November ended with a bang, at least for the Dow, with the Industrials rising 1.5% yesterday after a strong earnings report from Salesforce. However, the NASDAQ lagged amid some profit taking. Nonetheless, it was up 11% for the month while the S&P 500 was up almost 9%. The bond market achieved a commensurate rally with yields of 10-year Treasuries falling from close to 5% to about 4.3%. The dollar sank along with lower rates while the VIX volatility index fell to its lowest level of the year. Strength faded a bit toward the end of the month but was still robust. Breadth widened as leadership in the second half of the month shifted from the Magnificent Seven to a broader array of stocks that were losers for most of 2023.
Academic studies strongly support the conclusion that stocks are forward looking. They tend to price in expectations both for the market as a whole and on an individual company basis about 6-9 months ahead. Markets bottomed at the start of October. There are still some who look at this as a rally within a bear market. If that is so, a recession more impactful than currently expected would be the cause. Clearly, high short-term interest rates are impacting those industries where borrowing costs are a significant economic factor. The most obvious is housing. While new home construction has been strong given the lack of sellers of existing homes, total sales are down meaningfully. Auto sales are still okay largely because pandemic-related shortages limited available inventory for so long. But that catch-up demand appears to be abating. Retail sales had been supported by all the excess cash in consumer hands passed out by the government during the pandemic. But as that cash pile is diminishing and the cost to carry credit card debt rises well above 20%, retail sales trends are noticeably weakening. Thus, there is a strong case for further softening. However, that doesn’t support a strong case for a recession. As noted often, whether the overall economy grows or shrinks by 1% or less shouldn’t impact a large swath of corporate America, particularly with an unemployment rate hovering around 4%.
It is quite likely that as the economy softens, job losses will increase setting off further declines in retail demand. That could lead to a recession. But that also assumes the Fed sticks with its stated policy goal of leaving rates high for an extended period of time. 2024 is an election year. It’s one thing to leave rates high, waiting for inflation to fall to target in a sluggish economy. It’s another to leave rates high should growth turn negative and job losses accelerate. Right now, Fed Fund futures are pricing in the first rate cut in late spring, about six months out from the start of the current market surge. Make sense? Of course, it does!
That doesn’t mean it’s correct. Forecasting economic growth rates as far out as six months is both tricky and often inaccurate. Just turn back the clock to the beginning of 2023. Markets were pricing in peak Fed Funds rates far lower than the 5.25% that exists today. And there were exactly no forecasters expecting 2023 Q3 economic growth of 5%. Thus, while markets price in expectations, expectations change over time and so do markets. Sometimes they change both quickly and erratically. 10-year Treasury yields in July were below 4%. By late October, they were touching 5%. This week they fell below 4.3%. 10-year Treasury yields normally trace expectations for nominal GDP growth, a sum of real growth and inflation. It is fair to say markets were overly pessimistic in July and overly optimistic in October. Another way to say the same thing is that markets had too much euphoria in July and too much gloom in October. Briefly, in both cases, short-term emotional behavior trumped reality.
Back to today. 6-9 months out, a rational expectation is that whether there is a soft landing or a modest recession, inflation will be getting close enough to the Fed’s long-term target that moderation in tight monetary policy is called for. Indeed, if the Fed wants to stay apolitical, it will not want to be seen as too tight or too accommodative during an election cycle. If the economy is growing at a sub-normal pace, or possibly in decline, some rate cuts are out on the horizon. Now let’s move forward to mid-2024 and look out another 6-9 months. That is what investors will be doing next summer. A smart investor wants to stay ahead, not follow the pack. The early bird catches the worm is a good mantra for investors. By mid-2024 the most likely conclusion will be that with inflation back under control, the outlook would be for a more neutral monetary policy and an extended period of growth. That growth rate will be negatively impacted by worldwide demographics and falling birth rates. The U.S. demographic picture will be altered in either direction by immigration policy, both as applied to legal and illegal immigrants. Quite simply, the growth rate of bodies in America is a key economic factor. Markets don’t care whether they are here legally or not.
All this applies to the overall economic outlook. But all growth cycles are different. Between 2009 when the Great Recession ended, and 2021 when the pandemic peaked, monetary policy worldwide supported an unsustainable level of growth. Capital was free, adjusted for inflation. Eventually, the excesses created over those dozen years created the inflation rate that exploded once the pandemic-induced quarantines ended. Central banks are unlikely to replicate that mistake soon. They could lower rates sharply in a crisis but won’t leave them there for an extended period. Thus, looking ahead, one consideration for investors is that capital and leverage will have a cost. The good news is that the real cost of capital will sharply reduce what I would label as stupid investments. Look at the failure of WeWork, a company that borrowed big when rates were low to sign long-term leases for office space that it subsequently leased for periods as short as a week or month. The mismatches in duration were an instant recipe for failure. WeWork is now in bankruptcy. But it leaves behind millions of square feet of leases now in default. It seeded a phantom construction boom that leaves behind even more empty space. WeWork never would have gotten started in today’s rate environment. The same can be said for many of the SPACs and IPOs circa 2021. New venture and private equity investments are way down today, a sign of more sober behavior.
There are other differences. Generative AI will spawn a raft of new companies and new industries. Just as the evolution of smartphones led to the evolution of services like Uber and Waze, what we see today is only the start. Data centers designed to process and store traditional corporate and personal data now have to be completely revamped for a new generative AI world. Gone are the machines built upon traditional microprocessors replaced by graphical processors that can process data serially rather than in parallel. Remember search before Google? It was arcane and slow. What Google did was to string PCs together to process searches in seconds that used to take minutes. AI is the next extension. Mobility created a true social networking world. Facebook was originally desktop based. When I get on an elevator today, anyone under the age of 40 is busily texting, watching TikTok, and scanning emails.
Generative AI may be the most revolutionary event that will impact 2024 and beyond, but there are other megatrends that will make 2024 and thereafter different from 2009-2021. Obamacare took off shortly after 2021 and changed to way medical care was funded. Going forward, with entitlement spending out of control, Congress eventually will have to rein in some of those costs. A decade plus ago Netflix was mailing subscribers movie disks. Today, the world streams, but the economic model is in chaos. Too many companies chasing too few dollars. The same can be said for EVs. Tesla was first and is, by far, the lowest cost producer outside of China. It won’t control 100% of the market, but who else emerges is a big question knowing that the manufacturing of autos is a very capital-intensive industry. Speaking of China, it is a big accident waiting to happen. Population is starting to decrease. Many of its smartest are leaving. Government policies are chasing foreign capital away at an accelerated pace. What was made in China is destined to be made somewhere else.
One of those somewhere else places will be the United States. Just-in-time inventory management and global supply chains work most of the time. But as we learned over the past few years, not all the time. Reshoring will be a theme to consider. So will growth in infrastructure spending supported by over a trillion dollars of support authorized by the Federal government.
I could go on. The important point is to recognize what will be different in the future as opposed to simply buying companies that experienced strong growth in the last cycle. Don’t simply chase the obvious. Everyone knows the Nvidia story today. That doesn’t mean its stock is dead. It simply means that what we know, including 2024 expectations, are already built into its stock price. Will new competition emerge? Will China continue to be no-no land? Will there come a time when it must operate its own foundries? These are cogent questions. The next great success story can come from anywhere. Look at Lululemon’s performance over the past decade. Or Chipotle.
The prospects for great companies in the right places won’t be deterred by economic growth rates that vary slightly. Your goal should be to find just one or two standout successes and ride the wave. You don’t have to be super early. Microsoft# and Apple# came public in the 1980s. But if you bought either 25 years later after the Great Recession, you would have been a big winner. Identify the opportunity, set a fair entry price, be patient, and don’t worry about market cycles. There will always be bear markets. If you have to worry, concern yourself with new markets and new competition. That’s what ultimately kills corporate giants. Just ask Eastman Kodak.
Today Bette Midler is 78. Lee Trevino turns 84. Woody Allen is 88.
James M. Meyer, CFA 610-260-2220