Recession probablity reaches a new high.
Overvaluation. Apple market cap exceeds Russell 2000!
Nasdaq new highs on negative q1 earnings, declining further in Q2, low single digit revenue growth and record negative breadth.
Warning Signs for the Retail Sector.
Charles Schwab red flags as financial strains continue to spread.
Policy Solutions will take time and be ready to invest differently in the next decade.
Global growth challenges. China won’t come to the rescue this time.
Videos: Stan Druckenmiller annual Sohn interview. Russell Napier, Michael Pettis.
Clearly weak earnings from technology stocks and discretionary retailers have led to a record poor ratio between stock advances relative to declines. Nevertheless, a handful of mega cap technology stocks have still managed to generate further rises in big cap weighted indexes. A range of longer term challenges remains, not least the rising probability of recession.
Certainly small businesses are feeling it!
Overvaluation
The chart below shows the current market leaders have far surpassed the valuations relative to GDP of even the leaders of the 2000 tech bubble.
Apple’s market cap now exceeds the market cap of the Russell 2000. I believe this is the first time any one company has achieved that status.
In the last few months, the divergence of big and small cap stocks has been extraordinary and unprecented.
Long term revenue growth, without adjusting for inflation, has largely evaporated.
Warning Signs for the Retail Sector
The last time we saw three consecutive months of negative real sales growth on an annual basis was in 2020… and before that, 2009.
Charles Schwab red flags as financial strains continue to spread
A Case Study on Charles Schwab
The insolvency problems recently revealed by rising interest rates that translated into runs and failures at Silicon Valley Bank and Signature Bank are merely some of the first casualties of a systemic problem that affects the entirety of the US public and private securities markets. Management of other at-risk institutions and policymakers would have you believe those bank failures were isolated events that have already been contained, but we disagree.
As just one important case study, Charles Schwab experienced market losses on its massive portfolio of low-yielding long-duration USTs and agency MBSs of $36.7 billion in 2022. $22.6 billion of this hit was recorded straight to owner’s equity, so it did not even flow through the income statement which instead showed record profits of $7 billion. The other $14.1 of the total $36.7 billion hit was associated with “held-to-maturity” assets so did not even get “marked-to-market” on the balance sheet.
After subtracting goodwill of $12 billion, mostly from its richly priced TD Ameritrade acquisition in 2020, the firm was left with ONLY $6.0 billion in tangible common equity at year-end. These portfolio losses essentially entirely wiped out common stockholders’ equity for a firm that boasts more than $7 trillion in client assets. More concerning is that Schwab’s tangible common equity would be negative, i.e., insolvent, at -$8.1 billion if it had to reflect the additional $14.1 billion in market losses. Schwab has $9.9 billion of preferred equity that would absorb creditor losses in a fire sale or run, but that would still leave common equity stockholders with zero. The $12 billion in goodwill is worthless in a distressed situation like this.
Instead of adequately disclosing and discussing this issue, Schwab’s Chairman and its CEO have been aggressively painting a rosy picture of their business to both defend their stock and entice new client inflows. In a joint letter on March 23, the pair touted their “conservative approach” and “strong financial foundation” while advising shareholders and clients that it’s “very misleading” to focus on “paper losses”. Then in a follow-up letter on April 6, the two stated that “our business is extremely robust. This March alone, we saw a strong influx of core net new client assets of over $53 billion, the second highest March results in our history.” We find it concerning that investors are this naïve to be moving money over to Schwab amidst these problems.
Investors in Schwab’s common stock should judge for themselves whether mark-to-market losses on securities portfolios are relevant or not. We absolutely think they are. It is the same problem that sank Silicon Valley Bank. Higher interest rate and higher inflation macro regimes are ones that affect the entirety of the financial markets and are severely and negatively impactful to leveraged holders of overvalued long-duration financial assets.
The problem at Schwab that so many still appear remarkably clueless about is that it made a big bet on long-duration interest-rate assets with mismatched short-term liabilities, and it lost. It is now aggressively trying to essentially cover up these losses while luring in even more customers, creditors, and stockholders with outrageous proclamations. At the same time, company execs have strapped themselves to the mast declaring their intent to keep this large leveraged interest rate bet intact, citing access to liquidity despite a tangible common equity insolvency problem on a marked-to-market basis. What happens if the bet continues to go sour, which is a distinct possibility?
The valuation tide for long-duration financial assets is still going out, in our view, and likely won’t be coming back anytime soon. Our concern is that there are a great many parties out there swimming naked. To say that the problem is isolated and not systemic is foolish. It is faced by all banks and brokerage firms today. Even the Fed’s own balance sheet is mismarked and overstated.
Beyond the financial system there are also unresolved deep problems across the corporate sector
ZOMBIE CORPORATIONS – Out of Time & Options!
Approximately 27% of all US publicly traded companies now deliver insufficent Earnings Before Interest and Taxes (EBIT) to cover the interest on their debt. The number, who have been in this situation for 3 or more years, has also dramtically increased.
Rating agency S&P sees the US junk-grade default rate reaching 4 per cent by December, from a rate of 2.5 per cent in the 12 months to March. Moody’s anticipates a US rate of 5.6 per cent by next March, up sharply from its own figure of 2.7 per cent as of March 31.
Distressed corporations have bought time by turning to “Distressed Exchanges”. However, according to Moody’s, almost three-quarters of US corporate debt defaults last year were “Distressed Exchanges”.
FUNDING REALITIES OF ZOMBIE CORPORATIONS – A Labyrinth of Liquidity & Dependencies
Recessions throughout the “Great Moderation” era were relatively few and short lived! We should now expect longer recessions and more re-occurring recessions during the post “Great Moderation” era, which will dramtically end the mal-investment era of “Zombie Corporations”.
Zombie Corporations are currently surviving on Covid-19 Zero Bound financing, Distress Exchanges and Private Equity cash infusions. All of these are in the process of increasingly failing to supply the life blood for Zombie’s to continue to exist!
Over the past few months we have seen a dramatic rise of the “weakest link shares of the speculative grade” population.
If you are finding investing a challenge right now then you are in good company! One of the best investors of all time, Stan Druckenmiller, explains the dynamics as he sees them.
Before you rush into any shorter term Druckenmiller positions, consider the longer term outlook. Russell Napier also has a remarkably good track record and is an authority on economic history.
Over recent decades the Chinese have come to the rescue of world economic growth.
This time China is not likely to provide the same global support. Michael Pettis explains from his Beijing perspective, and describes how global trade is influenced by domestic policy.
It is important to recognize that we are in a period of instability. Make sure you have a robust and flexible process to manage your investments in these uncertain times.
“Best Investor” Standards Safeguard Optimal Investing
In order to optimize opportunities safely, investors need to be set up with the most productive framework possible. Why not adopt the methodology of the most successful investors of all time? They all ended up embracing their own version of “Capital Preservation and Compounding”. You can find out why here.
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Raise your accountability, transparency, understanding and control of your investing in real time by having access to this information.
Transform Your Investment Experience
The room for policy manoeuvre, and the stability of the current system should not be taken for granted. Volatility has increased and is likely to continue to stay high. The outlook has rarely been this uncertain. Investment management needs “Best Investor” metrics and techniques as never before.
Market and economic events are moving fast at this stage. If you need a quick review of the issues that you may need to know about for your own circumstances, schedule a FREE consultation today.
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