Putin’s Game of Chicken

By Crest Capital Advisors on February 18, 2022

Dow: (1.90%) to 34,079.18
S&P 500: (1.58%) to 4,348.97
Nasdaq: (1.76%) to 13,548.07
Russell 2000: (1.03%) to 2,009.33
10 Year Yield: 1.93%
Outperformers: Communication Staples 1.11%
Underperformers: Energy (3.71%), Communication Services (2.47%), Financials (2.29%)

Markets ended lower this week, as tensions between Russia and Ukraine continued to take center stage, driving market volatility. Consumer Staples was the lone sector providing a respectable +1.11 return with a strong showing to end the week. The Energy sector was the weakest performer with a 3.7% decline as oil prices ($91.21, -1.88, -2.0%) briefly fell below $90 per barrel. These geopolitical tensions come on top of a market already grappling with elevated inflation and rising Fed rate-hike expectations. Over time, we would expect market focus to shift from geopolitics to economic fundamentals once again.

Russia-Ukraine reports earlier in the week stated that Russia had pulled back troops from the Ukrainian border after completing military drills – a de-escalation that was welcomed by markets broadly. However, later in the week, we heard from both U.S. and NATO officials that Russia had not moved troops. In fact, U.S. officials claimed that Russia had increased its troop presence on the Ukrainian border by thousands, and a military attack may remain imminent in the days ahead. U.S. and NATO allies, including the European Union, stand prepared to deliver “swift and severe” sanctions against Russia if it were to move forward with military action. On a positive note, Russia’s foreign minister accepted an invitation to meet with Secretary of State Blinken next week to engage in further diplomacy, assuming no military escalation has occurred.

In addition to the geopolitical tensions this week, investors continue to digest news around the Fed and the consumer. Two data points that were particularly notable were the January FOMC meeting minutes and the monthly U.S. retail sales figure, both of which offered a bit of relief to markets.

On Wednesday, The Fed released the minutes from the January FOMC meeting, which provided some relief to markets, as they contained no material surprises or overly hawkish commentary. The minutes indicated that while the Fed was generally ready to raise rates in March, it did not particularly favor a 0.50% rate hike or any other overly aggressive move.

More good news on Wednesday, as U.S. retail sales for the month of January, came in well above expectations, with the headline figure up 3.8% month-over-month, above forecasts of 1.9%, and sharply above last month’s reading of -2.5%. The gains were driven by notable increases in non-store retail (online sales), furniture sales, and a rebound in auto sales, which were up the most in 10 months.

We believe that this solid retail sales report reflects a relatively healthy U.S. consumer and perhaps some waning impacts from the omicron variant towards the end of the month. We continue to see the potential for reopening demand to remain solid in the spring and summer months ahead, particularly if virus trends continue to improve.

Overall, while geopolitical concerns may be dominating the headlines and investor sentiment in the near term, market focus will likely again turn to the Fed and inflation trends in the weeks ahead. With another jobs report coming soon (March 4), along with a fresh set of inflation readings (March 10), all eyes will be on whether inflationary pressures show signs of moderation ahead of the March 15-16 Fed meeting.

‘Accurately’ Predicting The Fed

The market currently expects seven rate hikes this year and two more next year. If history is any guide, chances are the Fed will end up doing something significantly different. Since 1994, February market predictions of where the fed funds rate would end up have been off by nearly half a percentage point for the same year-end and more than a point for the following year-end. The Fed hasn’t been much better: Since the dots were introduced in 2012, its average errors for the same year-end and the next year-end have been about 25 bps and 75 bps, respectively.

As of today, and after adjusting for premiums, the market expects the Fed to implement a total of seven 25-bp hikes by the end of this year. The most recently available FOMC dots are more subdued, as they pencil in three 25-bp hikes by the end of this year and three more by the end of 2023. These dots are a bit stale as they are from December – new dots released next month are likely to be more aligned with market expectations.

An important question to try to answer is, how predictive have either market expectations or the FOMC dots been in the past? The answer, perhaps not surprisingly, is not very. The chart below shows the actual federal funds rate (reality) vs. where the market expected it to be each mid-February since 1994 and for the next three years.

Here’s a look at The Fed’s historical record…

Today’s situation, with its heightened uncertainty about inflation and many other variables, seems prone to result in even larger, rather than smaller, forecast errors than in the past. While it may seem obvious that The Fed will hike a lot this year, there are many factors, and indeed more than usual, that could conspire to induce The Fed to hike less than the market things or fears today.

When Controversy Meets Math

This week, Charlie Munger Warren Buffett’s business partner at Berkshire Hathaway) made waves in the financial media when he commented that he expects “over the next 100 years, the currency [US Dollar] will go to zero”. At first blush, it sounds incendiary. Legendary investor forecasts the US dollar to be worthless in 100 years! How can that be?! But what if we look back at what inflation and increased money supply have done over the past 100 years? What we find is, the US dollar has lost about 96% of its purchasing power. So, is it really that crazy to forecast that it will do so again? After all, the Fed is targeting a 2% inflation rate – in 100 years that implies the dollar will lose another 98% of its purchasing power.

The moral of the story? Sometimes statements that sound controversial really aren’t all that much. Both Munger and Buffett are masters at taking the long-term view…something so few investors are willing to do these days, which is why we can be fooled with comments like this. And, finally, investing capital to exceed the rate of inflation is the only way to maintain (or increase) your standard of living. Cash on the sidelines is a sure-fire way to real return losses.

Multiple “Normalization” – Valuations in High Growth

This week was another rocky one for cloud software stocks. The market is clearly still churning and digesting implications from higher inflation prints, and uncertainty around Russia.
Related to the high inflation print – it’s clear this year we’ll see a number of rate hikes, and this has started the process of multiple normalizations in cloud software land. However, not all companies are seeing their multiples “normalize” at the same rate. This has resulted in some companies going into earnings with still elevated multiples. So far, the results have been extremely harsh for those who don’t deliver anything short of perfection. With multiple normalizations, we should end up at a point where only the truly special companies have outlier multiples.

The overall median multiple is 15% below pre-covid highs, 3% above where we were on Jan 1, 2020, and 16% below where we were at the previous peak in August 2019. Looking at high growth software median only, businesses are valued on a multiple of their revenue – in most cases the projected revenue for the next 12 months. Multiples shown below are calculated by taking the Enterprise Value (market cap + debt – cash) / NTM (revenue over the next twelve months of operations) revenue.
Overall Stats:

• Overall Median: 9.2x
• Top 5 Median: 33.5x
• 3 Month Trailing Average: 11.7x
• 1 Year Trailing Average: 14.7x

Crazy Stat(s) of the Week

One of the most exciting NFL seasons has come to an end – it appears the ‘excitement’ translated into record-breaking viewership figures.

• The Super Bowl itself drew 112M viewers – up approximately 14% from last year.
• The Regular-Season viewership rose over 10%, with each Conference Championship Game averaging nearly 50M viewers.
• NFL gambling was up as well – the sports betting industry logged more than 80M transactions – more than double that of the previous year.

Quote of the Week

“The time to buy is when there’s blood in the streets.”
-Baron Rothschild, an 18th-century member of the Rothschild banking family
For reference, Cathie Wood (Founder/CEO of Ark Invest), one of the most listened-to money managers this decade, said she sees “blood” in an interview this week.

Chart of the Week

This biggest one-month decline in NY Fed three-year consumer inflation expectations on record!

Calendar of Events to Watch for the Week of February 21st

Monday 2/21 – US financial markets will be closed on Monday in observance of Presidents Day, or Washington’s Birthday if you prefer.

Tuesday 2/22 – The Federal Housing Finance Agency (FHFA) Home Price Index; The US Services PMI (Purchasing Managers Index) providing a snapshot of the health of the economy (specifically the services sector); The Conference Board’s Consumer Confidence Survey for the US Economy

Thursday 2/24 – The next release of the Gross Domestic Product (GDP increased at an annual rate of 6.9% in the fourth quarter of 2021, following an increase of 2.3% in the 3rd quarter; Initial unemployment claims (consensus = 215k); and finally new home construction & sales

Friday 2/25 – Data released in the Advanced Report on Durable Goods Manufacturers Shipments, Inventories, and Orders (Consensus = 0.60%); Monthly personal income outlays (consensus = -0.50%); Index of Consumer Sentiment (Consensus = 61.8; up from 61.7); National Association of Realtors Pending Home Sales Estimates

Source: FactSet