Q2 2022 Market Update

Table of Contents

Q2 2022 Is A Much Better Investing Environment Than Q3 2021

Equities

Fixed Income

US Treasuries

Investment Grade Bonds

Municipal Bonds

Meme Frenzy Seems To Be Dissipating

Cryptocurrencies

Q2 2022 Is A Much Better Investing Environment Than Q3 2021

In our Q3 2021 update we outlined our caution about what looked to be a rich point in valuations across asset classes. We expressed that we were hesitant to deploy a lot of capital into a market that seemed expensive relative to history.  We wrote:

“My concern is that a large vintage year bet on 2021 will create sustained losses in an environment where interest rates have any sort of moderation towards normalcy.  I believe there are certain investments that can be made today that will perform well in that environment - but they represent a smaller part of the equity universe.”  

We cited low long-term interest rates, low credit spreads, high equity earnings multiples and “bubbly” behavior in crypto currencies and SPACs (NKLA in particular) as evidence of the unfavorable environment.

Since then, markets have undergone a massive repricing, with short and long-term interest rates higher, credit spreads wider and equity multiples (and prices) way down. Given this backdrop, there are more interesting opportunities to deploy capital into, which we explore below.

Equities

Source: Bloomberg, SPX Index P/E

S&P 500 Price / Forward Earnings (P/E) multiples have contracted since peaking at 30x in April 2021 and have  declined ~35% to ~19x.

The S&P 500 has historically traded at a 50-year average of ~17x P/E, which is also similar to the P/E ratio since 2008.  While valuations may fall further, we are quite close to average, and are probably closer to cheap when taking into account that long-term interest rates are still quite low relative to history (lower than average interest rates should generally translate into higher than average P/Es).

Certain sub-segments of the market have seen valuation multiples compress much more violently.  Software companies have de-rated from a peak of ~20x EV / NTM Revenue multiples in Q4 2021 to ~5.5x, with many companies declining >70% in price since that point in time.

Source: https://cloudedjudgement.substack.com/p/clouded-judgement-61722 - Jun 17, 2022

Valuation multiples can exhibit some degree of mean reversion and multiples could certainly contract further from here. We see compelling opportunities to invest in companies with above market growth, well managed businesses and have moat-like characteristics that trade at reasonable valuations. For businesses like these, we believe they are likely to have compelling returns many years into the future, even if equity multiples continue to contract further. In the below example, we show strong potential returns for growth companies should valuation multiples further contract another ~20% to ~15x.

There are other companies that trade at high multiples, but have more modest growth prospects that may need to fall further if we continue to move into a higher interest rate environment. One such stock is Costo Co (COST), which has been a long time holding of mine, but one that I’m considering lightening up on given much lower return prospects given its current price, valuation multiple and growth prospects.

Fixed Income

Source: Bloomberg. Tax Rate Assumptions: Federal (37%), State (10%)

US Treasuries

10 Year US Treasury Yields

Source: Bloomberg, 10-Yr US Treasury Yield (USGG10YR)

In June, the Fed raised interest rates by 75 bps as the Fed Funds rate is between 1.5-1.75% with the expectation of reaching 3-4% by the end of the year. The 10-Year US Treasury is hovering around 3%, which impacts financing from auto loans and home mortgages to corporate financings. The current rising rate environment discounts future cash flows at a higher discount rate, which is partly responsible for the re-pricing of equity valuations.

Positively, the rise in interest rates is favorable for cash equivalent money market securities as the market is pricing in pre-tax money market yield of ~3% by EoY. We are firm believers in positioning a portion of your portfolio into cash as a source of liquidity for your lifestyle and as a source of optionality to invest in markets.

As you will see throughout the rest of our fixed income analysis, we believe the best fixed income securities continue to be cash equivalents as we currently don’t believe you are adequately compensated for taking on greater interest rate or credit risk in other segments of the market.

HY Credit Spreads: HY premium received above US Treasuries for added risk

Source: Bloomberg, BarCap US Corp HY YTW 10-Yr Spread (CSI BARC Index)

The above chart displays the recent increase in credit spreads for high yield companies (otherwise known as junk bonds) as the macroeconomic backdrop deteriorates. Simply, the higher the spread equates to a lower price in the underlying high-yield bond and a higher yield. While there has been an increase in credit spreads in the recent environment, it’s not yet at a stressed point where it makes sense to start allocating significant capital to the space.  

Investment Grade Bonds

IG Credit Spreads: AAA 10-Yr premium received above US Treasuries (in bps)

Source: Bloomberg, BASPCAAA Index

Investment Grade bonds are debt instruments issued by companies that ratings agencies deem to be high quality and have very low risks of defaults. These debt instruments are now trading at fairly healthy spreads to underlying treasuries, and are becoming more interesting. Unfortunately, these instruments are fairly tax inefficient and their absolute level of post-tax yield is still quite low when compared to other investment opportunities.  

Municipal Bonds

Municipal Bond Index (YTW):

Source: Bloomberg, LMBIYW Index

Municipal bonds are becoming more interesting and can be a tax efficient way to generate yield.  We recommend allocating exposure to the short-end of the curve (maturities <1 year) as long duration bonds do not give adequate additional yield to compensate for interest rate and duration risk.

Meme Frenzy Seems To Be Dissipating

Source: Roundhill Investments, MEME ETF

Source: Bloomberg, SPX Index

This time last year we were all spectators to the meme craze, which sent graveyard stocks like Gamestop, AMC, and others to astronomical heights. However, since then, investor sentiment has soured with the MEME ETF down (64%) vs. S&P 500 (22%). Investor’s have reeled in risky bets across volatile assets (meme stocks, crypto, SPACs) as there has been major de-risking across portfolios, particularly for companies that have not shown that they have a profitable business model.  

We’ve been extremely bearish on Nikola, the “automaker” that has not yet manufactured a car and once tried to defraud investors by presenting an engineless truck rolling down a hill as a drivable prototype. At the end of Q2 2021, the stock was at ~$18 per share and now it currently trades at ~$5.50.  

Cryptocurrencies

 Are being bug-tested in real time / Competing With Yielding Cash and Attractive Equities /

LunaTerra wasn’t a bug - it just was ponzi scheme run by a con man

Cryptocurrency Market Cap: Peak of $3T in Nov-2021, currently <$1T

Source: CoinMarketCap

The overall crypto market peaked in November 2021 at $3T, since then it has shed ~66% in market capitalization and currently sits at <$1T. The industry has entered the “crypto winter” as many “coins” have shed >70% in asset valuation as the system flushes out excess leverage, hyped-mania and focuses on developing long-term, sustainable use cases (i.e., ETH).

The future trajectory of crypto prices is extremely hard to predict. This is an asset class that we believe is highly speculative, with chances for huge volatility to the upside and downside. We think it’s useful to think of allocations to this space as a sort of “venture capital” deployment, where outcomes (especially to newer projects) will be most likely a complete loss of capital - large winners that potentially compensate for the losers.  

BTC & ETH Price Trend:

Source: Bloomberg

Terra LUNA Price Trend:

Source: Bloomberg