2023: The Year of Transition from Upside Down to Right Side Up
By James Cakmak and Ryan Guttridge
[See our 2022 review here]
Thank goodness 2022 is over. It was a memorable year, but for the wrong reasons. As we move into 2023 the door is finally open for a return to “normal”.
We’ve been upside down for nearly three years:
- 2020 represented a year when companies and society were forced to come face to face with an existential threat that was unimaginable in previous years — lockdowns
- 2021 marked the meteoric rise in the market due to historic stimulus and crypto proliferation
- 2022 saw the mature Dow components eclipse the next-gen companies represented by the Nasdaq, declining just 9% versus 33%, respectively
There is a silver lining, however. The 2022 reset was important because it helped set the stage for putting the Covid lockdown behind us. In fact, 2023 may be the first time we can say things are back to normal in three years. Finally, the effects of the lockdowns will come out of the numbers.
Here are our top three takeaways for 2023:
- Upside surprises likely coming from sectors currently out of favor
- PEG reenters valuations frameworks rather than just P/E
- Celebrating bad economic news in hopes of motivating the Fed comes to a halt
Sourcing Upside Surprises
In our 2022 revisited piece, we discussed the mean reversion in growth rates happening in the market. Here’s a quick background:
- Since Covid pulled forward so much demand for “tech” companies, growth rates far exceeded their sustainable growth curves
- To return back to those “normal” levels mathematically meant that reported growth had to fall below the curve in order to bring it back in line with the long-term average
- Although we were well underway to that normalized growth during 2H22, the Fed delayed that recovery with their rapid rate hikes
Using Amazon as an example, the company was growing at about a 20% clip prior to Covid. During Covid that rate jumped to 44% and fell down to 9% in 1Q22. While Amazon posted 16% growth in 3Q22, their 4Q22 guidance slumped growth back down to 5%. You can thank Jay Powell for that.
On the flip side, the companies that lagged during Covid like the Dow components were the source of the positive surprises. These are the companies where their growth rates had to accelerate in order to maintain pre-Covid rates.
2023 should have a similar effect for Nasdaq companies as their growth rates are likely to be closer to longer term averages. This means the growth rates should be higher than what is currently being reported.
That said, it will take a while for this fog to completely clear. As a result, this repricing will be choppy.
With a recession looming, the S&P earnings estimates still remain too high making security selection increasingly important.
On the flip side, a slowing economy puts a premium on predictable growth which implies many of this year’s losers are likely to regain their luster.
PEG over P/E
The long-term value of a company is the product of two components: return structure and the overall level of sales. If a company is earlier in its growth curve with understated earnings relative to its long-term return structure, then growth rates and sales multiples matter.
That went out the window in 2022 as growth curves were no longer predictable. Going back to the Amazon example, investors had to ask questions about growth:
- Do you still assume it’s a 20% grower?
- Do you extrapolate the 40%+ growth?
- Or do you extrapolate the 5% growth embedded in their latest guidance?
This uncertainty around growth rates led investors to go back to the basics and P/E valuations.
In an unprecedented move, Uber’s CEO even publicly acknowledged this change in investor sentiment and shifted the company’s focus back to bottom-line earnings and cash flow.
We believe that during 1H23 the confidence in the predictability of growth rates will return. In fact, that can happen as early as April when most companies report their 1Q23 results and provide 2Q23 guidance.
Indeed, this still means at least four months of choppy waters ahead.
However, this can also designate a shift back to PEG ratios and sales-based valuations relevant rather than just P/E, thereby expanding company valuations higher (particularly in NASDAQ components).
The days of the nosebleed 2021 valuations are over (until the next period of irrational exuberance), but pre-Covid valuations are more than likely to return.
No Longer Celebrating Bad News
Speaking of living in an upside down world, we are also in a world where the market cheers bad economic data. Whether it’s rising unemployment, falling wages, or slowing economic growth, each one is celebrated with what’s usually a big up day in the market.
Bad news is good news. Why? Because maybe, just maybe, it will help the Fed board come to the realization that a Machiavellian approach to driving down inflation by breaking the economy is not a good thing.
Importantly, several key economic metrics are now falling. Home prices have started to decline, used car prices are falling, gas prices have come back to earth, and even food prices are decreasing.
Another point, but more obscured, is that money supply growth has come back down to its historical average.
In broad terms, what this means for 2023 is that not only is pause in interest rate hikes inevitable. It’s also more likely to come sooner rather than later.
The term “money supply” is wonky, but it can be thought of as a measurement of how willing banks are to lend money, how willing people are to borrow money, and how willing businesses are to invest.
Think of money supply as the oil in the economic engine. As the engine grows, so must the money supply to keep the oil levels even. The more the engine grows (i.e. the more lending), the more oil is required in order for the engine not to seize up.
For context consider this chart from 2000 through 2012:
Notice that during this tumultuous time (market bubble, wars, historic bankruptcies and a major financial crisis, just to name a few) money supply always grew. Yes it wobbled around its average of 6%, but it never went negative. In fact, it eked out a 2% growth rate at the depths of the financial crisis. Meanwhile, the variance around that 6% average was always +/- 60%.
Now what has happened lately?
Enter Covid. In an effort to fight the lockdowns, the Fed exploded money supply growth to over 26%. As the economy reopened, M2 growth gradually moderated, finally coming back down to its 5% average in July of 2022.
In terms of the variance around the average, that’s where things turned upside down. The variance hovered at +/- 40% until Covid, but shot up to +400% during Covid and crashed to -150% post-Covid.
Since peaking in April 2022, money supply has been shrinking. In fact, it is now on the precipice of posting its first negative year over year growth rate in recent history.
Given that M2 was still advancing at 2% at the bottom in the Great Financial Crisis, inflation in all likelihood should cease to be a topic in 2023.
Monetary conditions are now more restrictive than in 2008.
To provide context how restrictive monetary conditions are, if the money supply shrinks again in December, that makes five sequential monthly declines. There were five total during the Great Financial Crisis compared to seven in 2022. And we’re probably not done yet.
For a Fed that is myopically focused on lagging indicators, such as wage growth, this means the Fed should soon have the confirmation it needs to pause rate hikes at the very least.
If this history is any guide, whatever path the economy eventually takes, it is likely 2023 will be a year of inflection in policy and equity markets. So even if the Fed gets to a certain point and decides to stand pat, the very fact they have stopped will help put a floor under equity valuations.
We’ve lived in a world that’s been upside down for the last three years. Hopefully 2023 marks the year we are right side up again. The data certainly suggests it.
Happy New Year.
[See our 2022 review here]
Clockwise Capital is an asset management firm with a private equity approach to the public markets. We focus on the meaning of time and the role it plays in people’s lives. We believe the essence of a great investment resides in the ability of a company to either save their customers time, or improve its quality. We understand how technology evolves to drive these two factors, which we believe define human progress. As a result, we search for securities with cyclically depressed valuations whose companies save time, thus using secularly advantaged industries to build a concentrated portfolio. With each series of investments our goal is to optimize edge, maximize return, while also minimizing correlation. This allows our portfolio to maintain a liquid, low duration fixed income balance, ready to capitalize on market volatility, while still generating market beating performance.
