Why a Bearish Cash Supervisor Likes Playing Shares and Is Able to Dump Apple

Niles got here into the yr bearish, and his worries have solely deepened. He thinks we’re headed for a recession, and sees the

S&P 500
index bottoming round 3,000—down 25% from right here—or perhaps decrease. He particulars his grim view—and shares a couple of inventory picks—within the edited interview under.

Barron’s: Dan, when we talked in late December in regards to the outlook for 2022, you informed me that your prime decide was money. “Will probably be a troublesome yr for something in tech,” you stated. That was spot-on, however after the selloff we’ve seen, why are you continue to bearish?

Dan Niles: Coming into the yr, we have been targeted on two issues. The primary was, we didn’t need to combat the Fed. And the second was, we didn’t need to combat the basics. Coming into this yr, our expectation was that the market could be down at the very least 20%. In Could, we revised that forecast to down 30% to 50%, peak to trough, by someday in 2023.

We thought inflation would decide up, and that, consequently, the Fed could be extra aggressive than others have been anticipating. Structurally, three issues have been in place to make inflation run hotter. The labor market had tightened, with the variety of job openings, relative to the variety of unemployed, at a file degree. The second piece was commodity inflation. After the 2008-09 recession, individuals didn’t spend money on capability for commodities resembling coal, oil, and copper. Our view was that if demand was going to be stronger than anticipated, commodity costs would rise. The ultimate piece was that we thought the housing market, with record-low rates of interest, could be very sturdy.

How does your inflation outlook inform your worries about company fundamentals and inventory valuations?

What does larger inflation do? It drives down company earnings—and inventory multiples.

From mid-June via mid-August, the Nasdaq Composite surged 20%. After which Federal Reserve Chairman Jerome Powell popped the bubble. Have been individuals simply deluded?

Earlier this yr, I checked out all of the bear markets since 1920. Each time, you get sharp rallies. You misplaced 49% of your cash, peak to trough, within the tech bubble in 2001, and 57% within the recession of 2008-09. In each circumstances, you had 5 rallies within the S&P 500 of 18% to 21% on the way in which to the underside. Within the Nice Despair, you had 5 rallies of greater than 25% between the crash in September 1929 and the underside in June 1932, in your technique to shedding 86% of your cash. So, the summer time actually was nothing particular. Individuals thought, “Earnings estimates have come down sufficient; issues ought to be effective.” However they’re not.

A few of the media commentary after Powell’s speech targeted on the drop in oil and different commodity costs, retailers’ extra inventories, and softening housing costs. Critics asserted that the Fed is being too hawkish.

That’s why Powell stated in his speech that the Fed will probably have to depart charges larger for longer than most individuals have anticipated. Within the Seventies, the Fed not as soon as, however twice, began slicing charges too early, simply as inflation confirmed the primary indicators of coming down. That’s why Powell stated, we’ve made this error earlier than, and we’re not going to do it once more, and careworn that we’re going to undergo some ache. He has seen this image earlier than.

What in regards to the bulls’ assertion that inflation is already easing?

About 70% of the U.S. financial system is tied to providers. Labor is two-thirds of prices for the typical company. Solely 10% is tied to the provision chain, and 10% is power prices. The one technique to take care of inflation is to drive unemployment larger.

Since November, we’ve had an enormous downdraft in tech shares. What would make them enticing once more?

The S&P 500 trades for about 20 occasions trailing earnings. For those who look again at 70 years of historical past, when the patron worth index has been above 3%, the trailing worth/earnings ratio, on common, has been 15 occasions. That’s a fairly large drop from the place we’re at this time. And when the CPI has been above 5%, the typical P/E has been 12 occasions. The final CPI report was 8.5%, and we’re buying and selling at 20 occasions. This appears unsustainable.

However some shares are already down 70% or 80%.

I at all times prefer to ask traders: When a inventory is down 90%, how a lot draw back stays?

And, in fact, the reply is 100%. Not 10%.

Proper. It will possibly at all times go to zero. I learn lately that about 5,000 web corporations, each private and non-private, went bankrupt within the 2001 and 2002 downturn. We haven’t seen that but. However with charges going up, the financial system slowing down, and stability sheets for a few of these corporations the place they’re, you will see bankruptcies decide up in 2023.

Let’s speak about particular shares. Two of your picks are large-cap retail bets, which some individuals would possibly discover stunning.

We’re bullish on

Walmart

[ticker: WMT] and

Amazon.com

[AMZN]. Look again on the final recession. Walmart shares rallied 18% in 2008 in a yr by which the S&P 500 declined 38%. The corporate gained market share. For those who hearken to Walmart’s earnings calls, administration talks about the truth that customers are buying and selling down. You’ve received extra high-end customers procuring in Walmart. And the corporate appears to be getting its stock points below management.

Amazon’s valuation isn’t almost as little as Walmart’s, and also you’ve seen development sluggish from 44% within the March 2021 quarter to 7% within the June 2022 quarter. However, like Walmart, they will achieve market share throughout a recession. Take into account that I don’t personal these shares in a vacuum—I’ve them paired in opposition to a basket of shorts of on-line and offline retailers. However the backside line is that Walmart and Amazon are going to take retail market share from all people else.

Then again, you’re fearful in regards to the promoting market. What issues you?

For those who return to the 2008-09 interval, advert revenues dropped greater than 20% in two years. At that time, the web was 12% of the general advert market. Now, digital is two-thirds of all advert spending. In an promoting recession, which we’re more likely to have subsequent yr, corporations reliant on digital promoting can’t escape; they’re simply too large.

Additionally, TikTok is taking market share from different social-media corporations, like

Meta Platforms

(META) and

Snap

(SNAP). And

Netflix

[NFLX] is launching an ad-supported tier. These are {dollars} that might have gone to others.

Apple

[AAPL], as a lot because it talks about privateness, is seeing its advert enterprise take off. You may brief these ad-supported corporations in opposition to an Amazon lengthy.

What’s your pondering on Apple?

We’re lengthy proper now. Over the previous decade, the inventory outperformed 60% of the time within the weeks main as much as product launches. However our plan is to promote and go brief after the iPhone 14 launch on Sept. 7. That displays the place we expect the financial system goes, what’s going to probably be excessive worth factors for the brand new telephones, and the truth that you’re beginning to see high-end client spending weaken. I’ve a tough time believing Apple’s income development will speed up from the two% they reported within the June quarter to the 5% vary, which some analysts expect for subsequent yr.

Dan, you’ve stayed bullish on the playing sector. Why?

We personal

Penn Entertainment

[PENN] and

DraftKings

[DKNG]. Within the final recession, income from the Las Vegas strip fell 20%. However Penn Leisure, which owns regional casinos and race tracks, was down solely 5% in that interval. I anticipate them to hold in rather a lot higher. We personal DraftKings due to on-line sports activities betting. About 20 states have legalized on-line betting, and we expect California will observe. Each corporations are down about 75% from their highs. Draft-Kings ought to develop income this yr by 60%, and compound at 40% over the subsequent three years. It is without doubt one of the final markets to go digital.

You’ve been dabbling in

Intel

[INTC].

That’s true, though I’ve my place hedged in opposition to different chip shorts. Intel, at one level, was thought of unassailable. They did every part they may to shoot themselves within the head, falling behind on manufacturing, lacking product launch dates again and again, and shedding market share to

Advanced Micro Devices

[AMD]. They will lose extra market share subsequent yr to AMD. Individuals have them returning to double-digit earnings-per-share development subsequent yr; they’ll be fortunate if earnings are flat. However with new CEO Pat Gelsinger, they’ve an engineer again in cost. They’ve an excellent CFO in Dave Zinsner, who simply got here aboard from

Micron Technology

[MU]. And the inventory trades at 13 occasions earnings.

The important thing for Intel is getting their contract chip-making enterprise going. However gained’t that take a number of money and time?

Sure. However they simply signed on a serious foundry buyer in

MediaTek

[2454.Taiwan], a big Taiwanese chip firm. If they will discover one other giant buyer, the inventory might be a greater performer.

The wild card is China’s testy relationship with Taiwan.

One of many dangers we noticed coming into this yr was Russia invading Ukraine, which is what occurred. One other we cited was China’s reunification with Taiwan, which we nonetheless assume will occur within the subsequent 5 years. The day you hear that China is transferring on Taiwan, you will see Intel rally 10% or 20%. This can be a geopolitical hedge.

You might see at the very least one different main firm decide to Intel’s fabs earlier than yr finish. And sooner or later, you would see Apple, which is so reliant on

Taiwan Semiconductor

[TSM], strike a relationship with Intel. Intel might be probably the most hated large-cap semiconductor firm, however at this a number of, it’s an fascinating thought.

Thanks, Dan.

Write to Eric J. Savitz at eric.savitz@barrons.com