2023 Market Preview: Jarvis® Update January 6, 2023

This week we turn the page on a putrid 2022 for markets. We give you our 2023 market preview this week on Jarvis Update. I'm your host, Brian Druss, director of research here at Left Brain, joined as always by our CEO and chief investment officer, also in a pastel shirt, Nolan Langford. Nolan, welcome to the program.

Hey, Brian, it's good to be here and happy New Year.

Happy New Year to all the people out there. Before we get started, we'd like to ask you to like and share the video if you find it useful. It does help other investors find it and get past that pesky YouTube algorithm and also subscribe and hit the bell for notifications. That way you can get— that way you can get a notification every time the videos come out. And we're out every couple of weeks with these videos. So we got a quick preview for you before we get started. First of all, markets were choppy this week as we did get some positive jobs news, but we know good news is bad news these days. We got two topics for you this week. First of all, it's our questions that we have for the market going into 2023. And then our second topic will be our strategic views moving into 2023. Before we get started, a few announcements. First of all, we produce this show for you, the everyday investor, whether you have a 401(k) or an IRA, if you manage your own money or you work with an advisor, we'd love to be a resource for you. If you'd like a second opinion on your portfolio, we'd love to talk. Please give us a call on the number below and we'll give you our thoughts. On how to position yourself for 2023. Also, if you're an institutional investor, we've got something for you as well. That's our investment research service, Left Brain Investment Research. We're folding that into Left Brain Wealth Management, but definitely click through on the link below. We'll get you to our website and let you subscribe if you're interested. Either way, sign up for our monthly newsletter, which we're moving toward monthly. We're off this week, but we'll be back next week with our 2023 preview. With that, we'll jump right into our market recap. Markets again were choppy this week. We had the S&P down 0.8%. We had the Nasdaq down 1.5%. And then the small-cap Russell was the strongest, but also down 0.5%. The market did respond to some better-than-expected jobs data on Thursday. Again, negatively. Again, good news being bad news in this current market. Treasury rates are starting to move slightly higher again. Start the year. We're just above 3.7% on the 10-year. We had gotten down to 3.4% in December. Nolan, any thoughts about this week's action?

No really big insights come to mind. You know, we were talking in our pre-production and 2023 is— the questions we had as 2022 ended, you know, those same questions are still floating around. If the Fed's still going to be hawkish and raise rates more than we anticipate, Are they going to cut sometime in 2023? Are we going to have a recession? Are we going to have a soft landing? Will corporate profits hold up? Will inflation ebb? Those questions are still with us. We haven't seen anything that answers any of them. So still a lot of uncertainty.

Totally agree, Nolan. That's a great segue into our first topic. So topic 1 is the 2023 questions to be answered. These are mostly macro-focused. We like to be more micro-focused here, but of course, with the Fed really in play, we do have to pay attention to the macro environment. Plenty of uncertainty coming into 2023. As Nolan mentioned, it does still feel like we're reading the tea leaves from the Federal Reserve more than anything else. Investors are still wondering the direction of the economy. Plenty of macro factors hanging over our heads. Of course, we still have China. Is it reopening? Is it, is it closing? We've got the Russia-Ukraine war still hanging around and plenty of other macro factors. Big question is, of course, are we going to go into a recession? So, Nolan, what are your thoughts on that question? Are we headed to a recession or not?

That one is unknowable. What we do know is the economy is slowing down. You know, just about all the data except for jobs show that we are slowing down. I imagine, you know, we, we heard another, uh, announcement of layoffs this week. It was Salesforce this time. So I think as we get closer to earnings season, you, we're in earnings confessional right now. You're gonna see more companies coming out and pre-announce, and they pre-announce generally bad news. So I think we're gonna hear more about layoffs. And what that means is, in future months, I think these job numbers won't look so strong and maybe investors then will start to be convinced maybe that the Fed won't need to be so aggressive going forward. So we're sort of in this weird realm where bad news is good news and good news is bad news. And that's what happened to us today.

Yeah, it's a great segue again into our next question, which is, you know, Nolan, we do have a lot of layoffs coming and they do seem to be concentrated in the tech sector and growth businesses. So this week we did have Salesforce announcing a major layoff and also Amazon.com. A lot of these companies had done a lot of hiring during the pandemic and now sort of seems to be a realization, a little bit too much headcount at these companies, and which is weighing on profitability. I got a bigger question and a more broad question, which is growth stocks have dominated the market for more than a decade. Do you expect a shift into value as we go into 2023 and beyond? And could that be long-lasting?

We're asking ourselves that question each and every day, and we're watching the daily moves in the market for clues like a hawk. I suspect this rotation that we've been in for the last 18 months or so is probably gonna continue except for some starts and fits here and there. I think every now and then you're gonna see some M&A, some company buying some other company, or you'll see one one-off earnings announcement and people will get excited and sort of go back to some of these businesses that are down 70 or 80% thinking that they've gotten a bargain. On the whole, though, I think the paradigm for investors have changed, and I think it's all about cash now. And promise of future riches, I think, is, is gone out. And what's back in fashion is cash today. So high free cash flow yields and companies that are generating cash. The juxtaposition of those type of businesses is very stark. Hey, my returns in the future, those means that those companies are generating revenues of 25 to 30%. And they, they're plowing whatever cash they get back into continuing to expand their business or grow their platform or to improve their technology in the hopes that they're going to get scale. And then in the future, you know, you're going to get leverage in your model and then revenue, not only revenues, but those revenues are going to drop to the bottom line and you're going to end up with profits or cash flow. That's at some point in the future. So that's cash later. But the businesses today that have very slow growth, In some cases you have negative growth. That's because anything that you have that's an unprofitable division or small business, you just lop it off. And so it looks like on the top line your sales decrease, but on the bottom line, because you cut out all the losses, now your earnings and your cash flow goes up. So I think that's the world we're in and we're likely to be there for the foreseeable future.

I agree with that, Nolan. I, I would expand upon that in one way, which is a lot of these value-oriented businesses in these sectors like energy, materials, industrials, they've been on hard times for about a decade. So that means the muscle memory is there for running business lean, being more profitable, generating free cash, and the muscle memory is not there for growth businesses. So as we move into a slower economy, I do feel they have a lot better chance to succeed in a difficult economy, in a difficult environment. So those are my thoughts on the value versus growth. We'll move on to the second topic. So topic 2 is our strategy moving into 2023. Again, 2022 was a year of multiple contraction as interest rates jumped significantly. You know, not to get too much into the weeds here, but the way that a lot of investors discount cash flows or discount the way that stock prices should trade is based on the interest rates of the 10-year Treasuries. And we've seen that move from 1.5% to nearly 4% in just a year. So it's definitely deflated a lot of the multiples, but we're also starting to see weakness in revenues and in earnings, especially in particular sectors, meaning tech and growth adjacent businesses. Nolan, what are your expectations for earnings in 2023 as a whole?

I think it's going to be sector specific. Some of the technology and growth areas I think are still going to be challenged. Let's start with semiconductors. You know, this is a capital intensive business. It is cyclical. You have upcycles, you have inventory builds, you have corrections, and then you have a new technology cycle that comes through. And that's kind of where we are in the chip sector or the semiconductor sector. So I'm not expecting great numbers from semiconductors this year. And I'm going to say the same thing about software. You can say the same thing about hardware. You know, the PC cycle, we had a big boom cycle during COVID and then people went back to the office, that kind of crested, and now we're in a down cycle. And I think it's the Same thing for handsets, which is why you've seen Apple stock be extraordinarily weak along with Qualcomm and some of the other handset makers. And some of the other areas that I'm looking at, let's take the consumer and let's talk about retail or consumer discretionary. So far, year to date, we're 3 or 4 days into the, to the year and we see green on the screen in consumer discretionary and in financials. And so for consumer discretionary, you asked about earnings. We're going to get those in about 2 to 3 weeks, and I'll be interested to see how did they do for Christmas. Is the consumer still spending? I think one area in consumers that I am optimistic about earnings is travel. And across the board, whether it's Boeing recertifying and redelivering planes once again, we know travel's been strong. The cruise lines— Delta came out with a really good report here a few weeks ago. American Airlines have been strong. So we know the consumer is still spending on travel. I expect travel earnings to be really, really good. The other area is energy. Energy did have a huge correction from $123 a barrel back in June, and energy just hit a new low yesterday. Although it's very interesting, the energy— the oil itself has been very weak, but the oil stocks have held up much, much better. So it'll be interesting to see how they— what they report on earnings. And what their forecast is going forward.

I think, Nolan, the point we want to make is those companies are still cash flowing at $75 a barrel. So that might be the disconnect that we see between the price of oil and the price of those oil stocks. I'll shift gears here. A couple more questions that we want to address as we go into 2023. The first is we've seen chronic underperformance of international stocks and emerging market stocks for years. We've talked about we like American stocks. We don't like international stocks for the most part. Is that something that's going to change now? We are starting to see a little bit of those signs in the last month or so. What are your— what's your take on that theme?

Yeah, we've noticed strength in two areas internationally. So the international developed markets, let's just start with Europe because it's the biggest component. Europe, we've seen some green on the screen this year. And our question is, will it continue? What's causing it, one, and two, will it continue? I think a little bit of what's causing it is a reprieve from energy prices. You know, we've had a warmer December, late December, early January, so the need for them to import natural gas and fuel alternatives I think has eased their crisis. And so I think that could have something to do with it, but it's been a few months that Europe's been outperforming, so we're definitely going to watch it and keep our eye on it. The other big area is China, which shouldn't surprise us. I mean, we've heard the news stories that they're finally starting to give up their zero COVID policy. And so finally, you know, those 1.4 billion Chinese are being able to get out and circulate and do what humans do, which is to be social and live their lives in public. I think that's brought with it a big sigh of relief for investors. The government's come out and they've said they're going to stimulate the economy and bail out some property that developers. And I think people are really bullish there that if the world's number 2 economy can get back to some sort of growth, particularly with the government stimulating, that that could be very positive. And so you've seen China shares are up, the internet shares in China, and basically any other stock, even if they're U.S.-based or not, that sells into China, you've also seen those stocks show some strength.

Yeah, Nolan, what we also know is that, uh, as China gets back to life They do what humans do and that's drink Starbucks coffee.

That's our favorite way to play it.

And then one more question, Nolan, and that's bonds. We had one of the worst years on record in bonds last year, which is especially unusual given that stocks were so weak. You don't usually see both tanking like that, like they did last year. So obviously quite a bad year last year. So do you expect bonds to bounce back in 2023? And is there a specific sort of area that you're looking at?

Yeah, so this one really has our interest quite a bit for a couple of reasons. One, if you're thinking about what's going to happen with the economy or interest rates, there's no better place to find that answer than in the bond market. As we've often said, the bond market is many times bigger than the stock market, and bond prices move generally in advance of what's happening in the stock market. And they're very, very focused— bond investors are— on the yield curve and economic conditions. And so what you would expect to see right now is if bond investors were expecting a terrible economic correction, contraction, call it what you want, you'd expect to see it in bond prices and bond spreads, and you're just not seeing it. You know, in investment-grade bonds, spreads are still fairly narrow, 1.5% or so over Treasuries, which is fairly normal. And even in high yield, You know, the high yield, the average spread to Treasuries is about 5%. And right now they're trading inside of that. High yield investors and investment grade investors right now are not pricing in any terrible recession, which kind of has you scratching your head a little bit. Outside of any nasty recession, I expect bond prices to do really well. A couple of reasons. One, we think that the, um, the end of interest rate increases are coming. Now, we may not be in a cutting cycle in 2023, but we know that at some point they're going to stop raising rates and that will be positive for bond prices.

Very much so, Nolan. That's where I'm looking for a lot of opportunity. And I think we're going to continue to do that for the rest of '23. We want to thank the viewers for being with us, wishing you a happy New Year. We would love to have you back for the, for the next installment of the Jarvis Update.