Deconstructing Alpha

EP 19: What is the next phase of this market cycle?

December 08, 2022 Geremy van Arkel, CFA® Season 1 Episode 19
Deconstructing Alpha
EP 19: What is the next phase of this market cycle?
Show Notes Transcript

So here we are, 9 months into a market decline.  What now?  In this interview we discuss what is likely to happen to the economy and earnings, what is next for capital markets, and where is the opportunity. 

Who doesn’t want to know that?  I don’t know anyone that can deconstruct it better than Brad Neuman. 


EP 19 Brad Neuman Alger_edits

Thu, Dec 08, 2022 2:06PM • 50:53


economy, growth, recession, earnings, valuation, market, stocks, companies, money, long duration, investors, fed, growth stocks, decline, rates, increase, supply, year, talking, podcast



Welcome to deconstructing Alpha. I am your host Jeremy van Arkel. In today's interview, we're going to interview Brad Newman from Alger funds, he is a returning guest for us. For us. Brad was on the show about a year ago. For the This isn't your grandfather's growth value debate. Brad joins us from algae funds, he is just such a good voice in this space where he really breaks things down into very tangible and understandable concepts. And today, we're going to talk about now that we're nine months to 12 months into this inflation cycle market decline cycle, rising interest rate cycle and what's turning into be an economic and earnings cycle. We're already into this now. And so we're gonna get an update from Brad about how we got here. And where we're going. And this is going to be hopefully be a very straightforward podcast, we're going to address what's going on in the economy. We're going to address what's going on in markets and what phases we're going through. And then we're going to address what the opportunities are. And so I could think of no better guest to bring on here to give us an update on those three concepts. And we're gonna break it down. We're gonna deconstruct it. So everybody, I appreciate you being on the call, and on the web on the podcast. And without further ado, Brad Newman, Alger funds. Good morning, Brad. Welcome to the podcast deconstructing Alpha. I'm so glad to have you back.



Yeah, thanks, Jeremy. Good to be back.



So for those listeners who are new to the podcast, we do have a previous podcast with Brad Newman from Alger funds, where we talk about how growth stocks are disadvantaged by the way that they have to expense their r&d, and intangibles, which is such a great podcast, I want to make sure that everybody recognizes that the podcast that we previously did, which is not your grandfather's growth value debate is available, where we really break down some of the advantages of growth, stock investing. But so on this podcast, though, I want to get to three questions. Right. So So much has happened in the last year. And I think there's three things that everybody wants to talk about. Right. And so the first thing is, what's the state of the economy comma now? And what what, what is happening in markets? Is this normal? Is this to be expected? are we way off the mark, or our markets sort of going through the phases that they should be going to appropriately? And and then the final thing is, is to end with what's the opportunity here? So Brad, I couldn't think of anybody better to talk about markets, economy and the opportunities here than yourself. So before we get started, will you remind our listeners, what is your role at Alger funds? And can you tell us a little bit about our differences? specialty?



Yeah, well, I'm the director of market strategy for Alger and outers. $25 billion asset manager, one of the pioneers of growth investing, founded in 1964, privately owned, boutique asset manager focused on growth. We manage money for institutional and retail clients all over the world. And my role specifically, is to provide thought leadership on a macro level, that includes the outlook for the economy and stock market, as well as key growth areas of innovation.



Excellent. So I'm glad to have you here. And sometimes I whenever people introduce themselves, I asked people or opera people to introduce themselves, when I hear what they do. It always leaves me wondering, what are you doing on here with me, but I really appreciate your being here with me. The second thing I appreciate, which is I don't know if you've noticed this, but it is the first Monday after daylight savings, time change. So we lost an hour and we're in the morning. So I do appreciate you being here after this, you know, what people are now calling the trauma of the of the time change, so, so appreciate you you being here.



Sorry, on that they're grim. I know



it's it's amazing how the internet can can can dig deep and narrow holes and provide you lots of data about that deep and narrow hole. Okay, so let's get started with the economy. Right. So about a year ago, we were talking about growth stocks versus value stocks. And now we fast forward a year or so. And that debate is still extremely important, I think, because there's actual structural differences between them. But but, you know, a lot has happened. We've had inflation really run out of control. We've had a sort of what I would call sort of a slow fed, but now we have a fast fed, and we have had the war, the war in Ukraine, and with exasperating inflation and now you know, we're we're nine months to 12 Listen to this, the markets are down 20 to 30% bond markets down 15%. So, so let's start with the economy. So, as you see the economy unfold here is this sort of a natural and normal reaction to the inflation.



It's, I don't even think we've seen the reaction yet to what the Fed has done. And I know your question was, how is the economy now? And I can answer that, but I can probably do you and your listeners one better and tell you where the economy's gonna be. I think that's more important. Yeah. Because like as, as Wayne Gretzky says, you want to skate to where the puck is going to be, not where it's been. So I think to figure out where it's going to be, I would look at a couple of different things. One is kind of an arcane concept that your viewers probably aren't super familiar with. But I think it's super important right now. And that's the money supply. So it used to be, you know, decades ago that the money supply was really was really focused on economists it used to come out every week, now comes out every month, and people were on the edge of their seats. Well, if you're an economic nerd, like me, you're on the edge of your seats and trying to figure out where it was going to be and what that meant for the economy. Now, the money supply is really important, because if you think about what the economy is, economic activity is how much money there is in the system, times how fast that money moves around the system. That's all it is. So when we talk about the money supply, we're talking about the money that's actually out there and in cash, talking about the money that's out there, and checking and savings accounts, retail money markets, those kinds of things. And one of the reasons why a lot of economists don't focus on it so much anymore, is because it's very hard to figure out how fast it's going to move around the economy. You know, I mentioned there's only two things that impact economic activity, how much money and how fast it moves around? Well, we know how much money there is out there at any given time, but we don't know how fast gonna move like Jeremy, if I gave you, you know, $100 your economy, meaning how much you spend, may or may not increase by the $100. Maybe you say, Thanks, Brad, I'm gonna go out and go to dinner tonight with that, and you spend it right away, and your economy in quotes increases $100. Or maybe you say, You know what, I'm gonna, I'm gonna save it for a rainy day. And you know, there's no increase in spending. So that's why it's not that meaningful to economists. So why am I talking about this? Because it's extremely meaningful, when there's huge changes in that, like, Jeremy, if I gave you $100,000, I'm guessing that you would probably spend some of it, at least a little bit of it. Yes. So that's what's happened in the economy, the economy had over 25% increase in the money supply during COVID to combat was a terrible issue for the economy. And that more than $6 trillion really impacted economic growth, because it was such a big increase. Now the money supply is the growth is decreasing, it's no longer increasing anything like 25%. In fact, it's increasing in the low single digits, its growth is continues to be driven down or decelerate, because the Fed is increasing interest rates, they're reducing their balance sheet, and the federal government is no longer spending so much. We believe that the money supply or I believe that the money supply will actually begin to contract over the next several months. If it does, it'll be the first time it contracts since 1938. So you don't have to be an economist to know that. If you're increased the money supply, by the most it's ever increased, you're gonna have a big increase in economic activity, ie 2020 and an early 21. And secondly, on the other hand, if you are going to contract the money supply, by the most in many, many decades, you're going to have a weak economy. And so we can predict that the money supply is going to contract and that the economic activity is going to decelerate or likely decline.



So you said some, you know, you came at this economy from a very technical manner, which is the money supply times money, velocity equals GDP, which is such a simple way of looking at the economy. And I completely agree with that. And, and, you know, I'd like to add, you know, money supply, you know, people often call it call out the, you know, money increase in the money supply that doesn't feel fiscally responsible. Right. And, and, you know, from the early 70s, since we went off the gold standard, the the money supply growth has been approximately 7% a year. It's not the same every single year, but it has been low uncontrolled in the 7% range, while some people say that's still high, and it has been going on globally. But when you do look at the charts for those listeners, if you want to pull up the money supply chart on Fred, you know, if you do look at this chart, and you look at the growth of money supply, the spike around 2020 is really I mean, you can look at the back to the 50s and you can see that spike and you just go holy, wow, that's really off the charts literally. And and so while we're used to a constant rate Have 7% money supply growth. We've never experienced, as you said, at least in terms of the graphics I've seen, there's never been a monetary decline. So they so that our whole, you can think of that as our whole system of our economy is reliant upon some level of growth, money supply. And then the second thing is that, you know, a lot of the classical economists you didn't mention this, but a lot of the classical economists believe that money velocity was was constant. Right? And money velocity has not been constant. You want to talk about that a little bit? Or? I mean, because that's the second part of that equation.



Well, you know, as I mentioned, it's a kind of depends on, you know, what economists have historically called animal spirits in quotes. And so to the extent that, you know, people are feeling good about their economic prospects, you know, their job prospects, that kind of thing, they're more likely to, you know, when there's more money, more money out there, they're more likely to use that money to do productive things and spend, etc. But when they're more cautious, they're more likely to save it. And that doesn't increase economic activity. The other the other kind of big picture leading indicator would be, well, we could look at the index of leading economic indicator, which is a very good one put out by the Conference Board, which has, you know, a variety of different things rolled up into it, it's really never has missed a recession. Anytime it's gone negative, there's been a recession, and it turned negative in August, and was further negative in September. So it is forecasting a recession over the next few months. It's got things in there, like building permits and durable goods orders. So that's a really good indicator, you know, and then finally, the last thing I'd say, again, looking forward is that, you know, if you listen to the Fed, they say that there is a narrow path to avoid recession, the path is getting now or we'll just to put it in perspective, in the past 13, rate hikes, cycles, there have been three soft landings, meaning only three times out of 13, did we avoid a recession. So right there, the odds aren't good. But in those three soft landings, the increase in the Fed funds rate was about 300 basis points and all three times. And today, if you believe the market, we're looking for probably north of 500 basis points of total increase in the Fed funds rate through you know, early to mid 2023. So if we did have a soft landing and avoid a recession, it would be completely unprecedented.



I, I couldn't agree more. So I think, you know, what I've been writing about lately, and the responses I've had to the latest fed hike. And I think the market's response to it is probably right on, which is, which is, I think a lot of people expected the Fed to say something along the lines of this is our last rate hike for a while. We're gonna pause for a bit and see what will happen with the rate hikes we've already done. Because Because part of this, you know, when when the Fed raises rates, they're decreasing the money supply and when they're lowering rates are increasing the money supply. And so we started with this money supply thing. So when they're deep, when they're increasing these rates, it takes a while for it to get into the economy, right. So I've heard that, you know, nine to 12 months, right? So if you go back nine to 12 months, we haven't raised rates at all. And so so there is no rate hikes built into the economy comma yet. Yeah,



I, we haven't talked about this, you and I, but I 100% agree with you. In fact, if you listen to the Fed itself, they say that, you know, the transmission lag is about a year. So close your eyes for a minute. And you can, you could just imagine that what you're seeing in the economy today is from the feds actions a year, year and a half ago, when they were increasing the money supply so dramatically. So of course, we have high inflation today. And what you'll see next year is what the Fed did this year, which is decrease the money supply and increase rates so dramatically. So so next year is going to look very different than this year because of that lag and what the Feds done. So definitely agree with that. We just haven't seen it. In fact, the analogy I've been making recently is that the Fed is like an impatient chef. They've got this cake and the recipe calls for it to be baked in the oven for 350 degrees for an hour, but they're so hungry, that they're that they turn it up to 500 degrees, and they're hoping it's going to be ready in a half hour. And all that's going to happen is that they're going to burn the cake or destroy the economy in the process there. So it really just doesn't work to turn up the heat or increase the rates so much and hope hope it transmits you know much more quickly.



And so when you know when I look at historically like you did mention that glass 13 rake heights, rake rakes and you can dig into you know, people all this information is now available wonderfully through the internet and hopefully some of that's accurate and And but we were able to, you know, we're able to go back in time and pull up all this data and say what happened around these times, right? And, and there's only one time when the Fed has raised rates as correct me if I'm wrong as much as fast as this. So in nine months, or at least in a year going up 5%. And that would have been the early 80s. So it's very hard to apply. Well, each time the Fed raises rates, I mean, you could look at the zeros, it'll get 202 Or three, you know, that easy. I'll Alan Greenspan got interest rates down to 1%, after the tech wreck, and, and then from, oh, 3207, they raised rates, four and a half percent 17 times, if I remember correctly, but the markets were fine with that. Because it was gradual. And the markets anticipating a bad economy, I don't know. That's why the stock market's down. But I don't necessarily believe they're anticipating walking into a wall of from zero to 5% interest rates, right. It's not as if in the last 12 months, we raised interest rates one and a half percent at 25 basis point increments. So I think the degree and speed of that is going to be a factor. And the comments on that,



or, oh, yeah, well, I definitely agree. That, that the Fed has, has not, has never had a soft landing with rates increasing so quickly, and at such a magnitude. So that's, again, why I say would be unprecedented for the economy to avoid us off to avoid a recession and make a soft landing. You know, I would just say, you said that the market is and we maybe we're getting into this with the market phase have this discussion that the markets have priced in some you have priced in or, you know, I don't know whether you said a decline in the economy or or exactly what your your term was. But I think that the Treasury bond market has certainly priced into recession, you know, as we're talking here today, on November 7, the yield curve, the 210 yield curve has is more inverted than anytime it's been since 1982. So clearly, the Treasury bond market is is expecting rates to come down and the economy the weekend over the next couple of years. But when you look at the stock market, if you think like 16 times is the normalized multiple there, and you took the current stock market index price and divided by 16 times to get the kind of implied earnings, you know, you get earnings that still show growth in 2023 versus 2022. And there's never been a recession where earnings grew. So to me, the equity market doesn't seem to have fully discounted a recession yet, partially. But hopefully,



that's a great point. And it is it is interesting how we recognize this in our investment group and talk about it quite often, how the bond bonded professional bond investors, how they view their outlook and their role, and how they view the economy, and how different that is and how equity investors view it. Right. And, and in theory, they're all the same investor. Right? They just are viewing the pieces separately. Right. And so I think that I think that's a really good observation. So one of the big debates, obviously, out there has been, you know, on one side, it appears that economists and strategists and people who are watching the entire economy and all over the world and lots of different factors that they are, they are expecting a recession, they're they're expecting this inflation is going to be can hang around longer than normal. And the Feds response is pretty abrupt. And it hasn't even taken a bite yet. And so the economy is probably going to be pretty bad. So the bond market recognizes that I agree. 100%. But it does appear that earnings forecasts have not come down, it appears that that equity analysts who cover I mean, assume that's where earnings forecasts come from, but equity analysts who cover their own stocks believe their own stock outcomes are going to be okay. It appears because we have rising, we actually don't don't have that much degradation in in earnings for this year so far. And then they're, you know, as far as I can tell, the s&p estimates for next year and 24 are higher than 22. So that would imply the analysts haven't changed their estimates too much. Well,



so I think, I think, you know, bottom up analysts are, you know, they're not going to be guided by the macro as much as a strategist would. So to the extent that the macro is really changing, and we think the macro is changing, some of them will be caught off guard, and I'll argue maybe we'll get into this later on that that'll be more kind of like value cyclical areas of the market will be caught more off guard guard by the earnings, weakness then kind of secular growth areas of the market. but just to talk to earnings estimates, big picture for a moment, they actually have come down. So 2023, I think in the middle of the year, just to level set 2021 Right now, s&p 500 earnings expectations are like $221, as we sit here, and 2023 is 222 inch or $33 per share that 233 was about 250. In earlier, kind of like the middle of this year, and to even narrow it down further, I was kind of surprised. Even though we've been saying that earnings estimates are going to come down now for months, and I continue to think they're going to come down. But if you looked at the fourth quarter of 2022, specifically, if just as recently as the middle of this year, June 30. That estimate for the fourth quarter for the s&p 500 was 9% earnings growth year on year. So it's expected to be a very strong quarter, at the end of October, before this earnings season started that 9% had come down to about flat. And if you look at it right now, it's negative, low single digits. And I think it's going to have lower, so it has come down to some degree. Some of that's been currency. Some of its been economic weakness, but it has come down just still has likely to go.



Yeah, and I think that's a really, I think it's, you know, it's not a nuanced point. It's a very big point here is that is that it does appear that bond investors are realists. Maybe and and the equity, the equity analysts appear optimistic. And that, in that I think it's healthy if these earnings estimates come down. I mean, then I would argue that, you know, down 10% estimate for 2023 is still fairly optimistic, right, we haven't even we haven't even faced the rate hikes. So So a big disconnect, I think they're between earnings estimates, and what is likely coming down the pipe and 2020 23



is still expected to grow. Yeah, year off 2022. You know, I never articulated this before, but you talking made me crystallize this, I guess, if you think about treasury bond investors, not corporate bond investors, but treasury bond investors, everyone, to some extent, kind of is a macro investor, as a treasury bond investor. But as an equity investor, you know, you might just be looking at your company, and what the management is telling you, etc. And so you might really, at times, tune out the macro, and depending on the kind of company you're investing in, that may or may not be the correct course of action. A lot of times macro dominates companies. And sometimes I'll argue that it doesn't, but it's interesting that on the Treasury side, macro, I think plays always a bigger role in each investor's mind. And it may be does in individual equity investment. Yeah,



that maybe that's what explains that gap. And that and that maybe the bond investors are faster to adopt change. Because they're viewing macro change differently. And then the equity investors are slower. So when we speak about that, so, so with the market down, you know, in this weird conundrum, that we're still in this zone, where interest rates really haven't had anything yet so employments great and economy's great, earnings are still coming in pretty good. In this zone, we're in here, how do you feel? And then given that the market leads the economy, right, everybody, I really want everybody to remember this, the market leads the economy, not the other way around. So the market is nine months ahead of what actually is happening. So so how are we unraveling here for equity prices, relative to sort of history? And relative to the events? Are we going through the phases correctly? Is it sort of unraveling appropriately? Well,



I think there have been two phases. I think there are two phases to the market headwinds, it's a little different than what most of us have lived through. So there's always there's always two parts of the market decline, there's always a valuation compression, meaning, you know, let's we'll take price to earnings multiples, for example, and then there's an earnings decline. And the earnings decline is they're both they're both different through different cycles. I think their earnings decline is a little bit easier to understand the the valuation compression is harder, because it depends on what the starting point is very significantly, you know, like, if you're coming from 1999, there's obviously a lot more scope for for valuation compression, than if you're coming from 2007. You know, the global financial crisis was a worst recession than the 2001 aftermath of the tech bubble. But valuations decline much more. You know, in the in the tech bubble, you know, broadly speaking for the market, even though there's some terrible things that happen on an individual company based on the global financial crisis, but the multiple for the stock market didn't go down as much in the global financial crisis. So you have to disaggregate the two. To make matters a little more complicated for this cycle. devaluation compression, I think, was really due to interest rates increasing and what I call the duration trade So just like a long term bond, a 30 year bond is more sensitive to increase in interest rates than a one year bond is. So two we think are longer duration equities, where their cash flows are further in the future than shorter duration, equities. And in fact, when we look at different characteristics or factors of companies, we find that you can see that the shorter duration characteristics have dramatically outperformed the longer duration characteristics. So for example, long term growth as a factor has underperformed the stock market broadly over the past 18 months sector neutral, market cap neutral, it's underperformed by hundreds of basis points. Conversely, if you look, that's long duration, because when a company is doing a lot of growth, the cash flows are more in the future. Conversely, if you look at shorter duration characteristics or factors like say shareholder yield, and we define that as dividends, plus share repurchase divided by market cap, those are companies that are giving a lot of they have so much current cash that they're giving cash back to shareholders, that's dramatically outperform the market over the past 18 months on a sector neutral and market cap neutral basis. So short duration, Within equities have dramatically outperformed long durations have dramatically underperformed and that you can see that even if you look within a given sector within growth, what have you. So that that is the first phase, I think of the market correction, this valuation compression based on higher interest rates, or what I call the duration trade. I think that that's largely over. I say that for several reasons, both empirical and, and fundamental. So empirically, it looks like growth is starting to find a bottom and maybe bottomed kind of towards the middle of the year. In fact, in the third quarter of this year was the first time that growth outperform value all year. And it was the first time that growth outperformed small growth outperformed small value for the first time, it was the first time in two years. And if you look at fundamentally, it looks like and we'll probably get into this and we look at opportunities, but it looks like the longest duration companies, those are small growth companies where the cash flows are further in the future. In fact, some of the companies are not profitable now. So all the cash flows are in the future looks like their valuations have hit a floor. Or you know, I can't say for certain, but just relative to the market, it looks like they've stopped going down.



Yeah, yeah. So so that, that makes a lot of sense to me. And I really, really appreciate the way you've just decomposed the market, you know, instead of being growth in value, it's it's it's more of this short duration and long duration, it makes total sense to me that if companies are giving you the money back today, then they have less inflation risk of their earnings in the future. And then long dated companies that earnings are pushed to the future, that that makes sense. And so So you did already reiterate this, I just want to touch on one more time though it you know, there was a general feeling amongst myself, maybe some other people that in 2021, you know, growth stocks were really hard to keep up with, there was a lot of euphoria around some of the growth names. And you know, a lot of people refer to 2021 is sort of the trying to keep up trying to keep up with a few names sort of thing. And, and so, you did touch on this, but just just Do you feel like in the in the big names, the big tax the things that most people own? You know, you're I guess you're saying that you think most of the price, sort of inflation, if there was price inflation, most of that is sort of taken out. So the price move the market adjustment, sort of maybe past us does that sound? Right?



Right. So if you believe what I said, there's these two phases. growth stocks were a terrible group to be in in the first phase. Why? Because they're long duration, the cash flows are in the future. And if you're going to discount them backed by a higher interest rate, you know, the real on the Treasury market, the real rate real tenure rates, meaning taking on inflation, where minus 1%, if you go back, you know, a year ago, today, they're over one and a half percent. That might sound like a small move to listeners, but it's a very dramatic move, because real rates typically are not higher than say 2% longer term. They're almost negative, never negative, you know, from a historical standpoint, but they were deeply negative. And so that caused valuations, rightly so, you know, mathematically speaking of long duration stocks to be to be higher. And that ended recently. And so that first phase was bad for growth stocks. But if it's over, then you're really talking about well, how will growth stocks phase fair and the second phase and the second phase of the market headwinds, I think are earnings related rather than valuation related. So, you know, we know that in recessions as I said earlier in the podcast, every recession season earnings decline. The markets only priced in a portion of that not not all of that, but not all stocks are created equal. And if you average the past three recessions, world stock declines have been less than half as much as value stock declines. And there's several reasons for that. And I don't know how much you want to get into it. But the biggest driver is the fact that growth stocks are more driven with their earnings, their earnings and fundamentals are more driven by market share games. They're more independent of the economy and value stock earnings, you know, you think about banks, financials, materials, industrials, they're more driven by the economy and economic growth. You know, the analogy I like to give is that of a sailboat versus a motor boat value, stocks are a little more like sailboats where they're driven by the economic winds, economic growth winds. And so when the wind when you know, the economy is growing, and those winds are blowing, it's great to be on a sailboat. But if there's no economic growth, the sailboats just kind of listless whereas think of growth stocks is more of motorboats with a little engine on the back, that's driven by market share gains that can grow independently of the economy. And we've seen that through every recession we've ever looked at over the past century, you go back to the early 90s. You saw PCs grew 30% and a stagnant economy as knowledge workers were getting personal computers on their desk for the first time, you go back to global financial crisis, smartphones got a shot in the arm from the iPhone being invented in 2007. They not only increase globally during the global financial crisis, but they accelerated same thing with E commerce internet advertising, which we think is now more mature. But they both grew 30% and a stagnant economy kind of from Oh, 709. So and then we saw the same thing during the pandemic, GDP took a huge hit, but software investment, according to the government continue to grow, because companies needed to invest in digital transformation, etc. So I think growth fared very poorly, rightfully so in the first phase of the market headwinds, which was that duration trade? And will fate fare much better in the second phase, which will be all about fundamentals.



Yeah. So I guess to, to recap that real quick is that if if if the interest rate hikes that have occurred very rapidly, in a short amount of time, that haven't had chance, a chance to sort of crystallize themselves into the economy or to spread into the economy, they're really just spreading into asset prices, because, you know, the stock market can react immediately, that consumer behavior and all that doesn't, doesn't react immediately, it takes a while, and business behavior and everything. And certainly if I'm a business, and it costs me, it used to cost me 3% To borrow money to build a factory, and now it cost me eight, I'm gonna be a lot slower and making that decision. So it really affects everything so so that the interest rate hikes, maybe haven't taken effect in the physical real world yet. And but the market has anticipated. And so during that anticipation, we get the valuation decompression, and then once the economy really does slow down, and earnings really do decline, you're implying that it then becomes a stock picker game, right? Because we want stocks that are going to be relatively unaffected by an economic slowdown or less affected, less affected by an economic slowdown is that that's about right. Right. And so if you, you know, this is that, I think a lot of people just look at things as stop boxes. They're like, No, this is growth, and this is value, and they're all the same, and I vehemently disagree with that. And a perfectly example of that is in the value box, you've got energy, you got utilities, you've got financials and you have cyclicals and then you have dividend payers, right. And all of them are going to respond differently. So for example, in the value box or value is outperforming this year, but in the value box, what's winning is this. companies that pay back the dividend payers exactly what you said we've noticed that and and so shareholder yield is winning. And but if the economy goes south because of rising interest rates, doesn't that isn't that terrible for cyclicals?



Yeah, yeah. And I mean, this is this is I mean, there are a lot of patterns to this. This is this this part is normal. So we've put this out before you know if you look six months to six months before the first rate hike to three months after value stocks typically outperform and why would they outperform because at that point, the economy is strong. Why else would the Fed be raising rates if the economy wasn't strong, so value cyclicals do well, in the early part of array tightening. However, of course, as you mentioned, it takes a while for rates to impact the economy and the market does look forward. But you know, they don't look forward so much in any way from from three to nine months after the first rate hike, then growth starts to do better. And of course, we increased rates for the first time, as you mentioned this year in March. So you know, three months was really after three months after that began the third quarter and that's when growth stocks on cue began to outperform. And I would think that a lot of these cyclicals that have been doing well, because the economy has been okay, in 2022. So far, will do much worse as the economy transitions to a much weaker state because the lagged impact of what the Fed is doing, as we both said in 2023, they're gonna be, you know, really tough for banks for industrials. You know, certainly we're gonna have a recession in Europe. So companies impacted by that area of the globe, is going to be tough, but those types of companies are going to have difficulty, whereas the types of growth companies that can have some market share gains can do much better. And I have actually, we went, I went recently through most of our strategies and search for companies talking about recession. And so I could even give you anecdotally what companies are talking about with regard to recession, you can plainly see that the companies with market share driven kind of motors getting back to that earlier analogy, are much more confident about their outlook and how the company will do in a recession. And those who are either just more impacted by the economy or just larger and can't escape the economy. So I really think small growth stocks which have taken on the chin, because they're the longest duration, assets and and mathematically impacted the most by higher rates will perform the best from a fundamental standpoint, because of what drives them and how they can disconnect from the economy to some extent. And we haven't touched on this yet. But because their valuations are so compelling right now.



Yeah. So let's so let's, let's talk about that. So this is really, you know, we're smack dab in the middle of the opportunity set here. Right. So. So it sounds like the market phases have been on cue, right? Bad news markets false. First, the Fed responds, it takes a while for the Fed to respond. We're just getting into the Fed response now. And and that will be likely further economic slowdown. And during that time, it feels almost offensive to be in growth stocks, which is I think, quite Iran, ironic, to a lot of investors, because they have this hunch that value does better in market declines. But so So the opportunity is twofold, then what you're kind of saying is the first opportunity is you have an opportunity to be at least positioned right on the risk spectrum, and that growth might be less risk than value. And but you're also fundamentally, yeah, fundamentally, and then and then you but you might also be hinting that there's a valuation play here, right, like that. Some of this some areas of the market maybe



are overdone. Yeah, you know, so when I speak to clients, clients want no part of unprofitable companies, you know, unprofitable companies did really well, in 2020, when money was free, and now money is expensive, and nobody wants unprofitable companies, and they don't want long duration companies, they don't want the companies where, you know, they have a very bright future in front of them. But as far in the future, they want, you know, show me the money now. So that, you know, I, if you're a contrarian, there's a big opportunity there. In fact, this doesn't normally happen in my experience where the fundamentals and the valuation line up. But I think tactically speaking, it does line up. So we already talked about why long duration companies fundamentally may be attractive now, because they have a growth engine that can be a little bit disconnected from the economy, because of market share gains, and they're smaller size. But also from a valuation perspective, because this valuation trade went so far, and clients pulled out so much money from the these types of companies and strategies. Small growth stocks are now as far as we can tell, like if you look at the s&p 600 growth, which are small cap growth stocks, we look at the relative PE compared to the broader market, the s&p 500 It's essentially the cheapest it's ever been. And the data goes back about a quarter of a century, what is normally, you know, a double digit premium. The small growth stocks trade at relative to the broader market, which makes sense because they grow so much faster. What's normally a double digit premium and the price to earnings multiple is today over a 20% discount. So you're getting the smallest fastest growing, you know, these long duration companies cheaper than ever before, at a time when they may be able to post the best results, potentially all 2020 When they were able to grow double digits. Despite a very weak economy. I don't know that it'll be you know, the history will repeat but it may rhyme in that small growth may do better than you know value type more cyclical companies.



So I love this breakdown that you did you know so when you're when you're talking about the markets and they're facing any sort of problem, the first thing to happen is the value decompression devaluation decompression point. prices come down to where they probably should be priced. Because I don't want to take any risks because it looks like the future is bad. And then the next thing is, is when you get into the phase of the economy doing poorly during that earnings decline, assets act differently. And I think that you're exactly right that this is a case where you could have less economic sensitivity, less volatility, and greater opportunity just based on pricing, and then the recovery cycle. So when you're in the recovery cycle, let's say, let's say nine months from now, let's say the market prices, the future 12 months out, and we say 12 months from now, we think we're going to be okay. Right. So then you're placing money today. Right? Based on that? I think 12 I'm not saying I think 12 months from now, it's gonna be okay. But for investors that say that it might be okay. Does this process reverse itself? Does it then say, well, companies that are likely to have stronger earnings, get the massive valuation push real quick? Does it reverse itself? If so, in the decline, the valuations come first, then the reality in in, in the when the market advances or recovers? Is it that the valuations come first it quickly, and then they well outstrip the reality again? So I



just want to clarify one thing, and then I'll answer that, yeah. The valuations, as you said, Do compress first, but this cycle was a little bit different in that we had this huge increase in real rates, which compressed valuations well took valuations that had been higher than normal for a certain segment of the market, because real rates were lower than ever before, negative. And as real rates went up, they compressed. The good news for for growth stocks is so the next the next phase is, you know, earnings headwinds. And you have to be a stock picker kind of or an asset allocator to where the fundamentals will hold up best. And then after that phase, you might ask, you know what happens, and then the economy will start to recover, and you would think, then value stocks may begin to outperform because they're more cyclical, and I think their earnings will eventually, you know, come back, although they haven't even been hit yet. So we're looking far into the future. But but they will recover. And that will be a nice tailwind for value investors. The beauty, though, for growth investors, besides the long term structural talents, which I think we talked about in the last podcast, but the beauty for growth investors is this negative impact valuation compression that we've already talked about from real rates isn't going to come again, I don't think because real rates are normally, you know, from a long term bond perspective, you know, something like 2%, you know, you just think, you know, you probably have to have some kind of investors require some kind of real return on their money. And it's low single digits, it's not, you know, no one gets, you know, for risk free anyway, you know, huge, huge returns, inflation adjusted, obviously, if you take risk, you can, but we're just talking about risk free, it's a low single digit positive number, not a negative number. The only anomaly that we lived through in the past couple of years was that it went negative, but now it's kind of returned to normal so that valuation shock is over. So growth stocks, I don't think we'll have you know, any more evaluation, compression now you can just live with, who's going to have, you know, if you're a long term investor, and you're investing over the next five or 10 years, now that valuations have normalized, and you could argue that long duration and I would argue that long duration, small capital stocks will actually have a valuation tailwind, but you don't want to get into that or don't want to price that. Now, it's really just comes down to fundamentals over the next five or 10 years. You know, and we would say that growth, stocks, value, stocks will dip, their earnings will dip in the recession, then they'll come back. But over the cycle growth, you know, when you're when you're betting on themes, like the Internet of Things, and artificial intelligence, that could be one of the most powerful things we've ever seen in our lifetimes. You know, Google says artificial intelligence will be more meaningful to humanity than fire. That will drive earnings growth much faster than the broad market and value stocks, I think over the next decade.



All right. Okay, so I think we've covered let's get a little recap. You want to recap for us? I think we covered it, right. Sure. Yeah. Yeah. So I think we talked about the economy and so so quick take on your economy. Well, your



your key economy is going to head into recession is gonna get worse.



Okay. And then markets is this normal? We're going through the phases correctly.



There was a shock because of a big increase in real rates that led to valuation compression, particularly long duration assets that are now cheap. Next phase of the market headwinds will be earnings declined, and those companies that are best fundamentally positioned will perform the best in my view,



right and then opportunity, and I'm going to add real quick on the opportunity. My All I want to say about opportunity is that the market price is the future. So if there are any stocks or selling stocks today, you should be doing that based on your at least one year estimate of what things will be a year from now. So opportunity. So what's the opportunity?



So the opportunity is that not all stocks are created equal, our earnings are going to come down for many stocks. And you need to be in companies that are where the fundamentals are more driven secularly rather than cyclically by the economy, and in my view, it happens that a lot of those companies that are best positioned to weather the storm, those long duration growth companies are actually trading favorable valuation discounts to what it has historically been premiums. And so they set up quite nicely.



All right. Well, for me, I think that was hard. I never summarized anything, but I think we kind of hit the major points real quickly there. So I appreciate that. So are there any final questions, any final points we're running up on? On 40 minutes, we could probably go on for a long time, I really enjoyed talking with you. And I've tried my best to keep this on track, because I feel like you talk about so many interesting points. And I would just love to grab some of them and dive deeper. But so anything you want to leave us with anything want to leave us with any key point we missed or anything you want to emphasize?



Well, you know, just we've talked a lot about tactical investing, you know, where you should position your portfolio for the next 12 months. And of course, many clients I speak with are interested in that, you know, it's human nature. But I think the bigger picture is one of long term wealth creation. So just using a historical analog for a moment, if you go back to the last time, we had a supply induced recession, the 1970s, were an oil embargo. 1973 had big inflation and a recession in 7475. And the market fell 40%. And earnings declined double digits in real terms. So very nasty recession caused a lot of pain. But instead of the market, being where it is today, 3700, it was 100. The s&p 500 was 100 Back then, and the market declined 40%. But that 40% was only 40 points, 40 points, we routinely move in a day these days. And the earnings decline was off of $7 in earnings per share, not $227, or earnings per share, which is approximately what we you know, could be at next year. So what's the point of that, the point is, is that while recessions feel very bad, and in many cases, you know, seem like they're going to threaten your financial security, while you're living through them in the rearview mirror, and judging the long arc of time, they're really just a little blip, and in what's a huge wealth creation. And in my view, the next you know, several decades will bring tremendous wealth creation, huge amounts of innovation, actually faster pace of innovation over the next 30 years. And it was over the previous 30 years. And, and so I would encourage investors to remain have a long term view remain invested. And I think there'll be a lot of wealth creation over the next, you know, several years and decades,



I couldn't have said that better myself. The older I get, the more I understand this sort of march of progress. And, and, and try to stop myself from falling down deep, narrow holes, to nowhere. And, and so and so, I again, I really appreciate you being on here. I I could have grabbed so many different topics and sidelined us into many different places. Appreciate your perspective, I think the way you put points into clarity are exceptional. And so I'm just going to say thank you. And hopefully we can come back and grab on some of these other topics. You know, I really I really, I really just think so many of the interesting things that your firm gets into and researches and really they are, you know, sort of the future. They're your growth investor, you look to the future and you look to the innovation and it feels incredible when I hear a lot of those stories, so we're gonna have to have you come back for more, maybe an innovation podcast, but for now. Thank you. super appreciate you being



here. Yeah, my pleasure. Happy to come back anytime. Thanks a lot. Chairman.



Thank you very much.



This podcast is for informational purposes only. The information does not constitute advice or a recommendation of any specific investment mutual fund or mutual fund company. Before making any investment you should carefully seek independent legal tax and regulatory advice. In particular, you should seek the advice of a licensed financial advisor regarding the suitability of the investment product, taking into account your specific investment objectives, financial situation, any particular needs and your ability to assume the risk and fees involved before investing. This podcast and presentation are for informational purposes only. Frontier assumes no liability for any action taken in response to listening to this podcast. Frontier asset management is not affiliated with any specific Fund Company. The views and opinions expressed by each speaker are their own as of the date of the recording, any such views are subject to change at any time, based upon market and other conditions and frontier disclaims any responsibility to update such views