By: Stash Graham
Downside pressures continued in the month of May as all three major domestic indices fell. The NASDAQ 100 fell the most, losing -3.3%. The S&P 500 and the Dow Jones Industrial Average (DJIA) had a minor decline of -0.5% and -0.22%. On May 20th, the S&P 500 briefly entered a bear market territory, falling more than 20% from the highs but used an end-of-month rally to help limit the damage. Year-to-date, the S&P 500 and DJIA generated their worst overall performance since the early 1970s. As has been the case for most of this year, we are happy to report that our accounts have maintained relative outperformance during May. We saw moderate positive returns for most accounts (especially accounts that did not include legacy positions from other firms). While the positive returns were not significant in size, a positive return in the face of widespread losses is very welcoming. Our divergent performance during May expands on our relative outperformance so far year-to-date. On a year-to-date basis, the NASDAQ is down almost -23%, and the S&P 500 is down more than -13%.
From an economic perspective, we continue to monitor the consumption levels of the average American household. Personal spending data during April was strong and reinforced our thesis that the risk of an economic recession in the calendar year of 2022 is very low. While individual savings levels have dropped significantly over the last few months, Americans have continued to spend. Instead of using cash to purchase goods, they are using their credit cards. In the two quarters following the COVID recession, we saw a historic drop in outstanding credit card debt. Consumers maintained those low levels of ready credit until the end of 2021. Furthermore, of the outstanding credit card debt, the American household has been historically strong in maintaining a “current” status. “Current” position is when a credit card borrower is on time with their payments due. Per the New York Federal Reserve, during the first quarter of 2022, American households are currently on 97.3% of all outstanding debt obligations. These dynamics, paired with a strong household balance sheet (a low debt servicing to income ratio), embolden our view that the American consumer still has room to purchase goods at a level that would allow the economy to continue to grow for the remainder of the year.
We are currently witnessing a shift in what the American consumer is buying. This was particularly evident in Target Corporation’s earnings call. Management noted that many consumers were shifting away from high-margin purchases like household appliances (dominant over the last two years) toward core goods and consumer staples like paper towels and toiletries. Higher expenses and the purchasing of lower-margin goods caused a significant earnings miss from Target, which generated substantial downside pressure (-30%) on its stock price after its earnings report.
A situation we will continue to monitor as the year progresses is the number of zombie companies in the United States. Of the largest 3,000 companies in the United States, 610 (20.3%) are “zombies”. A zombie company is a business whose operating profit either does not cover or barely covers interest expenses. One whose operations are just enough to let it survive, but they are neither able to generate enough capital to create meaningful returns for shareholders nor are they able to invest in their business to create future growth. Ideally, the capital going to the zombie companies should be going to more productive companies.
A material increase in zombie companies dampens the possible economic growth of a respective country as zombie companies struggle to grow because of structural issues. As the federal reserve’s monetary policy becomes increasingly challenging, interest rates for loans should continue to rise, making interest expenses even more considerable for these businesses. Separately as inflation continues to maintain elevated levels, costs should either continue to increase or maintain a higher than average floor compared to the last decade. The development of higher interest expenses with lower operating income due to inflationary pressures should generate more companies joining the zombie category over the next six months. If this development were to happen, we would expect more companies struggling to make positive returns in the market. When investing in the broad equity market, we need to be very specific about the types of businesses we allocate capital to. These businesses need to be market leaders that generate significant amounts of free cash flow with solid capital structures.
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