Stocks ended the week on a down note. For the S&P 500, it was two straight weekly declines. The NASDAQ Composite ended the week at its lowest level in a month. The surge earlier this year was led by the tech names at the top of the S&P 500. For the last several weeks, these same names have been notable laggards. Two steps forward, one step back. Bond prices also fell. The 10-year yield crept back towards 4.2%. The Fed may be winning the war against inflation but it doesn’t mean longer yields are destined to decline from here even once it starts to reduce the Federal Funds rate.
Simply said, investors have stopped chasing the hottest names as prices simply got too separated from fundamentals. Nvidia, the darling AI semiconductor stock, even after its recent correction still sells at 41 times sales and 63 times forward estimated earnings. These are valuation levels never seen before prior to the last few months. OK, AI may make a difference and its chips are the best. But AI isn’t the whole ballgame, and even if it becomes dominant in the years ahead, Nvidia isn’t going to be the only semiconductor supplier to the AI ecosystem. Microsoft# sells at 11 times sales. That may seem a lot cheaper but during the Internet bubble of the 1990s, whenever Microsoft sold for more than 10x sales, that was a red flag, at least regarding valuation. Apple# sells at 26x forward earnings even though earnings for the past several quarters fell from year ago levels. Is there an untapped market for smartphones? I doubt it. There are lots of ways Apple can build upon its existing base with all kinds of services. Moreover, its prolific cash flow feeds enhanced shareholder returns. But is 26x earnings a valid long-term valuation?
Obviously, markets are wrestling with these questions. Valuation always matters. Maybe not day-to-day or even month-to-month, but in the end, valuation trumps all. For a time, investors were chasing the magnificent seven names at the top of the S&P 500, especially institutional investors who measure their performance relative to the S&P 500. Overweighting the winners is how one gets outperformance. But the top 7 can’t outperform forever. Valuation matters. Once the tide turns, these same momentum chasers reverse course. When the top 7 underperform, they sell. They might even sell short. In the short run, that is the way markets work. As a result, they overshoot to the upside and the downside, driven by changes in momentum. As rational investors, it pays to watch. Don’t get suckered in to chasing momentum in either direction.
So right now, the tech winners of the first six months are verboten. Remember that momentum investors chase wherever momentum shows its face. Look at Eli Lilly as an example. It’s a drug company. Hot drugs see a surge in sales until patents run off. Right now, Lilly is in a great position. Its diabetes drugs also help the obese lose weight while reducing heart attack risk. Talk about a trifecta!! In addition, it is one of the biggest players in the search for drugs to forestall the onset of Alzheimer’s. But with that all said, Lilly now sells at 16x sales and 73 times forward projected earnings. I am not denying the promise of these drugs. Lilly has several certifiable blockbusters. But 16x sales is many multiples of what the other leading drug companies sell for. And anyone who has followed the drug industry for years knows that blockbusters have their cycles. Right now, Lilly’s stock reflects all the good news and then some, of its existing and late-stage drugs. For sure, part of the money that flowed into Lilly the past two weeks was the momentum money that chased the big tech stocks over the previous few months.
Please don’t misunderstand me. I am not knocking the wonderful fundamentals lying ahead for Nvidia and Lilly. But what I am saying is that hype can exceed reality. Stock prices can also get ahead of reality.
But if not Nvidia and Lilly, where does one go to find value? I would argue that in a world where growth is slowing, where market P/Es are high, and where a recession suddenly seems out of the picture, finding real value is hard.
We and others have been talking about the possibility of recession for months. It hasn’t happened. Current data suggests it isn’t imminent. Can it appear this year? Probably not. So, are the recession forecasters simply crying wolf? That’s a tough question to answer. It becomes more complicated because the outsized growth in fiscal spending, and the impact of the handouts during Covid complicate the picture. You can do the math. When Federal outlays are 25% of GDP and are growing at an annual rate of 11%, it’s hard to envision any recession. 2024 is an election year. Government handouts are not suddenly going to end. Thus, maybe a recession can be averted for as long as a year. But signs of strain persist. Leading economic indicators are still falling. Credit card interest rates now exceed 20%. Mortgage rates are pushing 7.5%. China is a mess. It’s over 20% of global GDP. It matters. The Federal government is now operating at an annual deficit rate of over $1.6 trillion. Does it matter? Two of three major rating agencies say it does. At present trends, debt service costs will soon exceed defense spending and even Medicare.
But back to the market. If the top 7 leaders are no longer leading, how does the market keep going up? Judging from the past couple of weeks, it doesn’t. For sure, leadership will rotate. Energy, so out of favor during the first half of 2024, had a sterling July. Health care stocks have revived a bit. So have industrials and consumer staples. Rotation is helping. As noted previously, with earnings season over, markets may be hostage to the direction of interest rates. Long rates, the key to stock market valuations, are rising. It’s too early to label that a long-term trend. But it does reflect an increasing likelihood that the Fed will take its time lowering short-term rates, and it suggests getting inflation back to the 2% target may take longer than optimists hope.
Normally, stocks do well in the fourth quarter, anticipating growth the following year. August and September are transitional months, often the worst months for stocks on average. I wouldn’t be a near-term optimist here. As for 2024 and beyond, a lot depends on whether there is a soft landing or recession coming. It’s a close call, one we can’t make yet. What I can suggest is that the euphoria priced in earlier this year may have been a bit overdone. The correction of the past two weeks makes my case. It also makes the case for not simply chasing momentum.
Today is Halle Berry’s 57th birthday. Magic Johnson turns 64. Author Danielle Steele is 76. Steve Martin turns 78.
James M. Meyer, CFA 610-260-2220