Dan Niles thinks the stock market is headed lower. Maybe a lot lower.
A Stanford University–trained electrical engineer who once worked at the old minicomputer giant Digital Equipment, Niles has focused on tech stocks for more than 30 years, initially as a sell-side analyst at Robertson Stephens and Lehman Brothers. He moved to the buy side in 2004, and now runs the Satori Fund, a tech-focused hedge fund. It is in the black for the year, despite the Nasdaq Composite’s 23% loss, due to nimble trading and some smart short sales.
Niles came into the year bearish, and his worries have only deepened. He thinks we’re headed for a recession, and sees the S&P 500 index bottoming around 3,000—down 25% from here—or maybe lower. He details his grim view—and shares a few stock picks—in the edited interview below.
Barron’s: Dan, when we talked in late December about the outlook for 2022, you told me that your top pick was cash. “It will be a tough year for anything in tech,” you said. That was spot-on, but after the selloff we’ve seen, why are you still bearish?
Dan Niles: Coming into the year, we were focused on two things. The first was, we didn’t want to fight the Fed. And the second was, we didn’t want to fight the fundamentals. Coming into this year, our expectation was that the market would be down at least 20%. In May, we revised that forecast to down 30% to 50%, peak to trough, by sometime in 2023.
We thought inflation would pick up, and that, as a result, the Fed would be more aggressive than others were anticipating. Structurally, three things were in place to make inflation run hotter. The labor market had tightened, with the number of job openings, relative to the number of unemployed, at a record level. The second piece was commodity inflation. After the 2008-09 recession, people didn’t invest in capacity for commodities such as coal, oil, and copper. Our view was that if demand was going to be stronger than expected, commodity prices would rise. The final piece was that we thought the housing market, with record-low interest rates, would be very strong.
How does your inflation outlook inform your worries about corporate fundamentals and stock valuations?
What does higher inflation do? It drives down corporate earnings—and stock multiples.
From mid-June through mid-August, the Nasdaq Composite surged 20%. And then Federal Reserve Chairman Jerome Powell popped the bubble. Were people just deluded?
Earlier this year, I looked at all the bear markets since 1920. Every time, you get sharp rallies. You lost 49% of your money, peak to trough, in the tech bubble in 2001, and 57% in the recession of 2008-09. In both cases, you had five rallies in the S&P 500 of 18% to 21% on the way to the bottom. In the Great Depression, you had five rallies of more than 25% between the crash in September 1929 and the bottom in June 1932, on your way to losing 86% of your money. So, the summer really was nothing special. People thought, “Earnings estimates have come down enough; things should be fine.” But they’re not.
Some of the media commentary after Powell’s speech focused on the drop in oil and other commodity prices, retailers’ excess inventories, and softening housing prices. Critics asserted that the Fed is being too hawkish.
That’s why Powell said in his speech that the Fed will likely have to leave rates higher for longer than most people have anticipated. In the 1970s, the Fed not once, but twice, started cutting rates too early, just as inflation showed the first signs of coming down. That’s why Powell said, we’ve made this mistake before, and we’re not going to do it again, and stressed that we’re going to go through some pain. He has seen this picture before.
What about the bulls’ assertion that inflation is already easing?
About 70% of the U.S. economy is tied to services. Labor is two-thirds of costs for the average corporation. Only 10% is tied to the supply chain, and 10% is energy costs. The only way to deal with inflation is to drive unemployment higher.
Since November, we’ve had a huge downdraft in tech stocks. What would make them attractive again?
The S&P 500 trades for about 20 times trailing earnings. If you look back at 70 years of history, when the consumer price index has been above 3%, the trailing price/earnings ratio, on average, has been 15 times. That’s a pretty big drop from where we are today. And when the CPI has been above 5%, the average P/E has been 12 times. The last CPI report was 8.5%, and we’re trading at 20 times. This seems unsustainable.
But some stocks are already down 70% or 80%.
I always like to ask investors: When a stock is down 90%, how much downside remains?
And, of course, the answer is 100%. Not 10%.
Right. It can always go to zero. I read recently that about 5,000 internet companies, both public and private, went bankrupt in the 2001 and 2002 downturn. We haven’t seen that yet. But with rates going up, the economy slowing down, and balance sheets for some of these companies where they are, you are going to see bankruptcies pick up in 2023.
Let’s talk about specific stocks. Two of your picks are large-cap retail bets, which some people might find surprising.
We’re bullish on Walmart [ticker: WMT] and Amazon.com [AMZN]. Look back at the last recession. Walmart shares rallied 18% in 2008 in a year in which the S&P 500 declined 38%. The company gained market share. If you listen to Walmart’s earnings calls, management talks about the fact that consumers are trading down. You’ve got more high-end consumers shopping in Walmart. And the company seems to be getting its inventory issues under control.
“Our plan is to sell [Apple] and go short after the iPhone 14 launch on Sept. 7.”
Amazon’s valuation isn’t nearly as low as Walmart’s, and you’ve seen growth slow from 44% in the March 2021 quarter to 7% in the June 2022 quarter. But, like Walmart, they are going to gain market share during a recession. Keep in mind that I don’t own these stocks in a vacuum—I have them paired against a basket of shorts of online and offline retailers. But the bottom line is that Walmart and Amazon are going to take retail market share from everybody else.
On the other hand, you’re worried about the advertising market. What concerns you?
If you go back to the 2008-09 period, ad revenues dropped more than 20% in two years. At that point, the internet was 12% of the overall ad market. Now, digital is two-thirds of all ad spending. In an advertising recession, which we’re likely to have next year, companies reliant on digital advertising can’t escape; they’re just too big.
Also, TikTok is taking market share from other social-media companies, like Meta Platforms (META) and Snap (SNAP). And Netflix [NFLX] is launching an ad-supported tier. Those are dollars that would have gone to others. Apple [AAPL], as much as it talks about privacy, is seeing its ad business take off. You can short those ad-supported companies against an Amazon long.
What is your thinking on Apple?
We’re long right now. Over the past decade, the stock outperformed 60% of the time in the weeks leading up to product launches. But our plan is to sell and go short after the iPhone 14 launch on Sept. 7. That reflects where we think the economy is going, what will likely be high price points for the new phones, and the fact that you’re starting to see high-end consumer spending weaken. I have a hard time believing Apple’s revenue growth will accelerate from the 2% they reported in the June quarter to the 5% range, which some analysts are expecting for next year.
Dan, you’ve stayed bullish on the gambling sector. Why?
We own Penn Entertainment [PENN] and DraftKings [DKNG]. In the last recession, revenue from the Las Vegas strip fell 20%. But Penn Entertainment, which owns regional casinos and race tracks, was down only 5% in that period. I expect them to hang in a lot better. We own DraftKings because of online sports betting. About 20 states have legalized online betting, and we think California will follow. Both companies are down about 75% from their highs. Draft-Kings should grow revenue this year by 60%, and compound at 40% over the next three years. It is one of the last markets to go digital.
You’ve been dabbling in Intel [INTC].
That’s true, although I have my position hedged against other chip shorts. Intel, at one point, was considered unassailable. They did everything they could to shoot themselves in the head, falling behind on manufacturing, missing product launch dates over and over again, and losing market share to Advanced Micro Devices [AMD]. They are going to lose more market share next year to AMD. People have them returning to double-digit earnings-per-share growth next year; they’ll be lucky if earnings are flat. But with new CEO Pat Gelsinger, they have an engineer back in charge. They have a great CFO in Dave Zinsner, who just came aboard from Micron Technology [MU]. And the stock trades at 13 times earnings.
The key for Intel is getting their contract chip-making business going. But won’t that take lots of time and money?
Yes. But they just signed on a major foundry customer in MediaTek [2454.Taiwan], a large Taiwanese chip company. If they can find another large customer, the stock could be a better performer.
The wild card is China’s testy relationship with Taiwan.
One of the risks we saw coming into this year was Russia invading Ukraine, which is what happened. Another we cited was China’s reunification with Taiwan, which we still think will happen in the next five years. The day you hear that China is moving on Taiwan, you are going to see Intel rally 10% or 20%. This is a geopolitical hedge.
You could see at least one other major company commit to Intel’s fabs before year end. And at some point, you could see Apple, which is so reliant on Taiwan Semiconductor [TSM], strike a relationship with Intel. Intel is probably the most hated large-cap semiconductor company, but at this multiple, it’s an interesting idea.
Write to Eric J. Savitz at email@example.com