The primary purpose behind game theory is to reach a correct ultimate conclusion. Typically, one starts with a hypothesis and then seeks conforming evidence to buttress it. But game theory teaches you that often leads to incorrect results. Rather, it’s the failure to disprove a hypothesis that reinforces the conclusion.
Let me give a simple example. I start with a rule that governs a 3 number sequence. Your job is to guess the rule. To help you, give me a three number sequence and I will tell you whether that sequence abides by the rule or not. When you think you know the rule, tell me what it is. But you only get one guess. 2-4-6 complies with the rule. So does 1-2-3. So does 3-6-9. OK, you see the pattern. But if you give me the obvious response, I will tell you it’s wrong. So we keep going. 2-4-8 complies. So does 2-6-12. But 2-12-6 does not! Aha! Now we are making progress. Why does 2-12-6 fail to comply? Does 2-5-4 comply? No. The rule turns out to be any three ascending numbers and the way it is discovered is by presenting a non-conforming example.
With that start, let me drift into a discussion of the stock market today. The obvious hypothesis is that all is good. Fed Chair Jerome Powell all but said rate cuts will begin no later than this fall unless there is a sharp change in economic trends between now and Labor Day. In addition, the turmoil over President Biden’s ability to lead for another four years has elevated the odds that Donald Trump will win the election. To investors, that means lower taxes and less regulation. Lower interest rates, lower taxes, less regulation, all good. No wonder the leading averages are setting new highs almost daily.
It’s easy to jump to conclusions. But, as game theory instructs us, let’s look for non-conforming evidence and at least consider whether the conclusion to party on is valid.
Let’s start with immigration. If one listens to the rhetoric, Trump would like to deport many millions. We all know that Trump’s hyperbole can’t be taken at face value, but clearly he will slow the flow of new immigrants significantly, both legal and illegal, while stepping up enforcement and sending back many who are here through other than legal channels. Without getting into the politics of immigration, the surge over the past few years has been a major boost to GDP growth. Birth rates are declining. Without immigration, our population would be declining. Thus, net negative immigration, combined with a declining birth rate and a normalized level of deaths, population change would be a big negative to GDP growth. While this is a hypothetical discussion and any deportation won’t happen overnight, beginning in 2025, demographics under a Trump administration would shift from a solid positive to either a smaller positive or an outright negative influence on our economic growth.
Now let’s move to taxes and tariffs. Many of the Trump tax cuts of 2017 sunset at the end of 2025. It is logical, that if Trump is elected, there would be a concerted effort to extend them. Perhaps further cuts are possible but, given our massive deficits, there would be strong pressure on both sides of the aisle to have pay-for provisions so that tax cuts wouldn’t result in even larger deficits. Lest we forget, interest on our debt now exceeds defense spending and soon will exceed Medicare.
To be sure, there are offsets. Trump would love to eliminate or scale back the Affordable Care Act. I should put quotes around the word affordable since it is (predictably) much more expensive than promised at the time of passage. He also would stop forgiving student loan repayments. But his big proposed offset is a 10% tariff on virtually all non-Chinese imports and a 60% tariff on imports from China. While such a tax would clearly generate revenue, it would also result in higher prices for imported goods.
Trump also talks of fiscal responsibility. But history (2016-2020) suggests otherwise. In 2016, the year before he took office, the deficit was $585 billion or 3.1% of GDP. In 2020, it was over $3 trillion or almost 15% of GDP. OK, that was a Covid year. But in 2019, the deficit was $984 billion or 4.6% of GDP, an increase of over 68% in just 3 years. You can’t blame that on Covid.
The first year of a Presidential term can often be chaotic in the stock market because change can be disruptive. We talk of the Reagan years usually in a positive way. But 1981 and 1982 were difficult as the Fed clamped down hard to lick inflation while the deficit almost tripled under supply side economics. It wasn’t until the late summer of 1982 that the stock market took off.
None of what I have said so far is meant as a prediction. What it represents is the search for non-conforming evidence, factors that could disprove the Goldilocks scenario so evident in the stock market today. I could add non-Trump related concerns like debt service now 7%+ of GDP and climbing.
But let me stop there and look at the market itself. While the S&P 500 was up almost 15% in the first half of this year and the NASDAQ rose by more than 18%, the equal weighted S&P rose just a bit over 4%. Second quarter earnings season is just beginning, but for the last two quarters S&P earnings, excluding the Magnificent 7, were down. Overseas, with the notable exception of Japan, markets rose just slightly faster. The conclusion is obvious. The stock market for the last year or more has been all about the outstanding performance of companies tied to the AI revolution. The rest of the market is up slightly, more due to lower interest rates and lower inflation than to any growth in earnings.
Now, let’s look ahead. While Powell has all but said short-term rates are likely to fall, it’s the 10-year rate that influences stock prices. The 10-year rate has wavered between 4% and 5% for a long time. While it could dip lower in the short-term, assuming long-term inflation near 2% and GDP growth of close to the same number, yields near current levels are a logical long-term assumption. Thus, any prediction of higher stock prices is predicated on projected increases in earnings. Those forecasts have to be divided between companies directly impacted by the AI-related spending boom and the rest. Right now, the composite forecasted growth rate of 12% plus through the end of 2025 seems high. But ex the AI leaders it is close to mid-single digits, a number consistent with a slow growth economy adjusted for the benefits of stock repurchases. That suggests that for the non-AI companies, market assumptions are reasonable.
As the for AI related companies, the two key questions are how long can hypergrowth related to capex to build an infrastructure to support AI needs continue, and what is the terminal growth rate past the AI surge. These stocks have surged as near-term earnings have steadily exceeded expectations. In turn, those expectations keep rising. At some point expectations will rise too fast to a point where they can’t be matched and a modest-to-severe correction is inevitable. When and how much are beyond the capacity of my crystal ball. Perhaps the upcoming earnings season will offer some hints. Last quarter’s surprises were consistently to the upside. We’ll see what happens over the next two weeks.
The obvious conclusions are that the behavior of markets so far this year has been rational and stocks are within the range of fair value. Further gains will depend on the abilities of companies to meet or exceed earnings expectations within an economy that may be slipping. With that said, the risks appear stacked to the downside:
1. GDP growth appears to be declining. Excess savings have been spent. Retail sales in real terms adjusted for inflation may have already turned negative. Consumer spending is what drives our economy. While the current unemployment rate of 4.1% is near historic lows, it is up from 3.4% and rising.
2. The aforementioned shift in immigration will be a depressant on economic growth. Even if a Democrat wins, the numbers crossing our Southern border are likely to decrease.
3. There is now over $34 trillion in Federal debt, and deficit spending is adding close to $2 billion per year. Debt service as a percent of GDP is now over 7% and rising. It was barely over 3% when President Trump took office. Both he and Biden spend without regard to the implications to the level of debt and debt service requirements. At some point, without enough buyers, rates will rise. When, is an unanswerable question.
4. A new President brings change. Wall Street doesn’t like uncertainty. Perhaps there won’t be a new President, but if there is, markets will have to adjust.
5. The Magnificent 7 have accounted for all the gains so far this year and all the U.S. economy’s earnings growth. They comprise almost a third of the total equity value in the stock market. As they grow, expectations have risen. Should they fail to meet heightened expectations, a market correction would certainly ensue.
With markets fairly priced and risks weighted to the downside, buyers should be cautious.
Today, Forest Whitaker is 63. Arianna Huffington is 74. Linda Ronstadt turns 78.
James M. Meyer, CFA 610-260-2220