Predictions

I wanted to publish this in January and I never got to it. There’s eleven months left until 2023. Better late than never. My figured my crystal ball can’t be much worse than the experts.

I would hate to be a financial strategist. Expectations are sky-high. At the beginning of each year you have to make ridiculously precise predictions about indexes, commodities, and provide some wisdom on how to achieve world peace. How do you keep a job like that?

I’m always reminded, when I read previous expert predictions, of just how hard it is to predict the future. Two years ago, none of us predicted Covid. Last year, no one predicted the levels of inflation that we’re seeing now, although some of us talked about the risk of inflation.

It’s important to be humble. Here’s the takeaway: Making predictions about the future is a fool’s errand, planning for the future is not.

For the purpose of fun, I’m going to give it a shot.

S&P 500

Target: 4500. Yes I think the market will finish in the positive (~4325 now). But it won’t be a smooth ride. 

The Fed is taking the punch bowl away. The pandemic-era party appears to be ending. Stocks, bonds, crypto, you name it—almost every asset class has hit a rough patch since the beginning of the year.

I think the market will “correct” from rate hikes and recover towards the end of the year.

Why 4500? Estimated earnings of $225 with a multiple 20x = 4500. The genius: I like round numbers. So expect some big ESP surprises.

Interest Rate

5 rate hikes max. The 10-year T-Bill will finish at 2.5%. It might trend higher during the year but will probably trigger a negative response and withdraw. Inflation should also normalize (come down) in the 2nd half of the year. More on that later.

If the Feds are too aggressive they risk inverting the yield curve, which would flash warning signals about a looming economic contraction. They don’t want to kill the recovery and some inflation is welcome.

Inflation

The key question was “Will the inflation be transitory, or can the Federal Reserve still rein it in?” Well you don’t hear the word ‘transitory’ anymore.

My sense is that inflation in the second half of the year is going to come down more rapidly than the typical media reports suggest.

Many of today’s headlines are just wrong. They take an overly simplistic view of what is happening. The inflation data, for one, overstate what’s going on. Of course I recognize that there has been an increase in core inflation, and that wages are rising. I shop and buy groceries like everyone. My bills are not going down.

But we have to recognize that much of the increase in measures like the government’s CPI comes from factors that are one-time events. There has been a huge increase, for example, in the price of used cars. Well, families don’t buy cars every year. There has also been an increase in home prices, but homes are not recurring purchases. 

Remember inflation is a year-over-year phenomenon. If oil goes from 50-100 in a year, that is +100%. If it stays at 100 the second year that is 0.0%. We are going to see inflation data come down. 

The best starting point from which to consider this is the bond market’s current expectations, which are for the Fed to indeed stick the landing; in other words, the market thinks that inflation is most likely to recede over the coming years and be close to 2-3% annually in five years. Perhaps it is the huge collection of assets sitting on the Fed’s balance sheet providing the market comfort that a path to quickly remove liquidity exists if need be.

Oil

I want to go with the  classic safe answer of “between $50 to $100 per barrel”. But that’s no fun. My job is not on the line here. I’m not on TV or popular magazines. It’s a blog. My blog.

The narrative is that market dynamics will keep pushing prices higher, well above current levels around ~$93 a barrel. Some analysts are saying $100 oil is just the beginning. The thesis is there’s simply not enough oil being pumped and demand is growing fast.

I’m going to go against the grain on this. Being an oil contrarian has paid off in the long term. Oil prices is one area where it seems that all the experts agree and that’s scary. I’m not an oil expert, so I think oil prices will go down by the end of the year. The thesis: Not supply and too much demand, is already incorporated in the price.

Traditionally speaking producers respond to high oil prices by over producing, which hurts oil prices. That’s why the cure to high oil prices is higher oil prices. Normally, a US$100 a barrel typically would spark a frenzy of new drilling. Producers get greedy and flood the market. It’s true that producers haven’t responded to high oil prices like in the past because of ESG concerns. 

They are also more disciplined. Because of past boom and bust energy producers are more conservative and preach disciplined capital allocation. Companies have committed to higher production. Not the kind of increases you would have seen in the pre-covid past, but a more measured production raised. Producers care more about having a decent return on their capital than trying to win market share at any cost. Cash flows will go back to investors through dividends and buybacks instead of more CAPEX. A balance market is better long term. A bust brings too much damage. But producers will eventually respond to the market. These prices are too good to pass up and the more they go up the more it weakens their discipline. It just will take a little longer.

There’s a failure of the analytical community to look at what’s happening on the ground, to look at projects that have been reaching final investment decisions, to look at where the efficiency of capital is. 

Capital spending levels don’t reveal very much. After the last oil crash companies have gotten much more efficient, reducing the cost of finding and development by more than half in the past few years. So every dollar they spend is going a little further, meaning production can rise without very much spending. 

Oil is a wild card. Analysts are calling for $100 oil. I wouldn’t be surprised if it hits it and goes higher. However I think it will trend downward. Yes the amount of CAPEX to pump oil out of the ground is down compared to other peaks. But I think what the market underestimates is how much more efficient they have gotten since 2014 and how much costs have come down. 

$100 oil is possible. Will it stay there? I doubt it. Expect supply of 101m-102m barrels of oil per day and demand to match it. But I think  that U.S. companies will boost production by more than 1 million daily barrels a year and the rest of the planet will respond. Prediction: $70! But of course a war or some black swan event is on the menu.

(Update, a few hours after writing the previous lines Russia sent troops in the breakaway regions of Ukraine. Fear of disruption in the energy market sent energy prices way up)

Gold

I have no clue on how to value gold. There’s no cash flow and there’s an esoteric feel to it.

We are in a period of “high” inflation, unrestrained government spending and the debt pile is getting higher. Central banks have been virtually “printing” money. Yet, the price of gold hasn’t responded. It has been trading sideways for over a year. The traditional thesis of 1) Inflation protection and 2) Alternative to the debasement of fiat currency is not working. You can also add geopolitical tensions and potential war to the mix. I’m not sure if I get it. 

My suggestion is to avoid the commodity directly (unless you are buying jewelries) and look at producers and royalty companies. They make good money at this rate.

My bet: Gold will finish the year below $2000/oz. Why? The central bank will raise interest rates and “restore” a little bit of trust in the dollar. 

Cathie Wood

This part is more opinion than a prediction.

Cathie Wood, the star fund manager and chief executive of ARK Invest, is the investment icon of the pandemic era. She crushed it in 2020. She was the winner of the pandemic. ARK’s seven ETFs returned an average of 141% in 2020. She was the toast of Wall Street.

But Wood has had a tougher time in recent months. The ARK Innovation ETF (ARKK) is down 31% in 2022. It has lost more than 56% since its peak a year ago. And most of her investors haven’t done so well because they piled in at the peak of her performance.

Why am I bringing her up?

As a valuation professional it’s frustrating to watch. People have invested their retirement money and their kids’ education money in her ETFs.

Look I don’t like to see somebody losing money. It can happen to anybody. But there’s a little bit of “I told you so” in ARK’s debacle. We have seen this tape played many times in the past. Her MO is concentrated investments in companies with neat ideas and zero earnings, with astronomic valuations (if they can be measured at all). This is a recipe for disaster because 1) when companies don’t live up to their prospects (e.g. Peloton, Roku…) and  2) when rates rise, and they will, it will hurt the present value of future cash flow. And all of Wood’s investments rely on the future profits in years to come. 

At the end of the day valuation matters. Fundamentals matter. Cash flow matters. Profit matters.

Prediction: More carnage for ARK.

Russia-Ukraine War

Russia won’t do a full invasion of Ukraine. The cost is too high. Instead it will support the separatist regions and will never stop harassing Ukraine through different means (cyberwar, coup, rigged election, propaganda etc…).

(Update, a few hours after writing the previous lines Russia sent troops in the breakaway regions of Ukraine. I still don’t think a full invasion will happen.)

Summary

The market could be in for a wild ride. At least for the first half of the year. The Fed indicated that it was heading for earlier, faster interest-rate increases and an eventual reduction of its balance sheet.

In a world of zero interest rate, it’s the more speculative of the speculative that worked. I sat that out. Why? Because valuation matters. The price you pay determines your future return. Now the tide is turning.

With rates rising I see a big shift coming in the investment narrative from a focus on the central bank’s balance sheet to a focus on companies’ intrinsic value. Cash flows, business fundamentals, and valuation considerations will be a greater driver of returns as the Fed potentially contracts the balance sheet. 

Wall Street and the financial media are fixated on the Fed. Business owners and Entrepreneurs view things differently. They say, “If I can’t make money with all this liquidity and super low interest rates, I should go out of business.”. Focus on the businesses.