Last week was a tough one for investors as some of the speculative froth started to come out of the stocks related to artificial intelligence. One sure warning sign is when a stock declines, sometimes sharply, on good news. Over the past couple of weeks, we have seen that scenario repeated multiple times, not only for AI-related stocks but across the whole technology diaspora plus other favored growth stocks. The trend wasn’t universal but the outsized moves were prevalent enough to remind investors that the stock market isn’t a one-way street to economic nirvana.
Last Tuesday was Election Day and the results were surprising in the consistency of outcomes. Americans loudly expressed their dissatisfaction with the status quo. Democrats won gubernatorial races in New Jersey and Virginia that were supposed to be hotly contested by more than a dozen percentage points. Voters in Georgia threw out two commission members who regulated utility costs and did so by resounding margins. A self-proclaimed socialist won a majority in New York City. When residents have to pay more than 50% of their income just to live in a 1,000 square foot apartment, they will flail at any promise to improve that situation, even one that seemingly makes little economic sense.
One of the corollaries of a surprising election outcome is that both Democrats and Republican tend to overread the tea leaves. Democrats, who won most of the big races, felt they somehow received a mandate, evidenced last week by further intransigence in Congress. The result was further public anger against everyone in Washington. On the flip side, Republicans are drooling at the possibility that a pending fiasco in New York City can be expanded into a platform to support them in next year’s mid-term elections. It may help elect a Republican governor next year but that’s it. As for President Trump, besides calling the media’s interpretation of the election results fake news, his domestic focus shifted to trying to break the filibuster rules in the Senate. When that didn’t work, he shifted to an offer to send $2,000 to most Americans from tariff revenues which he claimed would help to reduce the deficit and our national debt. Huh? Last Tuesday, support among Black, Latino, and lower income voters shifted dramatically toward Democrats. Withholding SNAP benefits won’t bring them back.
The government shutdown is now the longest on record. Last night, there was finally movement to bring the shutdown to an end, hopefully by the end of this week. It may take a bit longer to get airline operations back to normal. With that said, there are 435 House seats. Come next November, if inflation is still around 3%, utility costs are rising by 10% or more, and health insurance premiums are rising at double that pace, incumbents will be facing uphill battles. They may point fingers across the aisle but as last Tuesday demonstrated, voters will kick out the incumbents and try something new.
Does the government turmoil tie into the stock market’s shift from euphoria to concern? The actual GDP impact will likely be modest. Obviously, government spending this fall will decline but there will be a flip side when back pay and services are restored. There may be some long-term impact. Project approvals will be delayed. Airlines won’t recoup what they are losing in revenues currently. Thus, the shutdown can’t be ignored entirely. Consumer confidence has cratered. History shows only modest correlation between confidence readings and economic activity. With that said, the major retailers will be reporting quarterly earnings this week and next, setting the stage for Christmas. Robust isn’t a word one can expect to hear often. Consumer spending has been the resilient strength of this economy for a very long time. But credit card balances are rising as are defaults on auto loans. Consumers are clearly trading down, eating at home more, and making changes that allow them to enjoy the experiences they have gotten used to.
We are also seeing cracks in the tech world, at least within the stock market. One disturbing trend is that big tech companies are investing, either via financing or direct investment, in their customers’ business. Circular investing. You give me your money and I’ll buy your product. Let me offer a simple example. If a company that makes heavy machinery sells it to a customer on irresistible terms (e.g., buy now and pay later) and the customer then goes out of business, then the producers’ only fall back is to reclaim the used machinery. Reselling that machine competes with the sale of new products. At the end of the Internet bubble, Global Crossing spent many millions to lay cable across the Atlantic to service expected exponential growth in demand. That cable ultimately lay dark for over a decade. Our own government is getting into the act as well, committing to make direct investments in companies like Intel without any insurance that Intel’s chips years from now will be competitive. The one glaring difference is that at the end of the Internet bubble, companies were investing to meet future demand that often didn’t materialize, whereas today, capex is huge but can’t even meet existing demand. The obvious questions are when will supply catch up with demand, and how long can the pace of demand growth be sustained?
Debt and euphoria are the seeds of future failures. The ultimate catalyst is bad investments. Financing a home purchase made with too little money down to someone without enough income to service the loan leads to disaster. Building zombie shopping centers or high-rise condos using low or no interest loans and then finding out that vacant space yields no cash flow leads to foreclosure.
The Internet bubble burst on Wall Street not because the Internet failed to reach expectations but (1) because the market for Internet services took longer to mature than early optimism suggested, and (2) early pioneers failed and ensuing companies developed better mousetraps. How many of you use MySpace as a social media platform, perform search queries using Lycos, or get your email from AOL? Remember the Netscape browser? I don’t know any better than anyone else what the AI landscape will look like a decade from now. But I can conclude unequivocally that not all the obvious leaders today will be leaders tomorrow and there will be spectacular failures along the way.
You see examples of investor euphoria going bust all the time. Look at names like Peloton or Beyond Meat, now a $2 meme stock. Companies don’t have to fail for their stocks to fall sharply. Palantir is a wonderful company in so many ways. But its stock sells for more than 50 times revenues. Tesla shareholders are looking past EV car sales (which haven’t been going so well lately) to a world where every taxi is an autonomous vehicle and humanoid robots replicate Jetson-like servants in every home. Both may happen, but probably not in the next five years. But perhaps the best example of air escaping from the speculative balloon is the stock of Strategy, a company whose business model is to invest in bitcoin using leverage. While the price of bitcoin is still higher than it was a year ago, the price of Strategy’s stock is down about 50%. Pricking the speculative bubble is good for long-term investing. But the near-term pain can hurt.
The NASDAQ has been on a straight line up for 7 months since the Liberation Day tariff fiasco without a decline as much as 3%. The good news is that there are no signs of pending recession yet, and 10-year Treasury yields are still anchored within a 4.0-4.5% range. Earnings, overall, are still growing. That should mitigate the severity of any correction. But P/E multiples are still extremely high. It appears the purging of speculative excesses has begun. How far it spreads and how much short-term pain needs to be endured is still an open question.
Good investors are skeptical investors. They constantly want to test their hypotheses. They know that every promise won’t be fulfilled. That doesn’t mean to throw the baby out with the bath water. Great companies will still be great companies across every emotional market cycle. But somewhere within every portfolio is a company that is facing new headwinds, has extended itself too far, or offers promises that will never be fulfilled. Just as pruning makes a plant more robust, so does rehabilitating a stock portfolio. It’s been a nice bull market for several years and many investors have achieved significant unrealized capital gains. Just remember that realizing some of those gains means you made a lot of money. Don’t let tax considerations alone prevent you from selling an asset that may decline in value over time.
Please don’t overread my caution. We are still in a growing economy and AI will change the world as all technological revolutions have in the past. But there is a sober reckoning taking place that we all have to be aware of. Just as voters last Tuesday said we are on the wrong path, and that campaign promises are often unfulfilled, investors need to reexamine their portfolios, separating promises from sober reality. Near-term, it appears that public outrage over the government shutdown will bring it to an end over the next week or so. When that happens, perhaps the news will lead to a pop in the stock market. That would be a perfect moment to execute any portfolio changes that improve your investment health.
Today, Miranda Lambert is 42. Ellen Pompeo, the original star of Grey’s Anatomy, now in its 21st season, celebrates her 56th birthday today.
James M. Meyer, CFA 610-260-2220