Brett Caughran @FundamentEdge:
THE MACRO OUTLOOK, FOR STOCK PICKERS
This is the time of the year that the sell-side likes to publish 2023 macro & markets outlooks. When I first started researching the hedge fund industry in '05 I came across the 1987 Paul Tudor Jones documentary. My impression, influenced
Brett Caughran @FundamentEdge:
by that documentary, was that hedge fund managers were incessantly making market calls. What I found, in reality, was very different. When I joined the industry, I found that 80-90% of the time, there wasn't a strong "house" view on where the market was going.
Brett Caughran @FundamentEdge:
The advice I was given early in my career was this - "Brett, none of the great investing track records were built by making consistently correct market calls. Trying to do so is a fool's game. Focus on finding good longs & shorts".
Sure, there will be times when a manager
Brett Caughran @FundamentEdge:
has a high conviction market call, particularly at extremes, but I learned playing the game of whether the market is going up 15% or down 10% next year to be a complete crapshoot.
In fact, more of the long-short market share has shifted to risk envelopes that explicitly
Brett Caughran @FundamentEdge:
are not taking a market call (beta-neutral, factor constrained). After all, if LPs can access beta for bps, why pay 2 & 20?
Nevertheless, what you will hear from funds is that we are "macro aware". What does that mean? In my experience, while most L/S hedge funds are not
Brett Caughran @FundamentEdge:
explicitly taking macro bets, there is an understanding that the bottom's up portfolio embeds many implicit macro bets. So "macro aware" is the antithesis to "macro ignorant". As such, despite not explicitly making macro bets, I've had the privilege of sitting in on many macro
Brett Caughran @FundamentEdge:
strategist meetings over my career. And part of my year ahead process is going through the written 2023 macro & markets outlooks, which I did yesterday. In case it's helpful, I wanted to share a framework I use when thinking through macro & markets outlooks.
Brett Caughran @FundamentEdge:
1) DISTRUST THE POINT ESTIMATES. It's always super easy to pick on the sell-side for poor forecasting ex-post. There is an institutional bias to cluster, but the reality is that year ahead forecasting of the S&P 500 is incredibly tough, influenced by multiple unpredictable
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externalities. We're not here for the S&P 500 forecast - if you are, you're doing it wrong.
2) READ BROADLY, WITH AN OPEN MIND, TO IDENTIFY THE KEY ISSUES. What we are really looking for in macro work is working to identify the relevant issues. What is going to matter to the
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risk appetite of the markets this year? In '23, the fed is obviously topical. But what will influence the fed? In going through this process, there were many references to the labor market, given 4m still missing from labor participation post-COVID. The soft landing camp is
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calling for a modest uptick in the unemployment rate because of this dynamic, and the "mild recession" camp is citing this resulting labor inflation as the "higher for longer" view on rates, yet with full employment in a mild recession it's hard to see an '08 style recession.
Brett Caughran @FundamentEdge:
Do I have a view on the labor market? No. But going through this process helps me to see how news on the labor front will be quite important. And on the micro side, situations where goods deflation meets labor inflation could lead to margin pressures in '23.
Brett Caughran @FundamentEdge:
3) IDENTIFY THE BULL, BEAR & BASE CASE, AND ISOLATE THE KEY ASSUMPTIONS IN EACH. I like to ensure I read a bull, bear & base report, then do my best to pick through each assumption.
KKR, in the "higher rates for longer" camp, is making a call that services inflation will
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accelerate in '23 from '22 due to an acceleration in shelter (31% of CPI). Much of this argument is due to the lagged impact of shelter CPI. But by mentally flexing each of these assumptions, I can identify the potential weakness in these arguments. What if Redfin rent data
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starts to pull back more rapidly? If rents go from $1,500 to $2,000 back to $1,800 we are still higher pre-COVID, but that is a 3% headwind to CPI (10% pullback on 30% component). KKR assuming continued growth in shelter CPI into '24.
What if the war ends and energy/food prices
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come back to earth?
So rather than taking the headline view as gospel from each of these outlooks, I'm trying to isolate they key hinge points in each view. Not to say I know what will happen, but to identify what will break each case.
4) UNDERSTAND THE PATH DEPENDENCY. These
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forecasters are in a difficult position of forecasting the entire year. The benefit we have as public market investors is we can wait & see, then change our minds as the data rolls in. Again, if over the next 3 months we start to see new rental lease pricing DOWN yoy, that calls
Brett Caughran @FundamentEdge:
into question the KKR "higher for longer" camp, even considering the lag. Many of the bears are calling for S&P 500 EPS estimates down ~10% this year vs. '22. Will Q4 earnings season confirm that, or appear more resilient? Will the disinflationary impulse of the normalization in
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supply chains accelerate in the coming months, and could we see a crash in used car prices (KKR only models that down 4% in '23). Again, I don't know. But this mental process helps me to understand what to look for as I digest the news daily. So first frame the cases, then
Brett Caughran @FundamentEdge:
identify the key drivers to each case, then lastly just monitor which path we are on? The weatherman analogy is apt...you don't need to forecast the weather to know it's raining outside and to grab an umbrella. Frame the cases, monitor the path, as the macro path will influence
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the equity regime.
5) PATTERN RECOGNIZE. I really am a sucker for "priors" or historical situations that can inform the year ahead. JPM Asset Management put together this create chart of YUC (young unprofitable companies) that I thought was a helpful framework. Post the 99-00
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bubble, path to profitability was the key distinction. Those companies that became profitable bounced back, those that stayed unprofitable did not.
I also really enjoyed this analogue of the 2019-2021 bubble with the 1998-2003 NASDAQ bubble. And the lesson here...bubbles, once
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popped, usually stay popped. But there is opportunity in the wreckage for the disciplined investor.
I also like charts like this, from KKR. Generally when one sector becomes too concentrated as a share of the total market, it has been a bad sign for future returns.
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6) FIND THE EXTREMES. The broad market entering this year doesn't seem to be at extremes high or low, at least in historical context. 16-17x P/E is about historical average. But I like to dig below the surface to find extreme dynamics that may mean revert in '23. The extreme
Brett Caughran @FundamentEdge:
uptick in goods demand during COVID was a large outlier that is likely to mean revert (also perhaps why this feels like a very bad recession to RH and not at all to the airlines...)
This chart also caught my eye. The Russell 2000 is trading at 10.8x NTM P/E, a historic discount
Brett Caughran @FundamentEdge:
7) UNDERSTAND THE TRIGGERS. As I go through these reports, I'm asking myself "what would make me more bullish?". So I'm looking for specific triggers to keep in mind. One is simply the market P/E. Historic troughs have happened on average at 14x - suggesting a 15-20% pullback
Brett Caughran @FundamentEdge:
this year is feasible if the bear case hits. (the relatively still high P/E multiple against aggregate estimates that appear too high forms the foundation of the "meh" camp on markets heading into '22).
I also really like charts like this that give you some historical
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framework on when to act. Historically, ~halfway through a recession and when the fed changes posture have been signs to get more bullish (we may be a bit early on both...but who knows).