Published on June 9, 2022

If you were unable to join Larry Cordisco’s webinar on The Great Normalization: Managing Equities in a Highly Fluid Market, you can watch a replay to hear him answer the question: “What is normal?” in equity markets and the economy.

Transcript

Amy Jeang: Good afternoon, everyone. Thank you for joining our webinar today, titled The Great Normalization: Managing Equities in a Highly Fluid Market. I am Amy Jeang, and I am the Institutional Services Consultant at Osterweis Capital Management. And now I'm very pleased to introduce Larry Cordisco, who is the Co-Chief Investment Officer for core equity at Osterweis. I hope that you will find Larry's perspectives on the equity market environment useful. With that I will turn it over to Larry.

Larry Cordisco: Thanks Amy. And I want to thank you all for joining us today. And I hope this is thought provoking. And the whole point of this is to stretch our thinking about where we are, where we've been and where we're going. And I'll start with the whole concept of what is this Great Normalization. We know that Covid created one of the sharpest recessions and sharpest recoveries on record, both demand and supply shocks are contributing to today's environment.

And what we're working through now is a rapid and sometimes violent normalization as we exit, and hopefully continue to exit the Covid era. But the real question is what is normal? And as we go through this, as I mentioned, I want everyone to get a sense of where we've been, where we're going, but I really want to challenge people's thinking as to what normal is. Is it something that we've just come out of - that being a 14 year or so period after the great financial crisis? Or is normalization something else - was basically the post-Great Financial Crisis not really normal. But I basically want to challenge us to not apply a recency bias to the period we've come out of, to think that's where we may be going back because here, my team, we talk a lot about how going forward might be very different than what the last 15 years have been or so.

So let's talk about where we are. Well, we know that we all talk about GDP - the economy contracted and expanded at a rate that was unprecedented. And one thing though that I really want to focus on here that I think is the most important thing is one of the things that is most scary to the market today is the word "stagflation." You hear it a lot on the news. A lot of people comparing the current economy to the 1970s, and I don't want to take a necessarily bearish tone here at all, but I do want to point out that first quarter GDP was negative. I don't feel like that gets talked about enough. It's often explained away as being related to exports, but you can't ignore that the export weakness is a function of the global economy weakening and a very strong dollar.

And to think that there would not be continued ripple effects from that might be naive. So that's besides just putting it in a chart, the wild visual outcome of what the visualization of what the economy's done. I do really want to point out that we are below zero in the most recent quarter. When you think about the stock market and the long trajectory, the first thing is it has been an absolutely remarkable bull market from 2009. The market's up more than 7x from the lows of the great financial crisis to the highs of the cycle we just went through. And it's been also a very remarkably consistent trend line throughout that period, a low volatility environment, and that changed with Covid and we had a scare, but the most interesting thing, and if you would've said to me, "What do you thinks going to happen with Covid?" The global pandemic's going to happen. "What do you think will happen to the stock market?"

I would not have said the stock market is going to actually accelerate its returns during Covid. That would not have been my guess. And in fact, not only did we diverge from our long-term trend line, but we diverged significantly and significantly higher. And what we're seeing now is a normalization of the stock market. Now, a bearish chartist would look at this and say, "Well, we're going to return to the trend line." A trend line, if you extended out on a time basis is probably around 3,200 or so. I'm just eyeballing that. A bearish fundamentalist might say, "Well, we're about to go into recession." And if you apply the current... Assume earnings aren't going to grow and you apply 16 multiple to about $200 of S&P earnings, you get to 3,200.

So again, I'm not necessarily advocating for that, but I think it's one of the things we want to put in the back of our minds, that if things do continue to decelerate, there are a lot of forces that would be pulling the market, not only below the 3,800 level, which gets talked about a lot on the news and a lot on CNBC, but possibly further to 3,500 or 3,200, depending on how quickly the economy decelerates. It's interesting to us, if we basically normalize earnings growth and S&P returns, I did this since 2012, you can go back and see that a lot of the S&P performance has come from multiple expansion. Now, some of that's been reversed. We're going to talk about that a little bit more in a moment, but it is very remarkable that from an earnings basis, you have tremendous excess returns that have come from multiple expansion.

We know that some of this has come from again, a low volatility environment, low interest rate environment, and a really interesting composition of the S&P these days where you have four or five companies that at the peak here comprised almost 30%. I think it was about 27% of the index. So again, if you people want to go, I've heard Nifty Fifty thrown around. If you want to go to the 1970s, the last stagflationary period, we also had the Nifty Fifty, and I'm not, and again, trying to be bearish at all, but certain cycles rhyme. And so for those looking for a pattern to be cautious, that is a pattern that's out there. But we are in the process of wringing out this excess valuation. In fact, we're going to talk about that more in a minute, but a lot of the excess, multiple has been taken out of the market already. And I think that's really good news.

You may have noticed that the market's also quite volatile, and that is because the market performance has been very different in 2022 versus 2021. And again, we're going to bring this back to a little bit of the conversation on multiple compression. And what we did was we looked at the stock market and broke it into five quintiles based on price to sales valuation. And basically said, okay, if you have five buckets, how did each of those buckets do? And in 2021, which is the teal color graph, there was a really interesting bifurcation in the market. And that was that the most expensive quintiles and the least expensive quintiles, outperformed the market. And in fact, outperformed the market quite significantly. And in those middle quintiles actually underperformed the market overall. And so we thought about that and said, okay, well basically 2021 was probably a very beta-driven market.

And if you think about the cheapest companies where business was getting better with the recovery, that makes sense that they recovered. And if you think about the most expensive companies, like a Tesla or something, where you had just a lot of enthusiasm, they outperformed and everything in the middle was less exciting. And I think that was the hallmark of 2021. But interestingly, the calendar changed in January like always does. But the calendar changed and the market totally changed. And what we saw in 2022, and this was for the first quarter in the purple was just an obvious linear relationship here where the most expensive quintile underperformed significantly, and the least expensive quintile outperformed. Now this is the first quarter in that least expensive quintile. It's still doing better. Although I think it's evened out, it's been a much more volatile up and down market since. But clearly this is a story of multiple compression and how the most expensive stocks have responded pretty negatively obviously to a rising interest rate environment.

Another thing that we look at as an example of some of the market volatility is just on a daily basis. What is the divergence of returns on a daily basis between the Dow Jones, the NASDAQ and the Russell 2000? And in fact, if you look at today, the Dow was up percent or a little bit less and the NASDAQ was up more than 2%. So today is a day where there's a 100 basis point divergence between one of these or two of these three indices, between the Dow and the NASDAQ. If you go back to 2015 to 2019, you can see that happened 20, 30 times a year, 2018 was a little bit of an outlier. We all remember the fourth quarter of 2018, which was extremely volatile. So that bumped that number up.

But that was an anomaly in recent history. But then you look at 2020 and 2021 and year-to-date 2022. And so this year-to-date 2022 is of end of April. And so if you wanted to annualize that of about 50 days of trading days of the year, you get to about 150 trading days again this year where there's these wild divergences. This is making it really difficult to get a feel for the market on a daily basis. And I think it also shows that the market actually isn't very certain about what the direction forward is. And so you have, of course we know the Fed's tightening, we know liquidity's coming out and you end up with more of these rotations of people trying to find returns and maybe even computers trying to find returns. But there clearly isn't a real strong trend that we can count on in the market today.

One of the big reasons, we think, is that there has been an incredible uptick in options writing during Covid. So you can go back to 2016 on this chart, and you can see that on average, this is weekly options, eh, 6 to 8 million, maybe 7 million, let's just call the average weekly options written. That number has gone up significantly by about 6 million of options contracts per week. That's at 100 shares per option, or per contract, that's 600 million shares per week that are being written in excess of what we consider the long-term trend. You can see that starting to come down a bit, but the more interesting chart, maybe this one, which is calls minus puts, the bias has been really towards calls.

And we've heard this, but to see it graphically speaking, where you had one to 2 million call options per week spiking to something like 7 million call options, that excessive of it, extra 5 million contracts per week, again, 500 million shares is a lot of liquidity that's coming into the market. And a lot of trading, it creates a lot of trading volume. When you consider the New York Stock Exchange probably does about five and a half trillion shares per week. And then you have 500 million shares per week coming in through options issuance. It's added about 10% of upside pressure volume to the market. And I think that's clearly had an impact on some of the exuberance we've seen in the market. Now we know that this year's been different and you also see that call options have really trailed off this year, too.

So as people I think are starting to lose money with this strategy, maybe we're getting back to a more normal situation with call options, something that we would welcome. All this is added to a lot of, or contributed to a lot of volatility in the market. And again, this is an interesting chart. If you go back to 2012 and that's post great financial crisis. Volatility's been well, it's been, 20's been the ceiling, for volatility using the VIX as a measure. And obviously we know what happened when Covid initiated, but we've never really gotten back to pre-Covid levels on volatility.

And so one has to wonder if you look at the line where 20 looks like it was more or less the ceiling for a long period of time. Now it looks like it's the floor. And for those who like to do technical analysis, and I don't know how accurate it is to do technical analysis on the VIX or chart reading really on the VIX, I've seen it done. So I'll just point out that's a nice little cup formation happening, which would suggest that we may be springing toward a more volatile future, at least for a while that also coincides with a lot of nervousness about a slowing economy.

Bonds have also been a lot more volatile. And if you look at the history, going back to 1998, and this is the Bank of America bond volatility index, it's called the ICE index. You go back to 1988 to the 2006 or seven, there was decent amount of bond volatility by this measure. And it bounced around 100 for a long time. We had a great financial crisis and it spiked. And then when we came out of the crisis and we know interest rates were on the steady decline, further decline since then, it's been pretty calm. Hundred's been the ceiling. And we recently popped back over that. It's calmed down a little bit recently, but it's still above that 100 level that if you just eyeball a chart would suggest that we may be entering a period of a bit more volatility for bonds.

So bonds, as well as stocks entering a new regime, so to speak. Now what's been behind this? Rates have moved fast. We know that that's the case. We all see it. But when you see in a chart, you put in some context and we did this going back to 1990, you can see that this is the biggest six month change in a two year Treasury rate since 1994 or 1993, which is 1999, that period was also an interesting period globally. And from a macro perspective, you had the Orange County defaults in 1995, you had the Tequila Crisis with the Mexican peso in 1994, and a lot of people don't really talk much about it, but there was a Japanese banking crisis in the 1994 and 1995 timeframe as well, which may or may not be related to a spike in rates or volatility in rates in the United States.

But when you look at the Yen exchange rate back then, it looks like now, it actually got very strong back then. It's getting very weak right now. But whether or not it's weaker or stronger, I think is less important than just the absolute change in rate. And so certainly you can see here that the absolute change in interest rates has been pretty high. And this is one of the reasons I think people, another reason behind a lot of people's nervousness that something could break because you're not expecting to see this kind of volatility in the bond market. We looked at this volatility in a little bit different way. So we know rates have moved fast, I'd argue they've moved faster than you think, and what we looked at was not the absolute change, but the percentage change basis of the two year Treasury.

So this is basically the same chart you just saw, but instead of it being absolute change, this is the percentage rate over a six month period in the two year Treasury, the percentage rate change. And you can see that it absolutely exploded. It makes sense. You're going from a really low base of like 25 basis points. And now we're at 250 basis points, but I know that there's an absolute argument that we should be able to be able to handle two and a half percent rates. And that's true, but the speed of this change and on a percentage basis is like nothing that we've seen since 1980, at least I didn't take it back further, but I'd be willing to bet that this is a pretty rare occurrence in the great scheme of things. And certainly since inflation broke in the '70s, we haven't seen anything like this.

We all know this is because inflation is also moving really fast. It's the highest rate of inflation since the late 1970s, early 1980s. And it's another chart where you can look and say, well, for a very long period of time, from the mid '60s to pretty much you get in the great financial crisis, 2% inflation was the floor. We bounced around, we had a period of hyperinflation in the '70s, but even when things started calming down and we had the great bond bull market starting in the early '80s, inflation really didn't sustainably go below 2%. Then we had the great financial crisis. And especially as we started getting into 2010, 11, 12, a number of years past that, inflation had a really hard time getting over 2%.

So what had been the floor became the ceiling. Now that we've broken through that floor, again, it's a thought experiment, but one has to wonder a little bit about whether or not what had been the ceiling has now become the floor, because history points to the idea that 2% was a floor for a very long time. So we'll see. And I think when you think about inflation, there are some structural things to think about. We obviously know oil and gas is a contributor, oil and gas, and I bring this up a side note. One of the reasons oil and gas is such a problem is because we've been underinvesting in oil and gas for any variety of reasons, shareholders demanding more money in their pockets versus money getting thrown down a well, all these are legitimate reasons, but we've been underinvesting in oil and gas for a very long time.

And we may have finally hit the point of inflection with demand where we are at structurally higher prices because we're just not producing enough. That question of whether or not industries have been underinvested in. I'm going to revisit a little bit later, because I do wonder if there are other industries that fit that same paradigm. Which raises the question of whether or not inflation will be structurally higher going forward. Now, all this ties into what has been going on with the one interest rate that probably gets watched the most in the market. And that's the 10-year Treasury rate. We can see that there's a long term channel. And I suspect many of you have seen this chart recently. It makes the news rounds quite a bit. But if you look at the 10-year Treasury, since inflation broke in the early '80s, it's really behaved consistently within a long-term channel.

And what we've seen recently is we have broken a little bit, but it's very clear. We've broken out of the top end of that channel. So are we structurally here at the end of a 30, a 40 year bond bull market? I don't know the answer, but certainly the chart says that a trend has changed. And certainly in theory, zero should be the lower limit of a 10-year rate. We know that's not always the case as we look at what's going on in Europe. I certainly don't think that'd be constructive here. So assuming zero's the lower bound, it makes sense that we would've broken through. Where do we go from here is certainly one of the biggest questions that all I can point out is that a lot of people are keyed on three and a quarter percent, because that was the high point of the 10-year rate just before Covid broke out.

Well, actually a bit before Covid, if you go back to the high point in 2018, before we had whatever you want to call that correction in late 2018, three and a quarter was as high as the 10-year got, we are now sneaking up on that three and a quarter again. I think that if you buy the thesis that if we breach three and a quarter percent on the 10-year, we very well may put 4% in play. I don't suspect that would be healthy for equities in the short-term. We'd have to adjust to that. But if you're wondering what number may matter more than anything else, I would suspect that 3.25% on the 10-year is the number to key on.

So inflation expectations, I think a big thing that we talk about here a lot is, okay, well, we know inflation's high. Is it transitory, is it structural? The only way you can really measure what the market expectations are around that question is what are inflation expectations? And I just used the 5-year, 5-year inflation swap rate. I think it's a real generic way to look at things, I like to dumb things down. So to me, it's a real, simple, dumb thing to look at. And I think it captures the bond market opinion about rates. And two observations again, about two and a half percent was the floor for a long time. This goes back to 2004 of this chart, two and a half percent became the ceiling in the post financial crisis. We've broken through that two and a half percent.

We can see that there actually has been a decline in inflation expectations. And when you hear people talk about inflation going forward, there is a lot of, I think, rising consensus that with the economy slowing, we're likely to see disinflation over the summer. And so I think people are starting to price in the idea that we'll see a little bit better inflation numbers going forward. And that the long-term inflation outlook is maybe a little bit milder than what we thought a couple weeks ago, but this is one of those. If you want to look at two or three things in the fixed income market to get a sense for where we're going, this is one of the things that we watch really closely.

So the thing about inflation, why have we had this inflation? Well, it's a combination of a demand shock and a supply shock. And this is just some really interesting proxy for the demand shock. This is a retail sales number that's put out by the Census Bureau. And again, I go back to the great financial crisis because that's where a lot of these trends we've been living with started from, and you can see a really consistent line here, going back to 2008 of the growth in monthly retail sales. And you can see that just like the stock market, we diverge pretty significantly from that line during Covid. Now it's a combination of stimulus checks, people nesting and having nothing else to do with their money. They want creature comforts all these things, and you can see that the recent numbers actually have been in a further acceleration of this number of the retail sales number.

But we've also heard from Walmart, we've heard from Target, we've heard from a number - Amazon, a number of retailers that something has changed significantly. And it changed very significantly very recently. And it happened as gas prices nationally got over $5 a barrel in fact, or $5 a gallon. In fact, we own Dollar General management team there often speaks about how $4 gas is a magic number where they see changes in consumer behavior. So I think national gas prices are closer to five now. And a lot of retailers who have hundreds of billions of dollars of sales very consistently over the last couple weeks have said they've seen a really big change in consumer behavior that happened about four to six weeks ago. So this is a big number to watch to see the degree to which demand was pulled forward. And now we're going to enter in somewhat of a refractory period.

At the same time that we had the demand shock, we've had a supply shock. We are still not at the same level of workers in the U.S. economy as we were pre-Covid. And again, you can see that trend line was very consistent over time, and we're nowhere close to not only where we were, but to where the trend line says we should be. In fact, we're about 7 million workers short of what we should be. There's been the great retirement we've heard about, a couple million workers I've read between two and two and a half million workers left the workforce, because they didn't need to work anymore. It was time to retire and they didn't want to deal with Covid work environments. We don't know how many people left the workforce because of other inducements and incentives and to what degree they're coming back. So this is where the workforce stands today. And it certainly helps explain why there's a supply chain problem and a supply problem in the economy, shortages in the economy, even though demand is pretty strong.

All of this is weighing on equity valuations, and this being this higher inflation, this rising in interest rate story that we've been talking about. And so we don't know the degree to which the multiple will continue to drift to more pre-Covid or post great financial crisis levels. The long-term average, and I go back to 1990 to say what? It's an arbitrary choice, but this is sort of the modern economy we've been dealing with for a long time. 1990 is a nice time to pick we're fully are far enough removed from the inflation of the '80s to say what is a good multiple or average multiple in the stock market? It's around 16 to 16 and a half times. And the really good news is we're really getting close to that right now.

And the correction we've seen in the market since the highs is 15% plus correction has been really mostly about multiple compression due to higher rates. Now, if, if, if there is a next step down, the thing I would worry about is an earnings compression and I get back to, well, we left 2021 with about 200 and a little over $200 of S&P earnings. If we are going into an earnings recession or a real recession and earnings don't grow at all, okay, you're probably 200 at 205, $210 times 16x. Well, there you go. You're back to that 32, 3,300 number. I don't know if that's going to happen, but within my probability set of what I'm trying to think through when I'm managing money for the next six months to a year.

Now, this is why I worry about where the earnings number may go. This is the difference between PPI and CPI you can see, I take it back to the 1950s. It typically behaves in a really tight band. Obviously in the '70s, producer prices spiked much more than companies were able to pass along to consumers. We also know that was a very difficult time in the stock market for earnings growth. This, as you can see on the far right, is the biggest spike in the change between PPI and CPI since the 1970s. That's a little worrisome. It's a lot worrisome. Now, again, if inflation starts to roll over, maybe this won't be such a big deal, but one of the reasons it concerns me is because if you look at the earnings estimates for this coming year, 2022, it's premised on about 13 and a half percent or 13.7% earnings growth. By the way, this has come in about a percent over the last month or so because of some of the noise we've seen in the retail world.

So earnings numbers have come down a little bit and it's premised on 11% sales growth and about a half a point of operating margin expansion. The reason I'm nervous a bit about the operating margin expansion in particular. Well, on the sales growth side, we obviously are starting to see early signs of demand destruction. And on the operating margin side, we just talked about this squeeze that's happening with companies, input prices going up faster than they can pass those prices along. The second thing is we are at record high levels of operating margin going into this year. There is a worry that in 2021, we were overearning because basically companies were able to manage expenses. They didn't have as many workers as they needed. Demand was quite strong for all the reasons we just talked about with those retail sales numbers, and it all fell to the bottom line.

And yet estimates for this year have a continued margin expansion built in. This is something just to keep an eye on. So when you hear of companies having a little softer demand on the top line and a little margin pressure in the middle of their business model, this is why earnings multiples or earning, sorry, estimates could be a little bit under pressure. And the other thing I'll point out is if you take 2019 and say, I'm just going to grow earnings 10% a year for 2020, 2021, and 2022, you get about 200 to $210 of earnings. 10% earnings growth for three or four years in a row is pretty good. In fact, that's above normal, it's above the normal 7 to 8%. So there's a lot of reasons we can mean revert back to a number that's a bit below where we are today.

Now, maybe people are expecting with this $227-ish number. It might be legitimate. And the reason it might be legitimate is look, companies are more efficient. So I'm trying to keep my options open in thinking about this, but I am questioning the reliability of the earnings estimates and given what we're seeing in the economy and hearing from companies in the economy today. So what does that all mean? It means a lot is still changing, expect more volatility. I know for our accounts, we're running cash at higher levels than we normally would. We've seen a big divergence in portfolios are more value-oriented versus growth-oriented, growth has underperformed. We think the economy will continue to slow and the Fed will continue to tighten. So that's a formula that we have to be aware of.

Now, the stock market also has these periods. And I think today and couple days, well, right now is one of these periods where bad news is good news. People are starting to bet that the Fed's going to back off and that very well may happen. And that's what makes the stock market interesting and keeps us all on our toes. But that being said, I think we still need to be aware that the economy is likely to continue to slow, that earnings are at risk, and we don't really know if we're going to revert to the pre-period of Covid, which was the great financial crisis or something that looks more like the 1990s or early 2000s where the real economy was actually growing a bit faster. And you had a little bit more inflation. So I don't know where this bottoms, I've hinted that it could get as bad as 3,200.

And that's what I say. It could be as bad. I don't know that it's going to happen, but these are the outcomes that one has to keep in their range of outcomes, one has to keep in their mind. But whatever happens, I'm actually pretty optimistic that what's on the other side is going to be a pretty good economy. And I think it could be very much like a 1990s-style economy, driven by onshoring, reshoring, and infrastructure, a need to invest in America, so to speak. And that would result in investments in hard assets, which is inflationary. It's that would happen at a time when the labor market's getting tighter, because we have fewer workers. And we already saw that one chart about fewer workers in the economy, that's inflationary, as you demand more people to build America.

The opposite of that is the need to accelerate productivity. Productivity gains have been a massive story in the United States for 30 or 40 years. It's a big reason interest rates are where they are. And that is, I mean, low. And I would argue that you're going to see an acceleration in technology, productivity, and automation that will be needed to offset some of these inflationary pressures. So let's start with the first slide. This comes from our friends at Piper Sandler, they track, I think it's a super interesting chart, the companies that have announced onshoring since 2010, and you can see that those announcements are steadily increasing. So this is even before Covid. And the big reason is, China has gotten more expensive where a lot of these jobs and a lot of this manufacturing's been, China's now more expensive. It got more expensive to ship things even before Covid.

We now know of course that these global extended supply chains make things even dicier. And so basically, the acceleration of these announcements has happened post Covid. At the same time, if you look at the long-term trend of capital spending in the United States, it's been in decline. So we looked at this rolling five-year average to smooth out cycles and use a growth rate. What is the growth rate of capital spending in the United States? We took this data from the Federal Reserve, the St. Louis Fed, and you can see that since the '70s, it's basically been on a steady decline with some pockets of really big underinvestment. A lot of the companies we talk to in the industrial economy say this has to change. Well, it probably is changing and it's changing in a time when population growth has been in steady decline as well.

And so if you look at that number since 1992, well, we haven't been at 1% population growth in the United States since 2000. I think there's a blip there because of Covid. So the chart looks a little bit funky, but if you just go, extend the data points on more of a smooth line, you can see that the trend is clearly down. We're basically at a zero population growth society here in the United States. At the same time, the labor participation rate is declining. So where we used to have two thirds of eligible people in the labor force, now we have only about 60%, a little over 60%. So we're losing workers at a pretty big rate.

And the type of workers we have is aging. We all hear about China aging, we hear about Japan aging, we're aging here in the United States too. If you look at the retirees and the soon to retire and that teal line, they will now make up 30% of the population, they basically are there now. If you look at today's workers, between 25 and 54, that is on a steady decline to under 40% of the population. And if you look at tomorrow's workers, which are everyone from five to, or mid '20s who are just entering the workforce, that's also declining. So this confluence of population trends, isn't super favorable at a time when we actually need more workers in the United States if we're going to satisfy these goals of reshoring and making incremental investment decisions like Ford's building a plant in the Midwest. You hear Intel building semiconductor plants in Ohio. You're going to need workers for that.

So some ways to play. The first one is banks. I like banks, they have not been particularly great. But I think at some point, especially as we get on the other side of the cycle, especially if it's a recession, if you look at the last couple recessions and you look at the one in 2003, and the period that went from 2003 to the great financial crisis in 2008, and then post the great financial crisis in 2011, 12, for a period of time, the commercial loan growth in the United States was exceptional. It was 10 to 12% a year. And basically you had commercial loans, pretty much double in two different periods of time. And so if you think about what's on the other side of this and the types of companies that need to be funded, commercial loan growth should be pretty strong.

We like banks that have, or over-indexed to commercial loans is basically the point I want to make there. All this is happening at a time when banks have significantly underperformed the S&P 500, especially since the great financial crisis, typically, decent bank is trading at 10 to 12 times earnings, many have 3% dividend yields. So I think it's a place to look for value and a key indicator for us with the economy overall is the yield curve. And so if you look at the 210 spread, the spread between the 10-year Treasury and the 2-year Treasury to us, and I'll say we're speaking consensus, but it's good to know what everybody else is looking at. We look at the yield curve. We think that is a sign of economic health.

That yield curve has been as high, as spread has been as high as 250 basis points for long periods of time. By the way, if it gets back there there's tremendous earnings power of these banks. You could talk about the combination of loan growth that we just were looking at with net interest margin spreads expanding. If, this is the if, if those two factors came together, you're talking about a lot of banks that would basically double their earnings over the next five years or so, or more than double their earnings, which is a big move. And you see a lot of dividends going up as well. But it all depends on what this curve does over time. And we can see that it's been bouncing around zero here as the Fed continues to raise rates. The worry is that the yield curve will continue to flatten as the Fed basically steam out of economic growth.

And I don't think the Fed's going to back off. So in some ways you're rooting. This is where there's sort of you can't win or lose. You don't really know how it's going to play out. If you want this yield curve to steepen as the Fed's raising rates, you basically probably need the 10-year to move close to 4%, in order for you to get this spread. However, if the 10-year moves to 4%, that's probably a lot of pressure on equity valuations too. So until we again, normalize this whole process, I think this is another reason you're going to see a ton of volatility in the market.

So there's a couple ways we're going to play, and I'm not going to talk stock specific so much. This is going to get into a couple thematic ideas they have to do with productivity because we talked about banks, but the other way to play it is productivity. It's companies that are offering automation, digitization, and productivity opportunities to offset inflation. And I think this is a must-invest set of ideas going forward, because I guess as you can tell, I don't think inflation goes back to 2%, I think because of the population situation and because of the underinvestment in a lot of industries, I think it probably stays stickier in the three to 4% range. And that's one guy's guess. Yeah. I don't know for sure, but if you made me guess and they made me guess to do this presentation, that's my guess.

So here's some ideas that thematically, places that you can think about that tie into the productivity. Well, the first thing I'll say is, it's top of mind or anything else. There are a couple studies out this one, the top ones from McKinsey and they presented this at automation could destroy as many as 73 million jobs by 2030. But if you look at the population growth we were looking at, I think this is basically an offset to tens of millions of jobs being lost. I wouldn't necessarily think of this as replacing jobs as much as making up for the fact that we're just have, jobs retiring out of the economy. So I think this is a real big positive.

The second statistic there is that the pandemic's actually accelerated the need for automation, and we've all hear conference calls. We all hear companies, we all talk at cocktail parties with people we know who are in the economy, the real economy, and having a hard time finding workers. And so you think about the need for automation, it's everywhere. And I'll give you one example. We were looking at IBM not long ago, and listening to their conference calls, they have a natural language processing technology that McDonald's is testing out where when you drive up to the drive-through, you're not going to speak to a human 95% of the time. They have refined the voice recognition, the natural language processing to a point where they don't need people taking your order at the drive-through window. That's an example of what we think we're going to see a lot more of. And that ties into that last one where three out of four executives say they actually are working on these initiatives.

That spend is poised to grow significantly. According to Statista, it was about 6 billion in 2016, it's expected to be $34 billion in just another year from now. So there is a lot of investment going into digitizing and automating, what we consider manual and analog activities. One of the places that's front and center, and I laugh, is cloud computing. It's obvious, we've all know Amazon Web Services. We know Microsoft with Azure and we know Google. The thing is, if you look at this penetration of those services, they're only about 20% of the data center computing market today. That, and you look at the growth of just computing in general. And if the mix shift goes from 20% to 50% over time, these cloud computing platforms will grow 10 to 12 times over the next 10 years. And it's hard to imagine Amazon Web Services being 10 times bigger, but it's what the mass says, unless digitization really slows down.

And there's no signs. In fact, if anything it's accelerating. These are the places you want to be because this is where all these new computing applications are going to live. They're going to live in the cloud environments. That's where the cheapest cost of services. That's where you get the most efficiency. Another way to think about this is self-driving cars. We're basically automating something that everyone does all the time. And it's starting with advanced safety features. And it's going to go to self-driving cars in the next five to 10 years. And the way to think about this is with companies that do semiconductors in the automobile industry, the content of semiconductors per vehicle was very consistent around $300 per vehicle for a very long time. And we can see it started inflecting in 2014.

And what happened in 2014 is we started getting Tesla. We started getting advanced safety features, the cameras, the sensors, all that kind of stuff. So those cars have about 1,000 to $1,200 of semiconductor content per vehicle, as more and more vehicles mirror those functions, on average, we would expect the average car to have 1,000 to $1,500 of semiconductor content on it at some point over the next five years. There are a lot of companies to play this with, Analog Devices as a company that we own is a way, but you could go through a whole easy search for companies that are tied to automotive semiconductors. I know we have a timeframe here, so I wanted to wrap it up. It's noisy. And I think it's going to stay noisy because I don't think we're through this normalization process that we're in the middle of.

And it's definitely, especially the Fed raises rates and is forced because of inflation to not be accommodative as soon as the economy is used to it, is used to accommodation. I think there's the risk that stock market overcorrects to the downside. I'm not bearish long-term. I just think that we're working through some things and it's a normalization period and volatility will stay high. We don't know what's on the other side, but I hope I gave you some things to think about. And I also don't want people to... There's been a lot of hype and a lot of fast money in the market. I think this is the time to be very valuation-conscious and to focus on quality and secular winners. And if you can find the combination of good valuation at high quality company, I think you just got to jump on it, because it's not always there. But we may get more shots on goal here over the next coming months. And I'll stop with that, Amy. Thank you.

Amy Jeang: Thank you, Larry. I do have a question that came in. The question is related to work-from-home. Do we see this as a transitory occurrence? Or do you think that this is an actual structural change in our economy?

Larry Cordisco: I think it's structural. I don't know that everyone will work from home. As we come back to work here, I'm in the office a couple days a week. I think that sounds semi-permanent. I don't think I'm going to have to be in the office five days a week anymore. We follow PNC Bank, commercial loan-focused bank. So to give you a sense of that, they were asked on their most recent conference call about what they thought about office real estate. They were extremely bearish about office real estate. They think there's a structural change in San Francisco. I've heard more and more about 40% or so vacancy rates in San Francisco office buildings. And there's more and more talk. Of course, we also have a housing shortage in San Francisco, more and more talk about government incentives to convert these office spaces to residential real estate. I think it's permanent. And I think that's actually a good thing. And that's I guess, I'm not super excited about office real estate investments as a result.

Amy Jeang: And this is actually a two part question. The first one, seeing how high gas prices have come, you think it's going to continue to increase, or where do you think it goes from here? And I would imagine with the heightened gas prices, it's impacted people's discretionary income. Do you see that impacting the names within or the companies within the consumer discretionary sector? And if so, do you guys avoid companies in that sector or how would you get around that or play in that particular sector?

Larry Cordisco: Yeah, I'll take that second part first, because it's really been top of mind for us. If you look at our portfolios, we own Ross Stores, which is a very low-end consumer and got hit very hard by this. Management talked about a very sudden change in consumer behavior due to high gas prices. We also own Dollar General. They saw less of an impact, it's for staples and consumables and necessities, but they often talk about $4 gasoline being a real big demarcation. It's clearly having an impact. The way we are playing at those we're sticking with Ross. We own Dollar General, as I said, what often happens in these cycles is more people get pushed into the very low end of retailing. So Ross and a Dollar General have their markets expand over time. That is our thesis. We continue to own those companies, it's a not super optimistic view of the consumer. It's basically betting that more people get pushed into the low end of the market, but that is a way to play it. And we'll see if it's a correct way to play it over time.

In terms of gas. I'll tell you it's tough, because supply's not really going up very much. So it really depends on demand destruction. We're seeing signs of demand destruction and substitution. Walmart talked about people trading down from gallon milk to half gallon milk. Typically speaking, when people go to the pump and they can't get out of that gas station without filling their car up for 100 bucks or so that's usually when demand destruction starts. I don't have anything other than that. Say my formula says when you see demand destruction, you've probably seen peak oil prices, but that's just history talking. I don't know for sure, but I would be inclined to say that we're probably at the higher end of oil prices and gasoline prices. I just don't know how much they go down from here. And I don't know if I'm right, but they may say sticky because supply's not coming online.

Amy Jeang: Thank you for that. And we had another question that came in asking, how does, and this is specific to a company in the portfolio. How does Waste Connection fit into your Great Normalization thesis?

Larry Cordisco: Yeah. Well, I'll say this, from an economic standpoint, if you believe in this onshoring, reshoring infrastructure story, you're talking about the industrial waste portion of waste management, getting a lot better over the coming years, that's a higher priced, higher margin business. It's more cyclical of course. But if you go into the up part of the cycle, I'd say it's very favorable for Waste Connections. The other thing we really like about Waste Connections and all the waste companies is they have pricing power. Waste Connections tends to have more local monopolies as a percentage of their business. More of it's like a local monopoly, which gives them pricing power. But all the waste guys have shown ability to take price, offset inflation, and on a normalization on reshoring, onshoring, industrial investment cycle. All the waste companies should benefit quite a bit with the industrial waste portion of their business.

Amy Jeang: Got it. Thank you. I think that was all the questions that we have.

Larry Cordisco: Okay.

Amy Jeang: Thank you for your time. And if you guys have any more follow up questions, feel free to let us know.

Larry Cordisco: Thank you, everyone. Feel free to follow up.


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