What did we learn this week? (04/20/2023/)-Humility

There is an old saying that you could give the average investor tomorrow’s newspaper and they still couldn’t make money. Well, if someone had a time machine and made me privy to the below chart two years ago, I have to admit that I think I would have lost a little money up to this point. The chart depicts the expected next twelve months earnings trend (blue line) of the large cap info tech sector and the yellow line depicts the rate of change. What the yellow line tells us is that two years ago, Wall Street sell-side analysts were expecting nearly 40% tech sector earnings growth and now they are expecting earnings to decline by 7%. Over that time, these stocks were roughly flat to down 5%. I find that astonishing.

Bottoms-up stock analysts whether in the investment banks, hedge funds or active mutual funds spend their days speaking to management teams and poring over company financials trying to find a variant view of future earnings. That’s it, nothing else. I spent much of my career doing just that: trying to identify companies where the street thought they would grow earnings by X%, but my work suggested that the correct number might be well above or below that. The key assumption is that if you buy a stock that you think will grow earnings by 20% when consensus only sees 10% growth, you should make at least 10%. You might assume more than 10% because companies that are growing faster enjoy higher multiples than companies that are growing more slowly.

The legendary investor Michael Steinhardt was famous for asking his analysts the same three questions every time when they approached him with a long or short stock idea. He would ask: What is the consensus earnings forecast? What is your variant perception of the earnings outlook? What is the catalyst that will make consensus accept your view? Suffice to say that if you had an idea where the current consensus view of the stock’s future was 40% growth, but that in two-years time the outlook would decay to negative growth, Mr. Steinhardt would have been calling his prime brokers to get a borrow on a new short position.

So, why has the tech sector recovered so much when earnings continue to weaken at an accelerating rate of change? Why has the S&P been so resilient in 2023 led by only a handful of mega-cap tech names all of whom are now dealing with far slower growth than what they had enjoyed? These companies should all be in what Vadim Zlotnikov, Head of Fidelity Institutional, refers to as “growth purgatory”, which is the long and painful multiple re-rating period that has historically occurred when growth stocks lose their respective mojo and make the transition to just ordinary growers. The answer is that, while earnings growth is a key factor, it is only one factor that determines how a stock or a basket of stocks trade. There are of course all the exogenous factors having nothing to do with company performance such as central bank activity, fund flows, market narratives, etc. Benjamin Graham once said, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” As of now, the market is voting that we must be pretty close to a bottoming in economic growth and therefore, investors are looking through the “earnings trough” and betting on a re-acceleration of earnings in the future. If that view is wrong, the market will weigh these names at a value that is commensurate to their new reality.

Undoubtedly, the Fed is almost done in what has been the fastest pace of tightening in four decades. Futures markets are pricing in the Fed cutting rates in the latter half of this year. Investors have been conditioned like Pavlov’s dog to anticipate central bank liquidity to fuel the next run up in stocks. Our view is that this is rear-view window investing. We believe that after four decades of falling inflation, the days of riskless monetary accommodation are over. That is not to say that inflation wont continue to fall as we slide inexorably into recession, but that the risk of inflation accelerating is now always potentially right around the corner. Therefore, when Chairman Powell and other Fed Governors tell us they intend to keep rates higher for longer, we believe them. Equities at the current level are pricing in the good ole free money Fed to come back anytime now. We view that as hope, and hope isn’t a sound risk management process.

Tim Pierotti is WealthVest’s Chief Investment Officer. 

Tim has over 25 years of experience in various aspects of the equities business. Prior to joining WealthVest, Mr. Pierotti spent seven years in Equity Research management roles at Deutsche Bank and most recently at BMO where he was a Managing Director and Head of US Product Management. Tim has 11 years of investment experience most notably as Head of Consumer Research and Portfolio Manager at The Galleon Group, a former NY based $8Bln Long/Short hedge fund. Tim is a graduate of Boston College and lives in Summit NJ.

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