Are we towards the end of an economic cycle or is there still some room to go? It is difficult if not impossible to ‘call the top,’ and no one can know for sure with[out] the benefit of hindsight. We do however see some warning signs that it may be time to take a more defensive posture. We will offer some background as to our recent thinking and how that is reflected in our portfolio positioning for EOPS.
Earnings releases, and stocks’ reactions to them, give us a clue about where we may be in the cycle. ZM and DKS provide two recent examples of earnings and price action that we typically see closer to the end of a cycle than the beginning: Zoom video communications (ZM) released earnings on 11/22 which came in higher than expectations. However, their revenue guidance projected flat sales, which would make four consecutive quarters of little to no growth, and the stock fell ~15%. Companies with huge P/E ratios and expected profits out into the future cannot afford flat or negative growth if they want to sustain their stock prices. Dick's Sporting Goods Inc (DKS) has a much more conservative valuation (9x P/E vs 2022 estimated EPS) compared to ZM. On 11/23 they reported EPS 60% ahead of expectations, and since then are down ~9%. We believe it is a caution sign when the market stops rewarding beats of this magnitude.
Growth stocks in general have been coming under pressure with many single names down 30% or more from their highs, and certain growth ETFs down approximately 20% in November alone, month to date. It may be tempting to look at those numbers and say “so the selloff already happened,” but history shows that this could be the tip of the iceberg. Just one period for context - between 2000 and 2003 the average technology stock in the S&P 500 experienced an 82% drawdown. For the communications sector, the average drawdown was 68%, consumer stocks fell 57%.
How does inflation and higher interest rates play into this? Federal Reserve Chair Powell has been nominated for a second term, with the Vice Chair Brainard, the latter being much more dovish, focusing on inflation in her recent speech. That would lead us to believe that higher interest rates to curb inflation are not a matter of “if” but “when” -- Companies valued at 100 times earnings are at an increased risk of stock price declines, especially if they do not have pricing power to be able to pass on some of their higher costs to customers. Notice the recent rise in strength of the USD over the last six months relative to other currencies such as Euro and Sterling lending further credence to the anticipated rise in rates. EOPS strives to invest in some companies that may have some ability to pass on price increases to the consumer, leading to a stronger bottom line.
So what does this mean for EOPS in terms of positioning? We are not exiting our core positions or turning net short, but we think this is a good time to exhibit some discipline to limit the downside and continue to produce alpha if volatility increases or the market goes south. Throughout November, EOPS portfolio has actively pruned our oversized exposures and increased the number of short positions consistent with our view in the short to medium term that we expect some names in certain frothy sectors, such as electric vehicle manufacturers, to come under increased pressure.