Last Friday, in a note that was among Goldman’s most bearish reports published in recent years, the bank warned that while there are several mitigating factors, “stocks may be about to enter a sustained bear market” and warning that the recent sharp rebound in the market is to be expected during the “volatile period” that follows the last year of the average bull market before a protracted and painful slide into a bear market.
Then, later on Friday, none other than Dan Loeb published his latest letter to investors in which he revealed that unlike recent years, Third Point had a surprisingly disappointing year, returning -0.1% in Q3 and only 0.6% YTD.
Third Point’s disappointing performance was hardly surprising in light of the bloodbath experienced by hedge funds in the quarter and especially October, the worst month for the industry since 2011. However, what was unexpected was the sharp change in tone from Dan Loeb, whose traditionally bullish outlook for the past two years now appears to be over, and has been replaced with a general sense of derisking and foreboding near-term gloom:
“We have delevered our portfolio, reduced our tech exposure meaningfully, and grown our short book. We expect to be net sellers over the next few months if markets rally…”
To contextualize his new thinking, Loeb uses the analogy of the new NBC TV show The Good Place to elaborate how he, like many others, were caught wrong-footed by the market:
In the hit NBC television show The Good Place, (spoiler alert!) the audience is led to believe that a group of people who led righteous lives arrive in a utopian village where they are given the homes of their dreams to live in, are matched with their soul mates, and can eat endless amounts of frozen yogurt and never get fat. Eventually, the characters learn that their “soul mates” were chosen in error and that the angel played by Ted Danson was actually an evil demon who concocted the scenario as a way to torture them. Turns out, the “Good Place” was actually the “Bad Place.”
Looking back, it has become clear that we and many investors thought earlier this year that we had arrived at the “Good Place” in terms of market conditions. In January, fueled by tax cuts and synchronized global expansion, PMIs rose, economic growth estimates were revised upwards along with corporate earnings, and stocks surged across the board, especially growth stocks. Then, in February, volatility spiked to record levels and stocks dropped precipitously after a series of technical dominoes fell into place. After October’s market rout, it seems that the environment this year ought to have been dubbed the “Bad Place Market.”
Loeb then highlights the growing dispersion within the S&P as a reason for active management underperformance:
While the S&P is up slightly for the year, this statistic belies the extremity of the moves at the sector and global levels. Year‐to‐date, retail is up 30%, tech hardware is up 20%, and healthcare equipment is up 20%. By contrast, autos is down 18%, materials is down 8%, and capital goods is down 7%. At the lows, 63% of global stocks had entered into a bear market, which is almost equivalent to the 70% level reached at the 2011 and 2016 index lows. Rotation among sectors and industries has been violent, with the share of sectors recording extreme moves at the highest level since Trump’s election.
Looking at the catalysts behind the market volatility, Loeb understandably blames the sharp tick up in rates, which crippled the growth narrative and led to a brutal deleveraging of the quants during the peak of the buyback blackout period coupled with a troubling rise in negative earnings pre-announcements, all events duly documented here over the past month:
We believe the initial sell‐off was caused by a backup in interest rates that saw 10‐year yields rise from 2.8% at the end of August to 3.2% by the beginning of October. While equities and yield tend to move together over long periods of time, fast rate moves can cause equity declines in the short‐term. Rates were driven higher by Fed Chair Powell’s commentary that spooked the market into quickly projecting the worst‐case scenario, i.e. that a tightening overshoot would drive an otherwise buoyant economy into recession. These fears manifested themselves initially in the de‐levering of growth stocks, causing volatility to rise and the market to breach levels to the downside, driving systematic and quantitative strategies to accelerate selling in a window of time where corporates were not participating in buyback programs due to the blackout period. At the same time, a string of weak earnings pre‐announcements made investors question what had been a firewall for the S&P until that point. Strong earnings had allowed the S&P to withstand headwinds from weakening growth abroad and escalating tariffs, which had already driven most ex‐US markets lower this year.
Still, Loeb refuses to throw in the towel just yet, and while he expects volatility to “remain high versus recent history and, while we have officially graduated from the post‐financial crisis “buy the dip” paradigm” Loeb thinks “the strength of the US economy combined with the lack of significant inflationary pressure or structural imbalances still favors higher equities from these levels.” Specifically, at ~16x one year forward P/E for the S&P500, valuations are not overly demanding, especially when considered relative to real rates of 1.0%, which imply an above‐average equity risk premium.”
Thus, it is important to stay balanced and not get overly negative. The market has just been through its sharpest P/E multiple de‐rating since the 2011 sovereign debt crisis. While the current 10% consensus EPS growth forecast for 2019 is probably too high, the current multiple of 16x is already discounting cuts to the 2019 consensus. On the upside, delivery on 2019 consensus EPS and a return to the pre‐sell‐off multiple, which would still be below the peak 18x multiple in January, would imply ~8% upside. The biggest risk at these levels is immediate weaker economic growth, which in extremis could cause a recession, thereby driving down markets more substantially as both earnings and multiples would fall.
Looking ahead, Loeb writes that “while the prism through which we seek out our longs has not changed, we are increasing our focus on stress testing cash flow, asset productivity, and the interplay of rising rates to balance sheet strength and financial flexibility.”
From our vantage point, the debate around what is value (e.g. the index, the factor, sectors) versus growth loses sight of our aim to identify compounders of value. To that end, we increasingly will be doubling down on finding quality‐driven ideas, namely those with strong relative growth prospects, solid financial returns, and appealing relative valuation vis‐à‐vis their cash flows, peers, or the market.
Finally, it’s not just a reappraisal of market fundamentals that will shape Third Point’s investing process but a new focus on “further evolving our “quantamental” process to aid in portfolio selection, construction, and hedging.” Specifically, Loeb sees opportunities “to shape our portfolio borne out of a more thoughtful understanding of the derivative markets, passive and quant flow impact, cross asset signaling, and how investor behavior sometimes creates extremes in positioning.”
We have seen again over the last month what the new era in quant and ETFdriven markets looks like and we are determined to evolve in order to thrive as fundamental stock pickers in this environment.
Loeb’s full letter is below (pdf link):
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