March Madness
The first quarter of 2024 was marked by equity markets moving higher on the backs of the seven largest companies (by market capitalization), along with the recent bullishness of the Federal Reserve (FED). The "Magnificent 7" (Microsoft, Apple, Amazon, Meta, Google, Nvidia, and Tesla) are engaged in a race to develop and implement artificial intelligence (AI) into their software and hardware products. Thus far, investors have been willing to pay any price to "be in the game”, irrespective of valuations or the ability of AI to increase corporate earnings exponentially in the near future.
FED officials seem to have changed their priority from “doing whatever it takes to bring inflation to their 2% target” (even at the cost of a recession), to now “supporting full employment while tolerating modest inflation for a while”. This should not come as a surprise, as we are in a presidential election year. Recently, the Fed went even further to project US output (GDP) growth above 2% for this year and the next two years! In other words, the FED does not forecast a recession during the next three years! Naturally, the market bears had no choice but to turn into market bulls. However, the physics, economics, and data do not match the prevailing market narrative. And it is precisely at times like these, when our contrarian nature flashes “Caution”.
First, physics. While AI is expected to make companies much more efficient and profitable, we think investors overestimate how soon the full benefits of AI will materialize. AI runs on powerful processors that consume enormous amounts of electricity, which we currently do not produce. For example, the power consumption of the processors that Nvidia will produce in 2024 alone, if run at 70% capacity, will require approximately the equivalent of the state of Arizona's annual electricity consumption! This is just one manufacturer’s output for one year. That doesn’t account for all of the power needed to charge the growing number of electric vehicles (EVs) that the government is pushing the auto industry to produce, or the extravagant power consumption of Bitcoin miners that drain the power grid. Western states, such as California, are all too familiar with rolling power blackouts. Therefore, investors seem to be ignoring the limitations physics imposes on full-scale adoption of AI in the production process, and thus overestimating the impact of AI on company earnings.
Second, economics. While we celebrate the achievement of AI, we cannot ignore the social and economic costs associated with such innovations. School districts are already expanding online programs to replace teachers. Municipalities are looking to combine drones and cameras into their public safety operations to reduce the number of police officers. Companies are cutting costs by substituting automated processes, smart apps, and chatbots for administrative employees. In other words, pursuing “operational efficiencies” implies the elimination of many full-time jobs with salaries and benefits. If we know anything, it is that households hit by job loss or even the threat of job loss reduce spending, which will affect future output.
Therefore, we are not impressed by the FED’s recent bullish economic outlook. Plus, the FED has a horrendous forecasting record after all. For instance, the FED's forecast for the output growth rate during the fourth quarter of 2023 was 1.7%. Well, we now know the actual figure came in at 3.4%. So, if they can miss the quarterly forecast by 100%, how much faith can you place in the FED's ability to forecast three years out?
Third, data. Here we present data observed in our effort to detect future economic activity and potential corporate earnings.
Again, we believe they currently flash a "Caution" sign, but feel free to form your own opinion (unless otherwise noted, the data reflect the first quarter of 2024):
Leading economic indicators have been negative for 12 months in a row
Retail sales volumes (units not dollars) are down 1.8% (annualized)
Industrial production is down 5.6% (annualized)
Diesel demand is down. Paper box demand is down (proxies for production, transportation)
Continuous unemployment claims have risen year-over-year from 1.2 million to 1.8 million people
No new net full-time jobs created in the last 12 months, only part-time jobs
$1.1 Trillion in credit card loan balances (current rates on revolving credit lines average 22.75%)
Credit card and auto loan delinquencies are both at 8%. Mortgage loan delinquencies at 3%
At the end of 2023, 3.6% of 401(k) account holders took out emergency withdrawals (double the 2019 pre-pandemic rate)
So, what does all of this mean for investors? To us, the data suggest that the health of the US consumer has deteriorated over the past few months. Rising vehicle repossessions, foreclosures, and bankruptcies are not the signs of vibrant consumers ready to spend more money to boost the US output. (Continues on next page.)
Certainly, the stock market and the US economy are two different animals. While the average American household may be struggling to pay its bills, the top 10% of households may still have funds to invest and push the stock market higher. However, at these elevated stock market prices, the risk-reward relationship needs to be re-examined. We know that sentiment and psychology drive the markets in the short run, while earnings support valuations in the long run. The recent rise in stock market prices may be indicative of investor optimism (sentiment)— that AI gains in production efficiency (cost cutting) will offset the weakness of the US consumer, and a larger proportional drop in costs compared to revenues will generate higher earnings.
Only time will tell if this plays out soon enough to support the stock market. Meanwhile, we are in a presidential election year (which may explain the sudden bullish change in the FED’s narrative), and these years have historically finished strong with a market run-up after clear election results. However, the period between now and October could bring some turbulence.
We’ll be watching upcoming earnings reports closely for signs of profit margin strengthening (companies raising prices on consumers) or weakening (consumers not willing to pay more). Corrections that bring overvalued sectors like technology, pharmaceuticals, and financials closer to reasonable valuations could be seen as buying opportunities. We’ll be paying close attention to these sectors, observing any meaningful change in valuations, which could make them attractive again.
As always, we’re here to answer your questions and assist in navigating the complex landscape of financial markets.
Stay Fierce!
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