A Tale Of Two Cities: Opportunities To Go Long And Short

“It was the best of times, it was the worst of times,” begins Charles Dickens in his masterpiece drama, A Tale of Two Cities. Originally penned in 1859, this timeless statement aptly describes our current economic situation. It could also be called the most unusual of times. One of the reasons this is the best of times is because the Fed printed so much cash and spread it around so widely. It was also the best of times because the US government spent so much money to stimulate our economy.

The flip side of all that printing and spending is that we’re now facing rampant inflation with serious uncertainty that the Fed will be able to stop it. Rates have been so low for so long, and the Fed’s balance sheet has become so large (~$9 trillion) that unwinding it now presents all sorts of problems. We already see a painful correction in equity markets. Now, with interest rates rising, it seems inevitable that we’ll see even more market volatility, especially in the fixed income market.

Therefore, it will be very difficult for the Fed to manage a soft landing. The biggest hurdle to begin with is that nothing of this magnitude has ever been done before, not even in Dickens’ time. Thus, no one is sure which course is the right one or how to avoid a massive blowup along the way. My guess is that the Fed will try to combat inflation by continuing to raise rates. Indeed, they have begun to condition investors’ future expectations by making mention of raised rates in the public domain. The Fed is also attempting to unwind its balance sheet by eliminating monthly asset purchases and allowing held securities to mature without replacement. In effect, that’s quantitative tightening. Yet, if we see real change, or any indication of a real slowdown in demand, the Fed will waver. Indeed, it’s likely that they will slow down tightening even though we’re facing a pretty ugly picture with inflation all around us.

With choppy equity markets and a slight rise in interest rates so far, some investors have started buying reasuries under the theory that a tiny yield is better than nothing, and certainly better than a risk of loss from owning stocks. To these investors, treasuries may seem like a safe place to hide but their inflation-adjusted real return is negative. A better outcome for most would be conducting fundamental research to find good value investments, such as inexpensive stocks which also pay dividends. It makes no sense to lock in a loss when dividend-paying value equities can be sourced right now at attractive entry prices and yields.

For instance, automaker stocks can be purchased at prices that should give owners a more-than-satisfactory return over time. An approach like that might provide a much-needed edge in this uncertain market. But because those securities don’t stand still, it’s not an approach most passive investors should pursue. Rather, investors doing this should have specialized training to ensure that owning companies like this for the long term makes sense today.

MORE FOR YOU

These days, automaker stocks have all experienced a sell-off and are trading as if a recession is imminent. The market seems to have priced in a recession as a foregone conclusion with 100% certainty, even though there’s no guarantee that one will occur. The opposite is what we’re seeing right now. We have a very hot economy, with inflation for sure, but robust economic growth and extremely low unemployment.

It’s a tale of two cities. There are positives and negatives for automakers. On the positive side, we’re still not in a recession, and demand is incredibly strong. It’s so strong that new vehicle launches are sold out in minutes before they can even be produced with buyers literally lining up to purchase them. There is certainly tremendous demand right now for new GM and Ford vehicles. Customers are queuing up to buy electric versions of already popular brands, like GM’s EV Hummer and Cadillac Lyriq and Ford’s F-150 Lightning and Mustang Mach E. GM is also trying to stimulate demand for lower-priced vehicles like the Chevrolet Equinox and Bolt while Ford rolls out a plug-in version of its popular Escape SUV.

At the same time, there are numerous negatives confronting automakers. The most significant is the incredible amount of commodity inflation we’re seeing, which hurts most manufacturers. Automakers are impacted tremendously by inflation because so much of the cost of each vehicle is dependent on commodity inputs, including metal, rubber, plastics, and computer chips.

Similarly, supply chain bottlenecks are making it difficult for automakers to obtain the most crucial parts for modern vehicles: semiconductors. If it weren’t for the robust demand and all we saw were the cost inflation and supply bottlenecks, the auto business would look dismal. Instead, it’s the opposite. Despite these headwinds, automakers have been able to raise prices tremendously for the far fewer vehicles they do deliver. Some are making even more profit than before the pandemic since high demand has allowed them to push through major price increases despite painfully lower volumes.

The big question is, what happens next? Eventually, the supply chain will free up, and the automakers will get the parts they need, which could cause the supply of new vehicles to increase and prices to drop. But it’s uncertain whether robust demand will continue as the economic outlook gets cloudier and leading indicators start to look uncertain. Fortunately, shareholders invested in automakers who do rapidly return capital to stockholders may do fine despite a less-than-ideal economic outlook.

In addition to finding value investments for the long haul, this is also a great time to find opportunities to short sell. In fact, this is probably among the best of times for short-sellers. Over the last few years, as markets climbed ever higher, times were tough for dedicated short-sellers, and a number were forced to close up shop. But that’s changed in just a few quick months as trillions of dollars in market capitalization have evaporated. For investors on the right side of those trades, it’s been a very profitable time. Going forward, this is a trend that’s likely to continue with equities. The same is true for short-selling certain fixed income securities until interest rates reach a much more normalized level.

Perhaps the most obvious targets for short selling are those already overleveraged firms. Those companies will be facing an increasingly harsh environment for borrowing in the future. As their debts mature, the lending markets will be much less hospitable and much more expensive at best. At worst, those markets will be closed for certain borrowers, and they’ll therefore be forced to seek bankruptcy protection. Companies with this type of profile present the best opportunities for short selling now.

In these uncertain times, investors’ fates depend entirely on prior preparation. There are plenty of opportunities available beyond just going to cash or buying Treasuries. However, finding and successfully profiting from these opportunities during uncertainty takes focus and specialized expertise. Having a depth of experience over many market cycles would likely give you a competitive edge as well. But good fundamental research should always be the starting point for any investment, whether it’s during the best of times or the worst of times. Charles Dickens continued, “…it was the age of wisdom, it was the age of foolishness…it was the spring of hope, it was the winter of despair.” For investors who are unprepared for this new market cycle, the outlook certainly looks desperate, but well-prepared investors will do just fine.

Comments are closed.