Mid Year Market Review and Analysis
The second quarter ended on Friday with the stock market continuing the rally that started at the end of October 2023. During the first 6 months of this year, the widely followed S&P 500 stock market index increased by about 14%. This is a “market capitalization” index, meaning the movements of the largest companies within the index matter much more than those of the smaller companies. For instance, the meteoric rise of one company alone (NVIDIA) to a $3 trillion valuation accounts for 30% of the S&P 500 index gain during this period. The way the index is constructed, however, it is entirely possible for the majority of the stocks within the index to have gone nowhere, yet the index to be pulled higher by the increased stock prices of the biggest 10 companies in the index. True to this fact, looking at the “equal weight” S&P 500 index, which as the name suggests gives all companies within the index the same weight/importance, has gained only about 3.95% during the same period. A good positive return, but nothing spectacular, which may be a better representation of the true state and current condition of the overall US stock market.
It is important for investors to realize that having only a handful of companies account for most of the market’s returns is both misleading of true market conditions and also detrimental to the health of the overall stock market. The funds currently chasing after the momentum of the largest companies come from selling the remaining companies in the index. This creates a wider valuation gap among firms in the index, making the big companies even bigger and more impactful to the overall index movements, while making the small companies even smaller and more insignificant to the overall index movements. This increases the fragility of the stock market, as the index becomes more sensitive to the potential decline in the valuations of the biggest companies. For instance, when NVIDIA’s stock price declined 13% in just three trading days last week, its market capitalization declined by $600 billion. In other words, the decline was equivalent to a company the size of EXXON MOBIL disappearing from the face of the earth. Can you imagine the potential loss of wealth if there is a bigger downturn in the valuations of one or more of the biggest firms in the index?
Aside from this internal market structure fragility, it is also important for investors to consider the reasons for such increases in the current value of the biggest US firms, which coincidentally all happen to belong to the technology sector. After all, the first-quarter earnings results of firms selling directly to consumers pointed to a weakened US consumer, with depleted savings and higher debts. These companies also reported lower guidance (outlook) for sales and earnings for the remainder of the year. Companies included in this group are Nike, General Mills, Levi’s, Walgreens, L’Oreal, Carmax, Target, Macy’s, Kohl’s, Best Buy, Lowe’s, Home Depot, Foot Locker, Lululemon, FedEx, Dollar General, VF, United Airlines, Southwest Airlines, McDonald’s, Burger King, Wendy’s, Yum Brands, Starbucks, and others. This is a broad spectrum of businesses reporting that the US consumer is on the ropes and cannot keep up the same level of spending. Despite the Federal Reserve’s (FED) insistence on our strong economy and resilient labor market, investors don’t seem to believe there are good prospects in the near future for businesses selling directly to consumers, like the ones listed above. We believe that institutional and individual investors are finding refuge in the stocks of businesses selling mostly to other businesses (B2B), like those in the technology sector. From this perspective, at least part of the recent tech stock rally can be viewed as a pure defensive play/ rotation.
There is, however, another facet to the tech sector rally, which is a purely offensive play: The quest for the holy grail of artificial intelligence (AI). A lot has been written about AI in the past few months, making most articles regarding the topic simply redundant. For its part, Wall Street has done a great job marketing and parading AI “experts” to all types of financial media.
By now, investors have been brainwashed to believe that the hundreds of billions of dollars of shareholder money that are thrown into this quest by the tech companies are perfectly justified. Not only that, but also any price investors pay to own part of these companies is also justified.
We beg to differ. If history is any guide from past incidents of technological innovation, most of the funds being thrown into this AI race will be a complete and utter waste. Under the vague meaning of a term like “generative AI,” people imagine a future computer system that can tell our government where and when the enemy will attack, or tell a business what mix of products to offer and at what prices to wipe out the competition. However, we may be decades away from such achievements. The current AI race is all about upgrading the irrelevant, if not practically useless, smart-device assistants such as SIRI, ECHO, ALEXA, etc., to become more useful personal assistants. Once users become completely dependent on these assistants for booking appointments, reservations, travel arrangements, etc., they become locked into the particular tech behemoth ecosystem. That’s exactly when the tech behemoths will be able to maximize their low-cost advertising revenues.
Are these ‘better’ personal assistants worth the money currently being thrown to their pursuit? Are investors justified in buying into these tech companies at record highs? History certainly suggests otherwise…
For historical perspective, in 1835, the US had only 1,000 miles of railroad track, but there were 200+ railroad companies in a race to claim a piece of that new and promising industry. By 1916, there were 254,037 miles of track, but most of the railroad companies had disappeared. In 81 years, the railroad system expanded by more than 250 times, yet only a small number of operators actually survived. Today, only 5 railroad operators remain (AMTRAK, BNSF, CSX, Norfolk Southern, Union Pacific). Fortunes were made and subsequently lost because it was impossible for investors to predict which railroad company would survive or which type of operation would reap most of the benefits of that new industry.
In another example of innovative technology, the development of the internal combustion engine allowed the automobile industry to come into existence. By 1895, at least 1,900 different carmakers were trying to claim a piece of that new pie in the US. However, World War I and the Great Depression subsequently wiped out most of these firms. Today, only 4 US carmakers remain: General Motors, Ford, Tesla, and Rivian.
Jumping to the late 1990s, the rapid expansion of the ‘world wide web’ led to the Dot-Com bubble. The fantasy of simply having a website as a means of running a ‘successful’ business led to the creation of hundreds of new tech companies. During 1999 alone, there were 457 initial public offerings (IPOs), followed by another 91 IPOs during the first quarter of 2000. Unfortunately, soon after reality set in and the Dot-Com bubble burst, the technology-heavy NASDAQ 100 stock index collapsed by 80%, and most of these companies were wiped out of existence. It’s estimated that investors during this period suffered ~$5 trillion in losses!
More recently, throughout the 2020 pandemic, stocks of companies that helped us work remotely, hold meetings online, and exercise at home experienced a meteoric rise in their stock prices. Two years later, the same stocks are now struggling to stabilize at much lower prices (Peloton, Zoom, WeWork, etc.).
Additionally, during the period of easy money that followed the pandemic, the craziness of Special Purpose Acquisition Companies (SPACs) emerged. These new schemes had no particular business, but they raised funds from investors promising to buy/merge with some other type of business within two years of funding. Some SPACs pursued the trendy electric vehicle (EV) business. Investors sunk billions of dollars into these new companies despite the lack of proven products or operating models. The promise of easy profits was prevalent, and as Warren Buffet has written, “nothing sedates rationality like large doses of effortless money.” Nonetheless, within just a couple of years, scores of investors have been quietly wiped out as companies have gone bankrupt (Fisker, Proterra, Lordstown Motors, Electric Last Mile Solutions). Conversely, there are EV companies that are still alive but with very slim odds of surviving (Nikola, VinFast Auto, Canoo, Lucid Motors, Faraday Future, Lion Electric).
It is a well-known phenomenon that investors tend to suffer from ‘FOMO’ (fear of missing out) when prices of assets (stocks, real estate, commodities, crypto) incessantly move higher. Undeniably, momentum and sentiment rule out any danger and risk in the short run. Fortunes are made but lost just as quickly as rationality eventually prevails. In the long run, earnings do matter and valuations will return to accepted norms.
Instead of chasing unicorns, we prefer to focus on companies with proven operating models and reasonable valuations. Even when we delve into the realm of newer firms, we want to see discounted prices from recent price levels. After all, when the market experiences a correction, overvalued stocks tend to decline much more than undervalued ones. We also remain intensely focused on income generation and profit harvesting to capture as much of the gains that our holdings may produce.
As we enter the second half of 2024, it’s important to keep in mind that during the course of a typical year, the stock market goes through two to three 5% declines and one 10% correction. Thus far, we have only seen one 5% decline (which came in April). Therefore, it is reasonable to expect that between now and October there could be a few declines/corrections in the market. These downward fluctuations could provide better entry points into new positions.
There are a number of possible catalyst for the next correction. Currently, there are large unrealized losses from the commercial real estate (CRE) sector, which could cause multiple banks to fail if those losses were to become realized. The odds of a broader liquidity crisis ensuing from such an event increase significantly if the FED does not ease its monetary policy soon. Needless to say, overvalued assets do not fare well in such an environment.Typically, investors seek refuge in Treasury securities during such liquidity crises.
The next possible trigger is of course the extremely over-valued tech sector. Anything short of perfection in earnings or growth rates could lead to a precipitous decline in the stock prices of tech companies. Despite the uneasiness of watching indices decline, such a drop could actually be healthy for the overall market. Again, having just the tech sector marching higher doesn’t make for a healthy investment environment. A rotation and rebalancing of valuations between market sectors to broaden the market rally is much needed. We have written in previous newsletters that a rally which lacks breadth is very fragile.
Political risks are also present during a presidential election year. Debates, conventions, nominations, or lack of clarity around the election outcome have the potential to cause market turbulence. Markets do not care all that much about whether Democrats or Republicans win the election. Markets simply do not like uncertain outcomes. On the bright side, markets tend to rally after clear presidential election results are confirmed.
Finally, we will be monitoring and analyzing the second quarter earnings reports (coming out July and August) for clues of future corporate earnings. Wall Street seems fixated on its expectation of 11% S&P 500 earnings growth for 2024. In our view, this is all too optimistic as the guidance recently provided by firms (outside of the tech sector) is much weaker. Recent reports on Personal Consumer Expenditures (PCE) and Continuing Unemployment Claims indicate a much weaker economy as compared to what the FED and the Wall Street promoters would have us believe. But, in the end, the proof will be in the numbers— as in the corporate earnings numbers.
As always, we are available to answer your questions about the market, your portfolio, or your specific situation.
Have a safe and Happy 4th of July!
Stay Fierce!
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