“I think we’re still playing for ultimately the market is down 30-50% from its peak because
multiples still have to go down a lot more before this is all through…”
– Welcome back to the savviest 18,000 subscribers
out there!
You guys are amazing.
Now, Dan Niles is a hedge fund manager famous for anticipating the Covid Crash in March
of 2020 …among other things.
He’s been on Wall Street since 1990 and managing his fund since 2004.
In a recent interview, he discussed his views about our current downturn.
Against the constant flow of optimistic economists and investment analysts regularly predicting
that the bottom is in, Dan was able to mathematically articulate how much further you can reasonably
expect this market to go down before its ultimate capitulation.
I thought that would be helpful for you all.
As long-time viewers probably know by now, I appreciate a sound mathematical approach.
And if you’ve read my book, you know that and that I abhor the set-it-and-forget-it,
head-in-the-sand advice constantly shoved down your throat by mainstream pundits and
unoriginal advisors.
I’ve recommended you proceed with caution.
I’ve warned about the risks of inflation.
I’ve talked about the imminent recession.
I’ve advised only investing in things you truly understand and only after you’ve played
out in your mind the possible downside risk scenarios as well (in addition to the upside
scenario you’re anticipating).
Niles does a great job of articulating why I feel this is especially important right
now.
Here’s what he said when asked about the way the market has been behaving recently:
“I think this reaction to the Fed is relatively predictable.
Because if you look back over Jerome Powell’s history at the Fed, you know, when the stock
market has been up at least 1% during one of Powell’s meetings, the next day it’s
down 5 out of 7 times.
And if you even think about May, it bounced 3% the day of the Fed meeting and the next
day it went down 3.6%.
So this is a pretty predictable pattern.
And I think right now the stock market is dealing with the fact that you don’t want
to fight the Fed - just like you didn’t want to fight it for the last 13 years when
they were excessively loose.
And you don’t want to fight the fundamentals because numbers are continuing to come down.
So for us, we’re still pretty cautious.
We have over, I think, 15% of the fund is sitting in cash.
We have a fair bit of longs, um but, we’ve balanced that out with a fair bit of shorts.
And I think we’re still playing for ultimately the market is down 30-50% from its peak because
multiples still have to go down a lot more before this is all through.
That doesn’t mean you’re not going to get great bear market rallies along the way,
but that’s the ultimate what you’re playing for and what you don’t want to lose sight
of.”
If you’ve only been investing for the last 13 years - and honestly, my tenure (as an
adult in the stock market at least) is only slightly longer than that - but if you’ve
only been investing since after the lows of the Great Financial Crisis, you’re only
familiar with how the market behaves when the Fed has an extremely loose monetary policy.
When money’s cheap - interest rates are low - that creates an environment that supports
more and more zombie companies - companies that only lose money - for longer and longer.
But a tighter monetary policy - which again, we haven’t really experienced since before
the GFC - a tighter monetary policy kills the weakest of the zombies, severely cripples
the others, and brings the valuations of every company back down to earth (at least from
a historical perspective).
So at that point it becomes incredibly important that you understand fundamental analysis.
And as we’ve gone through some pretty detailed stock deep dives here on this channel, you’ve
seen exactly how I like to break out and scrutinize those fundamentals and critically think through
the different scenarios that might play out in the future.
I love the math of it all - I love … logic.
And here’s how Niles breaks down the math behind the broad market’s fundamentals:
“Let’s just take the valuation part: do we sink below the pandemic low of 14.7 times?”
“Well absolutely.
Because if you kinda think about it.
If you look back over 70 years worth of history when the CPI is above 5%, the S&P trailing
PE is 12 times.
If you want to be completely optimistic and assume somehow you get below 3% in the near
term, the trailing PE multiple is 15 times.
You’re at 19!
So to get from 19 times to 15 times, you still gotta go down 20%.
You wanna get back to 12 times which is the average when it’s above 5 - and obviously
we’re above 8 right now - you gotta go down 35%.
So… and that’s not taking into account the fact that I think a majority of companies
are going to have to cut their numbers when they report.
Don’t forget Target guided lower 3 weeks after they gave guidance.
Microsoft did it 6 weeks after they gave guidance.
Intel sort of soft pre-announced 6 weeks after they gave guidance.
These are massive companies that came out very quickly after they’ve already guided
to cut numbers again.
And I think it’s going to get worse when you see what Q2 results are for the market
in general when all these companies have to report and guide.”
Did you get that math?
The PE ratio is Price over Earnings.
Right?
So, the Price of the S&P 500 index is that number you see floating around.
Right now it’s in the mid-to-high-3,000’s.
Its intraday all time high was just a little over 4,800.
Right, so that’s the Price part of this equation.
The Earnings part is made up of the relative earnings of all the S&P 500’s component
parts.
So for the price of the market to come down - most people use the S&P 500 as the most
representative gauge of the market - so for the price of the market (or the S&P 500 index)
to come down, either the multiple is going to come down OR the E in this equation - the
earnings - are going to come down.
Right now, we’re faced with compelling reasons to anticipate pressure on both.
Right?
There was the historical precedent Niles pointed to for a lower multiple today.
AND we’re regularly seeing earnings fall - quite obviously faster than even the companies
themselves were able to anticipate!
So Dan here is working through the math with us.
Even if earnings stay the same, to go from a 19 multiple on your PE ratio down to a 12
multiple - that’s another 35% drop.
And remember, that 12 multiple is a historically relevant multiple for when the CPI is over
5.
And we’re over 8 right now!
So, that’s one aspect of this calculation that is still on the conservative side.
We actually don’t have much precedence for what happens when inflation is actually THIS
high.
The other aspect is - as Niles points out - the earnings.
If those continue to fall in tandem with the multiple - as they likely will given the inflationary
and recessionary headwinds - that mathematically results in an even greater move downward.
So how far could this go down?
Do we just wait until we’re down 50% from the highs and then magically we’re good
to go?
(… stupid question John…)
“We’re about 35% off the Nasdaq November high, I think.
I think we’re almost 25% off the S&P’s, so we’ve only got 300 points to go on the
S&P before we’re in your zone.
Right of 30-50% down from the peaks.
At that point, do you shift your strategy at all?”
“Well it depends on what the fundamentals are doing, John.
I mean, if you think about, you know, when the Tech Bubble burst, it took 2.5 years to
get to the ultimate bottom.
Now, same thing with the Global Financial Crisis, it took a while.
But it didn’t mean you didn’t get 5 rallies between 18 and 21% on the S&P 500 - five separate
rallies of 18-21% - while you lost 50% of your money over that period of time.
So you’re going to get some bear market rallies, sucker rallies, dead cat bounces,
whatever you want to call it on the way lower because every three months or so companies
cut their numbers when they report.
They say, ‘oh yeah…’ and investors go, ‘oh my God, this is the bottom, it’s a
buying opportunity, the stocks are so low.’
And then the fundamentals keep getting worse and then they go lower again when they report
another 90 days later.
And I think that’s what you’re in for right now.
So, I’m watching the fundamentals to tell me when the ultimate real bottom is.
It’s not so much the price.
But there’s a time component of this that I think - unfortunately for investors, if
you haven’t been investing for longer than 13 years - which is the period of time the
Fed’s been just pumping up the economy anytime there was a problem, driving valuations absolutely
crazy - you don’t realize that it can take you a year and a half to 2 years during a
recession to find the ultimate bottom.
I think that’s what we’re in for because the central banks have just started to raise
rates.
We’ve got a lot farther to go.”
I think Mr. Niles is right.
I think, at this point, what he is outlining is the most probable outcome.
But of course, there are no guarantees in the world of investing or economics, just
probabilities.
And, I do think there is one possibility here worth mentioning.
It’s the possibility that (sooner rather than later) these central bankers start to
loosen their policy once again.
They are kind of trapped between a rock and a hard place - I mean, they dug themselves
into that place, so I don’t feel bad for them - but that is the reality.
With our national debt where it is today, there’s only so far the Fed can push rates
up to realistically fight inflation and it still be sustainable for us as a country.
If you don’t know what I’m talking about, watch this video next.
When choosing between recession/depression or just prolonged inflation (and probably
still recession, honestly), I think they’ll end up HAVING to lean into the latter.
Either way, it’s going to benefit you to understand all this and be prepared.
I hope I can help.
I wish you all the best.
Take care.