TBG Market Color: Q1 2023

Key Takeaways:

• Q1 was an eventful quarter that saw a strong bounce back in growth companies despite a regional banking crisis.
• We analyze Meta below to demonstrate that a bounce back in technology companies has been driven by low estimates and low valuations going into the year that has created a strong upward trend for the group as they have surpassed expectations.
• We believe markets are starting to act more “normal” as we see examples of stocks going up on bad news as the market works to price in negative events into their stock prices days and weeks ahead of the actual event.
• We provide a FAQ page on the US market where we discuss: 
  • What the latest GDP forecasts are?
  • Are economic strategist notes a reliable indicator of market performance?
  • How are we thinking about potential downside in the event of a recession?
  • How long is the average market contraction?
• We close with a case study on a long-term theme we are investing in. 

Q1 2023 Recap:

Q1 was an eventful quarter that saw one of the strongest bounce backs in growth market indices to start a year along with turmoil in the regional banking industry that continues to reverberate in the economy (see Figure 1 for a chart on key factor performance year to date). As we outlined in our 2023 Outlook in January, we liked the opportunity in growth companies going into 2023 for four key reasons: 1) there was a reset of both estimates and valuations, 2) the pace of interest rate hikes was slowing allowing for a shift in market narrative, 3) the themes hadn’t changed, and 4) foreign currencies had strengthened versus the dollar providing a lift to US-based companies with international operations.

Fig. 1: Factor Performance YTD

What is driving this bounce back in growth companies?

Let’s analyze Facebook and its parent company, Meta, to explore this question further (note commentary reflects pre Q1 2023 results).  At year end 2021, investors anticipated Meta would deliver about $14.00 in earnings per share over the next twelve months (“NTM EPS”), i.e. estimated 2022 EPS. At the time, the stock was trading at $336. In 2022, Meta ended up delivering about $8.60/share in actual profits/share in 2022 with investors essentially expecting flat earnings of $8/share in 2023 for NTM EPS. The stock hit a low of under $100/share near the end of 2022 where it was trading at ~12x NTM EPS.  Since then, the company has announced layoffs of about 21,000 employees or 25% of their workforce, thus eliminating about $10 Billion in expenses for 2023.  Now, the stock has recovered by about 80% to $215, driven by an increase in both profits and an improvement in the valuation of the company as investors become more optimistic about the company’s future outlook (see the math in Table 1). In this example, both low estimates, low valuations and better exchange rates have helped drive a sharp bounce back.  From here, we expect revenue growth from continued consumer engagement in social media to be key to results.

Table 1: Meta Stock Price and NTM EPS

Source: Bloomberg data as of 4/26/2023.

Trading Observations:

It appears to us that the market is starting to act more normal.  If companies have good earnings where estimates are increasing (a la Meta), stocks have been going up. If companies have bad earnings, they can go down further.   Another signpost of a more normal environment, stock prices often reflect enthusiasm or pessimism of future events before the event and hence will sometimes do the opposite after the event. Sometimes, stocks will go up at first on strong earnings and then go down possibly as much as 5 or 10% days later as some investors take profits. We have noticed these patterns this year and ultimately, we think it’s a good thing for the market to get back to its normal rhythm.

We will not elaborate on the complexities of the regional banking crisis we saw in March. However, we will mention one recent example to highlight the above. Charles Schwab (ticker: SCHW) saw its earnings estimates for 2023 reduced from $4.80/share three months ago to $3.70/share going into Q1 earnings as investors realized that company profits would come down as brokerage cash migrated to money market funds and Schwab would raise some capital. As a result of this turmoil, the stock fell from $75 to $50, a 33% decline. On earnings on April 19th, the company reduced guidance for profits for the second quarter and 2023 earnings fell further to $3.30/share, however the stock went up on earnings day. From this example, you can see the market work to price in bad earnings news before the earnings results are even published. 

FAQs on the US Market Outlook:

Much of the direction of the economy will depend on decisions of the Federal Reserve among others. Economic factors will have an impact on the amount of unemployment and consumer spending patterns, which we think could be increasingly linked in the short-term to news flow. This feedback loop will make drawing long-term conclusions from short-term headlines more difficult. However, we provide some context for how we’re thinking about the US stock market.

1. What are GDP Forecasts? Currently, US economists are projecting 1.2% GDP growth in the US in 2023 and 0.8% in 2024 (average compiled by Bloomberg).  This growth forecast has been revised up from 0.5% growth in January. GDP growth compares to forecasts for S&P 500 sales growth of 4% in 2023 and 5% in 2024 though market analysts are modeling flat profit growth in 2023 at $220/share with some estimates as low as $200/share before growing again in 2024. Takeaway: Growth is slower than average but is not currently forecasted to be recessionary.
2. Are economic strategists and the media a reliable indicator of market performance? We are likely to see continued negative media headlines as economic uncertainty continues. So, the amount of negative headlines begs the question - are they correct? As a proxy, we’ll use the Bull/Bear Sentiment Indicator from Bank of America research. Based on Figure 2, it appears max bearishness tends to occur at market lows when one would want to invest more.  Takeaway: Bearish reports have an unreliable history of being correct investment indicators.
3. How do we think about potential downside to the market in the case of a recession? In the event of a recession, we anticipate that cash / US government interest rates are likely to come down to more average levels.  Over the last 20 years, the average Fed Funds Rate has ranged from 1-2% compared to 5% today.  So, if a recession happens, we believe interest rates are likely to come down which should expand the multiple of the stock market (see Table 2 below for illustrative equity valuation math on potential recession scenarios). As James Gorman, CEO of Morgan Stanley, said on the company’s recent Q1 earnings call, “absent any geopolitical surprise or limited progress on bringing down inflation, I think 2023 is likely to end on a constructive note in most areas.” Takeaway: Assuming continued normalization of inflation and cash rates, US markets could find support even in the case of a mild recession.
4. How long is the average market contraction? Per Goldman Sachs, the average bear market lasts a little over one year, while the average amount of time to get back to the prior market peak is around 2 to 3 years.  We are currently about 1.25 years past the prior peak of the S&P on January 3, 2022 of 4800 (the Nasdaq has been in contraction about two months longer). Surprisingly, returns are negative over the last two years across all major indices including the S&P 500 (-2% on a price change basis), the NASDAQ (-16%), the Bloomberg US Aggregate Bond Index (-13%), Emerging Markets (-29%), and the small cap Russell 2000 Index (-24%). Takeaway: We are working through a contraction period that happens periodically in the US markets.

Fig. 2: Bull/Bear Sentiment Indicator

Source: Bank of America Research Note, “The Flow Show”, Apr. 20, 2023.

Table 2: Illustrative S&P 500 Price Target Math

Source: TBG Illustrative Analysis, 10 Year US Treasury Yield per Bloomberg as of 4/26/2023.

Case Study on the ADAS and Electric Vehicle Supply Chain:

In uncertain and difficult markets, we are always looking to increase the probability of positive outcomes for our investments over time. One way we do that is by looking at shifts in consumer or technological trends that are likely to play out over long periods of times. The companies benefiting from these shifts have a greater chance of growing sales and profit even if the economy doesn't grow over that time, which typically leads to positive investment results even in choppy markets. One area we believe this will play out is in the technology supply chain to new cars. The growth is being driven by the influx of new advanced driver assistance systems (ADAS), including blind side detectors, rear-view cameras, and parking sensors, as well as an increasing number of electric vehicles (and eventually self-driving electric vehicles) purchased each year globally. Impressed with the new technology in cars after test-driving some vehicles, we began researching the automotive technology space in earnest. 

Through our research, we noticed that semiconductor suppliers to the automotive industry were growing revenues at very attractive rates for what were below market valuation multiples. The pace of this growth for these suppliers is likely to continue for several reasons. For one, these driver assistance systems can add more than two times the dollar value of chips per car as new cars contain multiple cameras, power systems to manage batteries, and radar sensors (see Figure 3.a. below).  And two, these digital-enabled cars are a small and growing portion of the U.S. market. Per Automotive News, there were under 1 million electric vehicles sold in the U.S. in 2022, or about 6% of the 13 million sold last year out of 250 million cars registered in the U.S. today (Tesla sold ~500k of these EVs for about 60% market share). Therefore, there is a large runway for growth, as the number of EVs purchased in the U.S. is forecasted to go from 1 million this year to 3 million by 2025 (Figure 3.b.) as manufacturers increase production capacity (Elon Musk indicated Tesla would grow production by over 50% this year).

There are many suppliers that have solid track records of innovation and growth in this space, and we see a plentiful hunting ground for strong investments. If you are interested learning more about the specific companies we are investing in, please reach out.

Fig. 3.a.: Illustration of AN Advanced Driver ASistance System (ADAS) in Car

Source: Robotics and Automation News

Fig. 3.b.:Projected Number of Electric Vehicles Sold in the U.S.

Source: IHS Global Insights via GS Research, 2/10/2023