Markets have been off to a nice start to begin 2023.  Today’s CPI was quite positive, increasing by 6.5% from a year earlier, marking the sixth straight monthly deceleration since peaking in the middle of last year.  While 6.5% is still an ugly number, which I know we all feel when we go out to dinner, or shop for groceries, the downward trend is building momentum.  Core CPI, which strips out food and energy, rose by 5.7%, from 6% in November.  Clear signs of inflation easing can be seen in used cars (down 6 months in a row for biggest decline in history according to Mannheim), shipping prices, energy prices, and now we are seeing rent and housing prices declining a bit.  Food inflation is a big problem, as you can see quite clearly if you’ve tried to buy eggs at the grocery store.

There is an interesting dynamic as the inflation data is improving, but the unemployment rate is still sitting at 3.5%, which is incredibly low.  That is a pretty optimistic setup on the surface, but most people believe we will go into a recession later this year.  As the old saying goes, “a recession is when your neighbor loses their job, a depression is when you lose yours.”  Different industries will be impacted disproportionately in any potential recessionary scenario.  Housing and mortgages are already tilting into a recession.  Tech layoffs are pretty substantial.  Many people are canceling their new home purchases, or negotiating for pricing discounts.  While backlogs are still big, construction at some point will be impacted. Meanwhile, travel, entertainment and leisure is booming, as global markets continue to open up with less restrictions.  Office buildings are priced as though they are shopping malls during a pandemic/lockdown and that few people will continue working in them.  Opportunity arises by taking advantage of the disconnect between price and value.

Most people seem to be bullish on energy prices and I’d find myself in that camp.  However, energy stocks roared last year and haven’t really come down materially despite big declines in both oil and natural gas prices, so the market is expecting those prices to rally.  If oil and gas don’t perform well this year than those energy stocks might be due for a correction.  Conversely, bank stocks are priced as though we are going into a Great Recession, despite solid credit performance and booming net interest income and trading.  If we don’t see a recession where unemployment meaningfully picks up to 5.5-6%, these prices will seem unreal when people look back given the strong financial/business performance we are seeing.

Big cap tech is getting more and more attractive despite revenue headwinds, such as weak advertising revenues, and slower consumer spending.  I think investors need to pick and choose though, as some of those stocks still seem too expensive in my eyes.  Google and Meta remind me of Microsoft around 2013-ish, when we owned it at 11 or 12 times free cash flow, which was enormously attractive.  Tesla and even to some extent Apple aren’t as obvious of values to me, though I’m always hesitant to bet against the Apple machine.  Amazon is expensive on conventional value metrics, but when you make some adjustments for capital spending and R&D that will bear fruit for decades, I think there is good opportunity there.  Using options to manufacture cheaper entry prices and/or dividends via covered calls is such a great way to play these names.  Google, Meta, and Amazon don’t pay dividends but we can sell covered calls way out of the money and manufacture a 4% yield to go with 30-40% upside, which is a great risk/reward scenario.

I’m glad we took advantage of the bond selloff last year and were fortunate in our timing as yields have come down quite a bit.  We will continue to look for opportunity there where it makes sense.  Selling deep out of the money put options on deeply undervalued stocks remains the best risk-adjusted return in my opinion, as I don’t think the market is that cheap on an overall basis, so creating a larger margin of safety is prudent in this environment.

Bank earnings start tomorrow, so I’ll have plenty of updates for you! Below are our three most recent research reports on Bank of America, Capital One Financial, and MGIC Investment Corporation for you to review at your leisure.

Bank of America

 

Capital One Financial

 

MGIC Investment Corporation