Sailing Serenely On
Clients of the Firm,
Many investors have been confused about recent market conditions as the matrix of risk has moved in a variety of ways over the past 18 months. As I write this letter the, the S&P 500 is at 4,534 or about 5% below its all-time high set in January 2022. Forward P/E, based on a 2024 estimate of S&P 500 earnings at 242 is 18.69. The VIX, a measure of volatility, has returned to the low teens at 13.74 and the ten-year Treasury yields 3.82%. One-year Treasuries currently yield over 5%.
Investment banking and deal making is in a recession. Both the volume and size of M&A transactions are substantially lower than recent years in public markets. Private equity funding markets are no better with incremental funding drying up for most companies that don’t have a sustainable profit path forward.
The notable exception are AI startups which are seeing the lion’s share of new funding with very large seed rounds that are largely paying for the compute power (hardware and chips) necessary to train generative AI models. Early-stage investments in AI are likely to be lottery tickets at this stage as there won’t be many companies that achieve top of the funnel status (i.e. search replacement). More promising investments may lie in the application layer of AI or vertically focused applications in Fintech, Health Care and other industry specific apps. Our view continues to be that the major tech players are best positioned to take advantage of the AI technology wave as they have the capital and infrastructure to build, buy or host the compute intensive generative AI tech.
Consumer spending remains robust as indicated by major banks and companies like American Express have reported record consumer spending. Banks continue to accrue for future losses from credit defaults. That said, large actual charge-offs have yet to materialize. Consumers still have an excess of savings from the COIVD Pandemic, although that has been reduced over the past 18 months. Jobs continue to be plentiful despite weakness in the SAAS and venture backed businesses. Unemployment remains extraordinarily low at 3.60%. In addition, inflation has begun to moderate. While prices are not dis-inflating, the slope of the curve of increase has dropped to about 3%, well below the peak levels seen last year.
It is hard to foresee a severe recession against a backdrop of these employment numbers. Our view is that it is more likely we will see weakness in certain sectors that are more exposed to interest rate risk. Most notably impacted will be residential and commercial real estate. Demographics are favorable for residential as millennials continue household formation and inventories of housing stocks remain low. The opposite is true of commercial real estate, as hybrid and work-from-home shifts have created what appears to be permanent slack demand for city center office space. Thus, commercial buildings and developers are reimagining space for multi-use (i.e. office, residential, entertainment, dining). Generally, higher borrowing costs for a leveraged asset like real estate generally leads to lower affordability and eventually price declines.
While the S&P 500 is within the vicinity of its highs, participation of the underlying companies is narrow and has been driven largely by the biggest tech names, which have had a substantial rally off their lows. As the S&P 500 is a market cap weighted index, these large market cap companies have an outsized impact of the performance of the index as a whole. For example, an equal weighted ETF of the S&P 500 has delivered about 40% less performance than the market cap weighted version year to date.
Stock selection in a narrow participation weakening economic environment continues to be important. Markets will likely reward companies that are strategically positioned, profitable and well capitalized. By contrast, story stocks with no profits, weak balance sheets or niche positioning will have a harder time catching a bid.
With short term risk-free assets yielding north of 5%, valuation models are impacted and have a higher required rate of return assumption which brings down valuations. The theory behind this is based in opportunity cost or the idea that one should receive some premium return above the risk-free rate in order to put capital at risk. The result in public markets is usually multiple compression to reflect this dynamic. In short, the price a rational investor is willing to pay for a stock is lower the higher the return on a risk-free asset.
As we enter the second half of the investing year against this backdrop, we will continue to seek out rational pricing in equities and fixed income. Narrow participation has created some valuation bifurcation that allows for prudent investing in a number of industries. We still see value in those areas. Fixed income continues to offer a strong premium for short-term Treasuries. These securities come with the assurance of the US government and are still globally considered a safe haven asset. Some duration exposure may be warranted in a measured way as the Fed rate cycle concludes, but we still see the better value at the short end highest quality of the curve, at least for now. We would continue to avoid high yield debt as the weight of rate hikes has yet to impact solvency in distressed debt. We anticipate these hikes will likely have a major impact in high yield as debt rolls and needs to be refinanced.
George Washington said, “Great people are not affected by each puff of wind that blows ill. Like great ships, they sail serenely on, in a calm sea or a great tempest”. Investing discipline and demeanor yields the best results when we sail serenely on. Staying focused on the pillars of safety, valuation and growth investors can achieve good outcomes in stormy or clement weather.
We thank you for the responsibility of managing your funds and wish you a happy and healthy summer.
Sincerely,
Peter C. Wernau
President, CEO
Wernau Asset Management
http://www.wernauassetmanagement.com/
Office: 617.871.0029
Fax: 617.507.8155
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Wernau Asset Management
30 Western Ave Suite 206
Gloucester, MA 0193