2023-11-16 09:30:00 ET
Summary
- Michael Kramer is disappointed by the recent CPI report, suggesting that the economy is cooling and expectations for earnings growth are too high.
- He believes that the market may anticipate rate cuts, but the Fed will be slow to deliver them.
- Kramer advises investors to be defensive and look for undervalued opportunities in sectors that have been beaten down, such as biotech, financials, and utilities.
Listen above or on the go via Apple Podcasts or Spotify .
Recession ahead? Michael Kramer, aka Mott Capital , explains why he's disappointed by this week's CPI report (0:55) and whether we're at a reckoning point with economic data (4:00). When credit spreads begin to widen higher levels of implied volatility follow (9:00). Staying defensive amidst market froth (12:45).
Transcript
Rena Sherbill: Michael Kramer, welcome to Investing Experts. It's always nice to have you on Seeking Alpha however we can get you. You run Mott Capital Management, you run Reading the Markets . It's great to have you on the show today.
Michael Kramer: Great, thank you for having me. It's a real honor to be asked to be on this today.
RS : Absolutely, it's great to have you. I've been following your work for a long time. I know many people on Seeking Alpha have. I know that you just wrote about the CPI report , which just came out.
What were you expecting for those that don't know maybe articulate or reiterate. And then, what's your reaction now that it's come out ?
MK : So my initial reaction was disappointment in some ways because I had been hoping and wanting to see a number that was a little bit higher still to suggest that the economy was still holding on and doing fairly well.
The big piece here is I think last year, the health insurance component, the medical services component, I think, understated CPI and the inflation rate. And now this year, obviously, it flipped.
But what this number really sort of demonstrated to me is how much other parts of the economy now appear to be really be slowing much more so than I anticipated, specifically used auto prices fell rather dramatically.
Obviously, we know that oil and gasoline prices came down, but that obviously had a very big weighted effect on the actual overall CPI headline number. And the core number also showed a lot of really meaningful deceleration as well, which is sort of a positive and a negative at the same time.
Clearly, the market is viewing it as a positive because interest rates are moving down. I'm not viewing it so much that way. And it's not because I'm just trying to go through the slides of trying to find things that are negative in it.
But what really sort of stands out to me is that this economy, since most of 2021 has been driven by two things, really, physical spending and inflation. And when you take away the big piece, which is the inflation component, which has helped to boost retail sales, which has also helped to boost earnings and sales estimates.
And when you really start seeing that inflation rate coming down, what it's telling me is that overall the economy is cooling and that because the economy is cooling, expectations for earnings growth next year and sales growth are probably too high. And that's really why it's disappointing because I wanted to see a number that suggested that the economy was still really humming at a very high and strong level. And this number doesn't really suggest that to me.
And that probably means that you're going to see the market really begin to anticipate rate cuts. But I think the Fed is going to be really slow to delivering them because I think they're really fearful of taking their foot off the accelerator too soon.
RS : Would you call this a bit of a reckoning moment, maybe if not a major one than a slight one? I mean I've been hearing rumblings that the economic data that people are looking at or the data that leads to the data isn't doing what they would like it to be doing for them to be positive. What are your thoughts on that?
MK : Yeah, and that's the thing. Like, if we were doing this interview tomorrow, I would have that one more data point to really go off of, because retail sales has been really the story of the economy, which has been the consumer spending. Retail sales is not adjusted for inflation. So it sort of has been aided by the fact that prices have been rising.
Now, with inflation coming down, with CPI printing a month-over-month headline 0, right, I mean, that's pretty close to deflation. And that would really suggest that retail sales tomorrow would probably be pretty weak, given that there was no increase “in prices” in the month of October.
And so really what this is sort of potentially leading to, when you couple that with the rise in unemployment now for a few months in a row, really talks and tells me that my fear of a recession approaching, I think, is actually closer than what the market has priced in.
You see, I've been fairly bearish on the equity market , not because I feared recession or that I thought something horrible was going to happen. It was because I realized that the economy was going to outperform in 2023, and that was going to mean more rate hikes, higher yields on the back of the curve, a stronger dollar, probably tighter financial conditions is what the Fed really needed.
And we got all of that and still the equity market for the most part tried to ignore it, right, instead focusing on AI or things of that nature, which proved to be a very short-lived narrative when we gave all those gains back in October.
Now the market is trading much more in line with interest rates and because interest rates are now dropping on the long end of the curve due to the slowing economic data, you are getting this rebound in equity prices.
So my fear of – is starting to shift from the economy being too strong and too hot leading to higher rates and a stronger dollar is now starting to shift to this idea that, hey, maybe this is sort of Pollyanna-ish moment for the economy is coming to an end. And like you said, maybe the day of reckoning is coming a little bit sooner.
And that's what this CPI number sort of suggests on the surface, especially when you take that and add it to the data we got with the employment data two weeks ago.
RS : So let's say that the retail sales come out tomorrow and it's disappointing . What are your – kind of how do you further your thoughts around that?
MK : So I think that would really more strongly point to the idea that we are seeing the economy really meaningfully begin to slow and that we're going to see rates continue to decline. But I think more so at the front of the curve, which is going to lead to more yield curve steepening.
And that's going to really be the moment of truth, right? Because if we start seeing the two-year falling to the 10, as opposed to the 10-year rising to the two, which is what we've seen to this point really, then that's really going to be the sign that the market – the bond market, at least, is really starting to seriously consider U.S. recession risk .
And, again, thinking out another two weeks from here, a tick higher on the unemployment rate to 4% would be a very big deal then.
RS : Do you feel like looking at the economic data and something Michael Gayed was on the podcast this week and he was talking about this credit event and the phases of a credit event coming? Are you of a similar mindset? And is that basically how you would describe what you just articulated?
MK : So I'm doing this very big piece right now for Seeking Alpha, which should come out in a couple of days. And in it, what I do is I overlay the unemployment rate with the 10-2 curve, with credit spreads, high-yield credit spreads, and with the VIX. And what you find is they all move together, right?
So the bond market anticipates a rising unemployment rate because once the unemployment rate begins to rise, the 10 – 2-10 curve begins to steepen in anticipation of Fed rate cuts, knowing that once the unemployment rate starts to rise, it motivates the Fed to cut.
When we start seeing the yield curve steepen, it also results in high yield credit spreads beginning to really widen as the risk of recession begins to get priced into the market. And as high yield credit spreads begin to widen, VIX implied volatility metrics for the S&P 500 begin to rise.
And so, yes, I mean, I don't know that the formation or the type of credit event you might see in this in terms of a specific. But what this is telling me more broadly is that as we head towards recession, as the yield curve re-steepens and turns positive, which seems to be an inevitability, right? The yield curve doesn't permanently stay fixed inverted.
That, as it – as the yield curve re-steepens in a way where the two is falling to the 10, then we should see credit spreads really begin to widen and that should lead to higher levels of implied volatility.
RS : Would you give standard conservative advice to investors looking at these events coming up, or do you think that investors are missing something that they should be aware of?
MK : Well, investors, for the most part, from the way I can look at it, right, and the only way I can look at it is two things, right? I look at what is the market anticipating in terms of earnings growth for next year, and then I look at implied volatility levels, which tells me some sort of level of complacency or fear in the market.
A VIX at 14 is obviously suggesting there's no fear in the market. There's a lot of complacency, understanding what I understand about spreads and economics would tell me that the VIX is probably too low and will need to rise in 2024.
The other thing is that earnings are expected to grow by 10% next year, which I don't see as a possibility given that, number one, inflation is coming down, right, which is clear. We know that. I don't think anyone has been a denier of the fact that we know that inflation rates are falling. It's obviously the pace at which they fall and where they get stuck perhaps along the way.
But what seems clear to me is that probably by the time we get to the second half of 2024, you're going to see inflation approaching that 2% target, right? And what that means though, is that companies will no longer have pricing power to pass onto the consumer anymore, which means they won't be raising prices, which means that the whole reason, the whole way that the market gets to this 10% earnings growth rate is through profit margin expansion.
But if you can't increase prices anymore and you have employment costs rising, as noted by a higher average hourly earnings and higher inflation due to medical costs or health insurance, then we know that margins can't expand and margins will need to contract. And so if you get a 5% sales growth number, you need margin expansion to get you to a 10% earnings growth number.
And what we're already seeing for the fourth quarter estimates is you've seen fourth quarter sale earnings growth rates come down by about 4 percentage points since beginning of October, and you've seen margin compression already showing up in fourth quarter numbers.
And so I expect that to spill over into 2024. You're beginning to see it in the first quarter, but it's very slow to mature at this point. And I expect that those numbers will begin to reflect that as well in the 2024 number.
And so if you're going to see an economy really slowing and a GDP growth rate coming off of a sugar high 8%, it just tells me that you're not going to see a 10% earnings growth rate next year. And all of a sudden, an S&P 500 trading at 18x or 19x next year's earnings with a sub 10% growth rate is going to be a very hard multiple to maintain.
RS : Yeah. So in terms of moving forward, do you feel like investors looking at the different sectors, there is something to be gleaned at this point from kind of, I mean, we talked about the AI mania and the disappointment that came from that. Is there something that you feel like is getting frothy or too frothy or that investors would be wise to kind of be looking at?
MK : So my approach to investing in 2023 has been to be defensive. And what I mean by being defensive is owning what I've done personally is own high-quality stocks. And I've used opportunities where the market has moved up to raise more cash to earn my risk-free rate of return in my money market account, right?
And so what I've also sort of discovered over this last couple of months is that you've seen basically just one part of the market really lead the way. I was just doing an analysis actually this morning and essentially you strip out the top seven names. The S&P 500 has no performance this year, right? It's completely flat. When you strip out the top seven names, the NASDAQ composite basically has no performance this year, right?
When you look at the number of stocks that are down double digits as opposed to the number of stocks that are up double digits in the NASDAQ composite, the number of stocks down double digits far outweighs the number of stocks that are up double digits in the NASDAQ. The same goes for the S&P 500.
And so what it tells me is that there are pockets in this market that are probably extremely undervalued, right, because they've just been unfairly beaten up. The question becomes obviously is when is the right time to really pull the trigger and get in front of that, because the frothy names, which are some of the high-quality names that I actually own, like the Apples (AAPL) and the Microsofts (MSFT) and the Amazon and the Alphabets (GOOG), which have done really well, are clearly holding this market up, right?
And at some point, I think, you're going to see that rotate out, because these companies aren't, I mean, I've owned them for years. I know that they're not immune to economic cycles, as many people seem to be betting right now, right?
And so what that tells me is that not that you should be a seller of these names, because I don't advocate selling these. I think that these are too ingrained in our lives and they're too important in our lives that they are positions that you just need to be a part of and just hold on to.
But that if you, from my perspective, that I'm beginning to look for parts of the market that are just deeply oversold at this point, right, where valuations are so low that historically, even if we do go into a recession, there's the possibility that these companies could at least not go down any further.
And those are the types of opportunities that I think exist right now, because I think a lot of bad news has already been priced into things like biotech. I think a lot of bad news has been priced into things like financials. I think a lot of bad news has been priced into things like even utilities, right, because rates have gone up so much.
And even when you look at consumer discretionaries, I mean, you take out Tesla (TSLA), you take out Amazon ( AMZN ), where would the ( XLY ) be, right? I mean, because the consumer discretionaries retailers have done horribly because they're – they've been getting crushed.
But – so there are opportunities even there, even in staples. I mean, because again, like a lot of these stocks have just been really beaten up because of fears of margin compression and the economy slowing down and they've been left behind. And they're more, again, representative of the broader market when you take out the top seven. And that's really what this is about at this point.
RS : Do you have any – do you use options at all in your investing?
MK : I use them as part of my analysis, but I do not invest in options. I've been doing this since I'm 16. So it's 30 years, right? I'll give you my age, right, at 46 years old. And I've worked at various different firms and I've had various different roles.
But the last role I had, which was as a buy-side trader, where I traded domestic and international equities, I got to learn a growth investing strategy that really just made a lot of sense to me.
And I think the thing that a lot of people investing do is they try to be something they're not, right? And I've experienced a lot of different cycles and I've experienced a lot of things that have worked for me and not worked for me.
And the one thing that I found to be the most impressive takeaway from my last experience was that you want to invest in growth companies that are changing the way we go about our lives, right? And to do that, you need to be a long-term owner of stocks, because this is how you really generate, I think, substantial wealth over time as being an investor.
And to do that, you need to be able to basically remove two big things that come in, I think, most investors way. One is time and the other is leverage. And so the only way you can remove time is by not being involved with options because options are very time-sensitive. You need to get that timing right to get that option to pay off, and leverage – removing leverage from the equation removes the risk of an event happening that forces you to sell a position that you may not otherwise want to.
And so the way I go about investing right now is looking for those really high-quality names that are going to not only drive a narrative for the next six to nine months, but that can drive a narrative for the next five to 10 years. And the only way that I can do that is not to be involved with options and not to be levered.
So I only invest by buying and holding, and I do it by not even using leverage in my approach. And that allows me to ride through a lot of these crazy cycles we've had even in the last five or six years.
And more importantly, using the macro and my understanding of where the economy is and what's happening in the economy and what's really driving the market allows me to be able to make instantaneous decisions on whether or not I should be really buying or selling.
So like in 2022, as the market was coming down and I was very negative on the market openly, I was also using that as opportunities to add to my portfolio, buying names like (SHOP), buying names like (ISRG), buying Amazon, which was a name that I hated for a very long time.
And – but I also recognize where we were in the economic cycle. I realized we weren't going into a recession. I realized that the market was going down purely because of Fed interest rate risk and knowing that allowed me to benefit. And I think a lot of times investors are too focused on the short-term.
And I write and do a lot of analysis on the short-term, but the purpose of for me to do that is to understand what the long-term trends are going to be. So that I can at least understand when these opportunities arrive that I'm not like running around confused with a chicken without its head, trying to be like, “Oh, my God, what's going on? What's driving the market here?”
Oh, let me see what they're saying on TV or let me read the latest news. Like, no, I already know what's happening and I already have an opinion about where I think it's going and that really helps me a lot.
RS : What's your favorite part? I mean, you've been in the game a while, you do a number of different things. What's your favorite part about what you do?
MK : What I love about it is the excitement you can get with being right, but also that deep low you might get for being wrong and then rising out from it to be able to prove again that you can be right. And that's really what drives this is that I find that I've actually had jobs that were away from the market.
And for a period of time when I was about 36, I had it – I pulled back actually for like nine months. And I'm like, I don't - when I was transitioning from being a trader to just not knowing what I wanted to do next. And I pulled back from being a trader and I did really almost nothing during that period of time and kind of just explored other things that I may be able to do.
And what I found was that there was nothing that was as exciting to me as the stock market because it was changing on a daily basis. And to be able to form opinions and views and then to be able to share them easily on a platform like Seeking Alpha to me became really exciting and really is what has driven me for the last eight to 10 years now.
RS : It's interesting how sometimes stepping away from something makes you realize how much attachment you have to it. Anything else you want to leave our audience with, Michael? I really appreciate this conversation and appreciate your presence on Seeking Alpha. Anything else that you want to share?
MK : I just think that this is a precarious time. And I think that investors shouldn't be so quick to assume that because something didn't happen the moment that it was supposed to happen, that that means it's not going to play out a certain way. I think investing takes a certain mindset. And the idea for me, at least, is to not burn myself out, right, is that I want to be in this for the long-term. I want to be in this for the long game.
I hope to still be doing this hopefully when I'm 76, as opposed to being 46 with the same energy level and the same vigor, because I try to think about everything I do with a long-term perspective and preparing for the future. And that means going through every single thing on a regular basis, on a short-term basis to be able to do that, so that you don't really feel that stress when the time comes.
And I think too many investors are too short-term focused today because everything moves so quickly. They feel like they have to be in it at every moment of time. And the truth of the matter is you really don't. That my biggest mistakes have come when I've chased the market because I got emotional, and that has really hurt me at times.
So my key takeaway is try not to be emotional, try to have patience, and try to really be focused on the longer-term, because I think that's really what drives real wealth generation, not this short-term day trading stuff.
But that's coming from someone that's been around for 30 years and has had a lot of different roles on Wall Street.
RS : Yeah. The notion of investing versus trading is something that we talk about a lot. And yeah, I think, even – if you do either one, you need to build wisdom and you need to dance that dance of resilience either way. But yeah, I think a lot of nice insights there for listeners.
On Seeking Alpha, you run Reading the Markets , that's your investing group. Your author name on Seeking Alpha is Mott Capital Management . Anywhere else listeners, the audience can find you?
MK : So I have a big Twitter following. You can follow me on Twitter @MichaelMOTTCM. I post everything there. So I mean, if you want to follow me, that's the easiest way to make sure you're not missing anything. I also post some insights on there as well. I also do post a lot of stuff throughout the day on my chat room on the Reading the Markets forum as part of the Seeking Alpha Investing Groups.
So, I try to bring the same approach to the Investing Group that we've just had this conversation about. And so, if you enjoy this type of view, then this is certainly a place that you want to check out. And I'm a guy that likes to get into the weeds a lot so.
RS : Yeah, take advantage of Michael getting into the weeds and share a conversation with him. Michael, really appreciate you having this conversation with us today.
MK : I really appreciate the opportunity.
For further details see:
CPI Disappointment, Cooling Economy, Recession Ahead? With Mott Capital