1 billion.
Depending on the amount of stock they buyback that would be 50 cents to 1.33 cents per share
in free cash flow. That said, nothing has been easy or good with this stock and count us as really
frustrated with this one. This stock has been a big loser for us this year.
Our inflation hedges were up for the year. Our oil stocks, gold stocks, steel stocks and Latin
American stocks were all up for the year. We own these stocks as a substitute for having that
money in cash. We think those stocks will do better than what we get paid in a money market.
That worked out well this year. We expect another surge in oil which will move these stocks
higher in 2023. If we get that right, we plan to sell some of these stocks and redeploy the
money in other areas.
We have owned Apple’s stock for almost 10 years now. It was down over 25% this year. We
continue to see them with an advantage that isn’t easily attacked by competition. We do think
the supply-chain problems China are having will slow the development of new phones in the
future. That slowdown will be offset somewhat by the gains they are making in services being
sold over the phone. Of all the tech stocks we follow, this one has performed the best this year.
That said, down 25% isn’t what any of us want.
We own a bunch of large money center banks as a play on rising interest rates. We got interest
rates going up right, but not the direction of the stocks. As a group bank stocks were down
about 20%. The investment community is convinced that loan losses are going to rapidly
accelerate and hit the banks’ balance sheets. If we were in a deflationary environment, we
would agree with that. Because we are having inflation above 5%, we don’t. This is a position
that will be sold in time if we get the right prices for them.
The world is convinced that we are going into a recession in 2023. It’s the base case for almost
all investors today. Hence the decline in stocks this year. The treasury yield curve is inverted
(long rates are lower than short rates) the most it has been in almost 40 years. Inverted yield
curves are usually a precursor to a recession. We think the economy will slow down in 2023 but
not enter a recession like 2008-9 or 2001-2. We think THIS economic slowdown is more related
to an inventory correction related to the supply chain than to an evaporation of demand in the
US. A lot of companies double-booked orders to get products when the supply chain messed
up last year. As the transportation crunch ended, so did their need to have too much inventory.
We saw this first hit in the big retailers who sell a lot of products from China. The other area
was semiconductors in cars. Those two areas were the worst hit and now appear to be running
normally. When companies go back to normal ordering patterns, we see that moderating the
slowdown in the economy in 2023.
We bought more Data IO and Transocean this quarter. Data IO should benefit from the
semiconductor shortage turning into a glut. Transocean should benefit from the world
resuming drilling for oil in the oceans. Both reported very good third quarter earnings.
What are we looking at these days? We have started looking at growth stocks and tech stocks
again. This is a year when the average tech stock is probably down over 50% from its highs if
not 70%. This was an extremely popular trade going into 2022 and it blew up. We are looking
for survivors in this group. Should we get the sells right on banks and commodities this might be
an area where the money goes. Stay tuned.
Our last comments are about our philosophy on how we view stocks versus other investments.
We will steal a quote from Buffett here which was, “In the short-term markets are a voting
machine, in the long-term they are a weighing machine.” What does that mean? In the short-
term where a stock goes in any month or quarter is just a function of order flow. If Wall Street
likes it, they recommend it and the stock has buying pressure. If they hate it, the opposite
happens. However, in the long run the earnings of the company will OUTWEIGH the short-term
popularity or order flow of the stock. Let’s give you an example. If company A is trading at $10
and it earns $1, that company is basically earning its investors 10%. If the stock drops to $8 but
it still earns that, $1 it now is earnings you 12.5%. As the money piles up inside the company
the WEIGHT of those earnings will eventually overcome any sentiment issues or order flow
(voting in his words) in the short term.
When we look at investing your money, we try and find companies that we think will earn 8% to
10% for you. If we get the earnings estimates roughly correct, it’s just a matter of time until the
stock reflects those earnings in a positive way. For the last 12 years interest rates have been
basically zero on the short end and that made owning stocks an easy call. With rates at 4.5%
today it’s harder. When we sold parts of Tesla and Apple in the previous years, it’s because the
yield we were getting had declined and the growth rate that it needed to grow to get to an 8%
or higher yielder with us was too optimistic. At the time we sold them, the stocks were
skyrocketing. Today they aren’t. It’s this balancing act between what you pay for something and
its growth rate versus the risk-free rate of Treasuries that makes this at times more of an art
than a science.
We mention this because when you have a crummy year like this one based solely on the price
of the stocks we own, it seems stupid to own anything. In our view as the WEIGHT of the
earnings keep piling up in our stocks, good things will eventually happen. What day or quarter
or even year depends on when these stocks become popular. It gives us comfort in this rotten
market to see the money pile up and know it will be put to good use at some point, either
through dividends to us or stock buybacks. Buffett was right; it’s a weighing machine but
weighing machines don’t have calendars on them. The timing will be a guess on when they
become popular.
We hated to cancel the Holiday Party. The prospect of minus 40 degrees wind chill was too
much for us to ignore. If any of our clients had been injured because of this, we would have a
hard time forgiving ourselves. Three inches of snow we can ignore. Possibly dying in freezing
wind chills, we could not. You will receive a gift in the new year as our thank-you for hanging in
there with us this year.
Sincerely,
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR