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How Deep and Long Will the Recession Be?

Recession Risks
Written by Andy

We are almost in December and most valuations have been beaten up. Lately, there are some more bullish spirits out there of late with inflation topping out, interest rates topping out and falling away (which will be a major relief) and ultimately shares catching some demand and even causing some speculative buying in the higher risk loss making growth companies.

On the other hand, you are sat there thinking how the earnings are going to hold up next year and how the debt will come in to play here and elsewhere. You have all kinds of forecasts of house price drops in the UK and one in the US yesterday was suggesting a 20% move down.

End of Year Tally for 2022 (USA Stocks)

End of year tally for 2022

Federal Reserve has been Hiking Interest Rates in 2022 at a Very Aggressive Rate

So how deep and long will this recession be, can employment hold up and what does that mean for earnings and valuations?

That all remains to be seen. If the price of a stock has been decimated, the company keeps performing or doesn’t miss forecasts by too much, it is risk to the upside. If they keep downgrading (and substantially), the market could take fright with the price going lower. Clearly it is all relative. If the debt comes into play too, then the opportune time to buy might be on a discounted placing that reassures the finances and recovery of the company.

The other thing is we don’t know here and in the US how these aggressive rate hikes are going to eventually feed through into the economy. The markets are suggesting any recession won’t be severe and earnings will hold up or most of it is in the price.

Europe does not move like this otherwise. I would also say the US would have gone to test the low 3000’s (based on earnings falling to somewhere around $200 and much more realistic multiple, though it can go under 14 if it were to get really bad) if they anticipated a much more severe downturn.

I thought the USA was headed to the low 3000’s but it only fell to just under 3500 so I was miles off. Their bond curve is so inverted that a recession is on its way so are they being too optimistic into year end (seasonal short term bullish move?) with the reality hitting home hard next year as earnings fall more than they expect or the FED overdo it with QT also coming into play?

Can the markets also bottom at this early stage without the full brunt of the earnings recession yet to be felt?

It would be peculiar.

One note of caution. You don’t want to be holding anything that needs to raise fresh cash. Balance sheet strength is absolutely key right now, as it’s so tough to raise fresh cash. Case in point: Trackwise Designs (LON:TWD) did just that. It is doing a placing in December 2022 to raise £3.65m (before fees) at just 1p per share. The price the day before was 12.65p, so the fundraise is at a 92% discount. The share count will rise from 37.5m in issue now, to 402m after this placing, an increase of 972%. Then there’s likely additional dilution of 150m new shares if the open offer is fully taken up, so 552m shares in total. PLUS there’s more potential dilution from warrants being issued, although I wouldn’t worry about that, because the exercise price of the warrants is 6p, which would be a delight to achieve a share price of 6p or above. Management express ‘deep regret’… Management reassurances about being able to find funding, turned out to be worthless. The other question is whether this is going to be enough fresh cash? Will it need to raise again? From now on it is now likely massive discounts or no bailouts for companies which urgently require further funding and my stance on those is generally to avoid/sell.

Here is some deep stuff from a company selling Biological washing powder and the lot:

“The stock market is far too complex a system to think in certainties. We prefer to think in probabilities. We combine this probabilistic thinking with one of the most underrated temperaments of investing: patience. These traits afford us the luxury of investing with a long-term mindset and enable us to ride out the inevitable volatility and humbling periods of underperformance. They allow us to focus on what a company could achieve if things go right. We understand that whilst some of the innovators that we own will succeed, others will not, and some we will miss completely but the passage of time allows us to make and own our mistakes, hone our understanding, learn from others, and deepen and develop our thought processes.

In times of rapid change the temptation is to grasp the familiar, ‘the certainties’; take comfort from the recognisable and double down until ‘normality’ returns. But with change comes opportunity. Probabilities enable us to stretch our thinking and imagine these opportunities. There is no ‘normality’. ‘Normal’ is not a static concept. Companies do not operate in a vacuum; they are part of an ecosystem. They evolve, adapt and impact each other.

In nature, many complex systems, like ecosystems, have a tendency to self-organise into a ‘critical state’, a sort of teetering calm, where minor changes or disturbances can lead to avalanche effects of all difference sizes. One way to conceptualise this is by thinking of a sandpile. Consider a flat table covered in a thin layer of sand. The addition of a single grain will have little impact on the other grains; there is stability. However, as more grains are added, the sandpile grows, from a layer, to several layers, to a heap. Eventually, the sandpile reaches a critical point, where the addition of another grain can cause local disturbances or even system wide avalanches.

There are parallels between these sandpiles, natural ecosystems, and the global economy. The Covid pandemic could be thought of as just another grain added to the already complex system that is the world economy. But it set in motion a huge avalanche. In biology the term used to describe this is punctuated equilibrium. Under this definition evolution occurs in spurts instead of following the slow and steady path outlined by classical Darwinism. Long periods of relative inactivity, the building of a sandpile, are interrupted by rapid disruptions, large avalanches. And just like in nature where species evolve or mutate rapidly during periods of punctuated equilibrium, the same can be said of companies during the pandemic. Many businesses had to evolve their business practices and go-to market strategies, and adapt to massive surges in demand and challenges with supply. And just as happens in nature, some thrived, others evolved to survive, and some will no doubt go extinct…..”

Even have some reproduction in there. This is new so let’s give them a mention:

“As companies, big and small, evolved and adapted to their new environment, they impacted each other and the environment around them. The biological term for this idea is ‘fitness’. The higher the fitness of a species, the better suited it is to survive and reproduce in its specific environment….”

Hang on…hang on…

“And just as the survival of a cheetah depends not just on its own genetic code but also that of the zebra it hunts – if the zebra sprouts wings it doesn’t really matter how fast the cheetah is”

To conclude this feature, companies with good balance sheets will shine through. It is riskier with debt laden companies, but when risk on returns, such stocks tend to go higher (often on nothing volume once sellers have been exhausted) too so it will be a call on when bullish spirits firmly return.

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