Last week was a big one for economic news. Both consumer and producer prices rose less than forecasted despite stubbornly high shelter related costs which continued to rise at a pace of over 4% annualized. Sandwiched between the two major economic releases, the Federal Reserve’s Open Market Committee kept interest rates steady but hinted toward two possible rate cuts this year. Treasury markets responded with enthusiasm driving the yield on 10-year Treasuries down toward 4.25% about 50 basis points below where they were just a few weeks ago. A bond rally that sharp normally would ignite an equally explosive rally in stocks. While both the S&P 500 and NASDAQ Composite edged higher, the rally was hardly explosive. The Dow Industrial and Transportation averages both fell.
What’s the message?
We have noted for some months that while the overall U.S. economy has continued to grow, strength was isolated within a few pockets of the economy. The most obvious strength related to all the capital spending needed to support the generative artificial intelligence explosion. Seeded by high performance chips made by Nvidia# and others, and accelerated by software that turns that processing power into new levels of intelligence, companies like the big cloud providers have spent tens of billions of dollars building the capacity to satisfy present and future needs fulfilling the promise of AI. So far, it’s been a bit of “build it and they will come.” The hardware infrastructure is coming together faster than the software needed to perform the most sophisticated queries. Media reports highlight some of the often lowlights of searches. But it is inevitable that the stumbles will soon become less frequent while the ability to query your computer and get virtually instant, thoughtful and accurate responses is only months or a few years away.
AI isn’t the only economic hotspot. Spending on healthcare continues to expand at rates consistently faster than the overall economy, testimony to medical advances and an aging population. New home construction stays strong amid a lack of quality homes for sale. Infrastructure spending is also starting to expand boosted by a large increase in government outlays.
But, some of the areas of strength just a year or so ago are starting to wane. Eating out is getting very expensive. Traffic at both high and low end restaurants is starting to decline amid menu sticker shock. It doesn’t help that Americans have largely spent their excess savings built up during the Covid pandemic. Airports are still crowded but weaker ticket prices show that airlines need to tweak prices lower to fill seats. The same is starting to happen for cruise lines. Retail is spotty. We will learn more tomorrow when May retail sales numbers are released. But both high and low end retailers are showing signs of stress. We are also seeing a world where the “haves” (think Wal-Mart and Costco#) are taking share from all the have-nots. While a few standouts remain, like Dick’s Sporting Goods and Williams Sonoma, virtually all the low-end dollar stores are suffering while the very high end is also feeling pressure even amid record stock prices.
So, what’s the message from last week’s economic news and market reaction? There is an old saw on Wall Street that notes it’s a good thing when stocks stop going down on bad news but a bad thing when they fail to respond to good news. As noted, the S&P 500 and NASDAQ did respond positively last week but the gains were heavily concentrated within a few stocks that reported better than expected results. The message from the Dow averages, much less weighted to the high-tech leaders, is that the rest of the economy is rather punk.
I don’t want to dwell on the negative. Markets are a composite of good and bad. The good, as highlighted above, is so good that it can lift the overall economy. When one industry invests tens of billions of dollars to support future growth, those benefits drift down through a wide swath of the economy. The beneficiaries aren’t just semiconductor companies; they are as diverse as management consulting firms and electric utilities.
With that said, it’s rare to see an economic and financial world as bifurcated as now. Just a handful of stocks make up a quarter of the S&P 500. That same handful accounts for more than 100% of the corporate earnings growth this year. We see the bifurcation everywhere. I just mentioned retail where the best managed chains gain share while others struggle to survive. Homebuilders are flourishing at a time when overall housing sales are in decline.
There are also a lot of myths and false hype that investors have to sort through. Let me note a few examples.
1. High mortgage rates are bad for homebuilders and will force home prices lower. WRONG. Almost everyone who buys a home does so for lifestyle reasons. High costs may force those who want to buy to accept a smaller, older, and less well located home. But they will buy. Empty nesters may be disappointed at the price they receive for the home they loved for 40 years, but they still will move to something more fitting of their lifestyle. As for prices, I would argue that if mortgage rates were suddenly 4%, it would ignite an explosion of homes for sale that could well drive prices lower. In the meantime, in a world where mortgage rates are still 6%+, don’t look for major changes.
2. It’s only a matter of time before EVs replace gasoline-powered cars. MAYBE. But EVs are not ready for prime time, at least not yet. Americans will adapt to new technologies when the economics are clearly in their favor. In time, we discarded our film-based cameras. We migrated from desktop to laptop to smartphones. But only when the economics were compelling. Forget the environmental stuff. Almost all consumers do. No one wants to add to pollution but no one wants to pay thousands of dollars extra to protect the planet either. Meanwhile, the EVs are more expensive than their gas guzzling alternatives, they are more expensive to insure and repair, and the charging infrastructure is still lacking.
3. Reshoring. If reshoring is exploding courtesy of trillions in government handouts, and changing supply chains post-Covid, why is the growth in manufacturing jobs so anemic? To be sure, some reshoring is taking place. Supply chains have been altered post the Covid debacle and that includes some reshoring. Moreover, the U.S. economy is persistently stronger than elsewhere, an incentive to having more manufacturing closer to home. But we are not the only nation handing out checks and incentives to bring manufacturing to the U.S. The regulatory burden is generally higher here than in emerging markets and that burden continues to grow. Finally, when it is left to the Federal government to decide who gets the big handouts, there is little evidence that it is a better allocator of capital than the private sector.
4. Climate change is real and corporations need to react. In fact, they are. While the media emphasizes the callous behavior of some, corporations understand that it makes a lot of sense to do whatever they can to reduce harmful emissions. New technology is making natural gas-fired turbines virtually pollution-free. Smaller nuclear plants are much safer than those built 30 years ago or more. Oil companies are leaders in carbon capture. Many of our largest corporations expect to be net neutral polluters within a decade. Again, it’s the economics that is the ultimate driver. What Americans and investors fail to understand are the costs associated with climate change. It isn’t just the damages caused by storms and fires. Climate change alters everything agricultural. In the 60s and 70s, Americans went south seeking better weather once air conditioning became ubiquitous. But now cities like Phoenix, Las Vegas and Dallas are becoming simply too hot. The ideal location to live will shift courtesy of climate change. One can argue the causes but no one can argue the fact that the planet is getting warmer and that has huge economic consequences. Over the next decade look for technological solutions to emerge that could create an industry on a par with other high-tech sectors.
5. Nothing is free of fashion. When I first started as an analyst, there were two constants; Levi blue jeans and London Fog raincoats. Then along came fashion jeans. As for raincoats, does anyone buy them anymore? Clearly there are trends. Sneakers are more comfortable than leather shoes. A century ago, men wore suits to go to a baseball game. Our dress codes have gotten ever more casual since. Owning the stock of a maker of suits or formal wear isn’t a likely ticket to riches. But it is also true that success breeds competition and everyone wants to be hip and wear the newest hot item. It isn’t just clothing. Fashion impacts how we travel, where we go, and even how we get there. It impacts what car we buy. Which label has the most cache today? The odds are that it probably won’t have the most cache tomorrow. Iconic names like Starbucks and Nike feel the pressure. Staying on top is hard.
6. In business, nothing stays the same forever. Every business that wants to succeed over the long term must pivot over time. 60 years ago, you could buy a hamburger, French fries and a Coke for $0.50 at McDonalds…and not much else. Today, over 75% of traffic goes through the drive-thru, and ordering is done via an app or a kiosk. 40 years ago, your first PC was run on DOS. It was a standalone machine that could do word processing and spreadsheets. Pivot #1 was to Windows. Pivot #2 was to network. Pivot #3 was to incorporate email and the Internet. Pivot #4 was to move to the Cloud. Pivot #5 is generative AI. If a company didn’t do each well, it disappeared. The best companies constantly pivot.
The trick to good investing is to identify great companies, to separate the hype from the reality, and to be disciplined. Don’t chase a tall tale without substance. Most of all, watch what management has done and what it plans to do tomorrow. We study history to help us understand what may lie ahead. In sports, why do the same teams always come out ahead persistently over decades. The Yankees and Celtics are obvious examples. Can the same be said of the New England Patriots without Tom Brady or Bill Belichick? Time will tell. The same holds true for business. Names like Procter & Gamble and Coca Cola have been leaders for decades. But in the fast lane of technology, there are fewer standouts. Of the 20th Century leaders, only Microsoft# is still on top. In the corporate world, nothing lasts forever.
Today, Venus Williams is 44. Barry Manilow turns 81.
James M. Meyer, CFA 610-260-2220