In early 2023, we have seen a bit of a return of the speculative euphoria that was so pervasive in 2020 and 2021, which has driven up asset prices once again. Market participants are more optimistic about things based on the belief that inflationary pressures are headed far lower, which should result in the end of Federal Reserve rate hikes. While I’d put myself in the camp that believed a mild recession was likely in 2023, the reality is that the economy has shown signs of strength early this year. Car sales, consumer spending, and even real estate is firming up a bit relative to expectations. While these are positives for the overall economy and likely will prolong a true entry into a recession, it could also keep inflationary pressures, and in turn interest rates, higher for longer. Today the Consumer Pricing Index was a bit hotter than expected highlighting the stickiness of inflationary pressures.
In this context, it is important to think about who this benefits and who this hurts. Commodities were by far the best performers last year, as higher prices resulted in surging profits. Financial stocks also saw their businesses perform really well, as earnings were bolstered by higher net interest and investment income. Both sectors should continue to benefit from these dynamics in 2023.
While many of the more speculative tech stocks have been bid up to start the year, higher rates for longer could keep pressure on their price to earnings multiples. Speculative stocks trade at high multiples on the idea that their earnings will grow rapidly over the future. A stock trading at a p/e multiple of 50 per se, only has an earnings yield of 2%, which is the inverse of the p/e ratio. A stock trading at 10 times earnings has an earnings yield of 10%.
The higher interest rates are the greater the opportunity cost is of forgoing near-term earnings. The company earning the 10% per annum could reinvest those funds in higher-yielding debt securities if they wanted to, while the perceived high growth stock has to keep delivering exceptional earnings growth to rationalize the nosebleed multiple. We saw in 2022 just how many of these perceived high growth stocks crashed 60-80%, highlighting just how extreme the bubble had gotten. Value stocks tend to outperform over the long-term as the expectations baked into their stock prices tend to under-appreciate future prospects, while the growth stocks are valued too optimistically.
At TTCM, we are taking a relatively conservative investment stance in 2023. We are betting big on the screamingly obvious buys that have the most upside with long stock positions. In addition, we are taking advantage of higher yield fixed income opportunities, and we are utilizing our more conservative income-generating options strategies to reduce risk and instill a disciplined purchasing process. These strategies should position us well if inflation lasts for longer than expected, necessitating the need for higher rates. Our investment process is geared towards identifying undervalued securities and utilizing whatever tools best allow us to maximize the risk-adjusted returns on them. This is a good environment for us as the overall market isn’t a screaming buy or sell, so we are able to really focus on security selection and investment tactics. As always, we will keep you posted as things develop, but I just wanted to keep you abreast of some of the recent market developments.