Stocks drifted lower yesterday amid a lack of hard news. The JOLTS survey, which measures job openings and quits, got outsized attention due to the drop in job listings last month. Today, we will see ADP’s estimate for net jobs created in November ahead of Friday’s employment report. All this is a preamble to next week’s CPI report and a Federal Reserve meeting that almost certainly will end with no change in interest rates and no indication when the first-rate cut might occur. As for future rate increases, they appear increasingly unlikely given the steady trend toward lower inflation and slower growth.
The question whether our economy faces a soft landing or recession remains unresolved. As data weakens, concerns about recession will naturally increase. But the actual odds one occurs won’t change much until we get further into 2024. But investors don’t focus on economic growth; they focus on earnings and interest rates. Slower growth and lower inflation mean slower nominal growth, whether there is a soft landing or a recession. It also suggests strongly that in a weakening economy, companies are likely to lose pricing power, at least those companies whose fortunes are closely tied to the state of the overall economy. To me, that suggests that as the economy slows, as inflation recedes, and as overseas growth opportunities (specifically China) become more speculative, there will be downward pressure on 2024 and 2025 earnings estimates.
Long-term Treasury yields often mirror nominal GDP growth. In part, this explains the recent sharp decline in the yield on 10-year Treasury bonds. Federal Reserve goals are 2% inflation and 2% real growth. Combined that is 4%, not far from the current yield of a bit over 4.2%. While growth early in 2024 may be less, inflation is likely to be a little more. If the economy later next year starts to grow by more than 2% and/or inflation stays a bit higher than the long-term 2% target, one could argue for a 10-year yield closer to 5%.
The sharp November rally has reignited investor spirits. The rise in bitcoin has reignited speculative spirits. All this is well and good. But for those who remember the 30%+ rallies that followed bear market bottoms in 2002 and 2009, take a deep breath. First, this time we came out of a market correction, not a deep bear market. We had a smaller hill to climb to get back to the top. Second, valuations at the aforementioned bear market bottoms were materially below historic norms. At the end of October this year, valuations were close to historic norms excluding the high valuations assigned to the Magnificent Seven at the top of the S&P 500. Any further sharp rally will move stocks overall into overvalued territory barring a spike in earnings. But, as suggested above, receding growth and inflation will likely cause earnings deceleration, not acceleration.
Seasonally, there is almost always a Santa Claus rally. Given the current level of optimism, I have no reason not to expect one this year. But I would not want to end 2023 overextended in equities.
Monday, I promised to return to the mantra of Charlie Munger. The way I want to do that is to look beyond whether the market is going up or down near-term, or whether it is currently fairly valued or not. Whether a recession ensues in 2024 or not, it is not likely to be very sharp. There really aren’t any severe fundamental imbalances in the overall economic environment. That doesn’t mean we won’t see shocks akin to the spate of bank failures witnessed this past spring. But just as they self-corrected quickly without much overall economic impact, I would expect the same in 2024. That excludes China, which faces some real and serious structural imbalances.
The question I want to pose is “How will the U.S. economy differ post any slowdown or recession from the U.S. economy of the past twenty years?” Let’s start with what has driven economic growth for decades. A few factors come to mind.
1. Technology – Over the past two decades, technology gave us smartphones and social media. As a result, we became more mobile and in communication 24/7. While texting replaced voice in many cases, we gravitated toward a world where information was contained in the palm of one’s hand, not locked into a fixture on a desktop.
2. Free money – Except for a brief period prior to the Great Recession, the real cost of money was zero or below zero for most of that period. That led to a surge in bad investments leading to excess capacity and low inflation.
3. Exuberant government spending. In 2000, the government deficit was $240 billion. Last year, it was $1.36 trillion. This year that just ended, it will push close to $2 trillion and will be significantly higher next year. As a reminder, over that span we had 12 years of Republican Presidents and 11 years of Democratic Presidents.
Thus, it is no surprise that the stars of the last two decades have been the technology names that sparked the revolutions in mobility, search and social media plus industries that were prime beneficiaries of government efforts to “share the wealth”. Health care would be an obvious example.
But Charlie Munger didn’t look backward. So, let’s look forward. How will the world be different a decade from now.
1. I wish I could say government will spend less exuberantly. It won’t until there is a crisis. With that said, look at China where governmental support has created an explosion in excess capital investment, specifically real estate related. Now big developers are collapsing. Only a government bailout will save them. The U.S. government is not going to bail out real estate investors. Our problems are nowhere near as severe as in China. But as I have noted, what will ultimately require change is entitlement spending. How and when that happens is an open-ended question. But the net result is obvious. Seniors will have to pay more out of their own pocket. Second, health care providers, from hospitals, to doctors, to drug companies, will have to receive less. We see that revolution clearly happening already. Nursing homes are closing. More medical care is treated as outpatient. Urgent care centers replace emergency rooms as primary care centers for many. Telemedicine is just emerging. It’s way too early to guess the real winners but there is little doubt in my mind that the combination of technology and a needed move away from high-cost providers (e.g. in-hospital stays) to the lowest cost avenue of care will only accelerate.
2. Artificial Intelligence – This isn’t brand new although ChatGPT is. AI has been evolving for decades. To work, it requires massive computing power. That means newer PCs with different processors and more memory. It means faster gravitation to the cloud. It will change virtually every step we take. It will change how we buy, and how customers are serviced. It will accelerate the development of new products and ideas.
3. Money won’t be free. Once the current economic pause is over, we are not about to reenter a world where money is free. That means holding cash won’t penalize us. It means stupid investments built on a pyramid of free capital will be less
4. Technology accelerates the rate of change. That can be both good and bad. Good means we can get to the end zone quicker. Bad means one can get hurt running into brick walls along the way. We are heading toward streaming and away from linear TV. That isn’t going to change. But what will change is the way we stream content. Newspapers have faded away. Over the next decade or so, they may disappear entirely. But those entities that deliver the news may still flourish. The New York Times makes vastly more money today providing content online than at your doorstep. In the streaming world, only Netflix makes money. Users are not going to pay $20 for a dozen different streaming services. Within just a few years, there will be massive consolidation of streaming platforms. The survivors will flourish. Many will die. Next look at EVs. Same thing. Tesla can make money although future profit margins may not be sustained at current levels. GM and Ford survive today making gas-powered SUVs and trucks. They are way behind when it comes to EVs. But Tesla won’t have the world to itself. Nor is it clear that EVs powered by lithium-ion batteries are the endgame.
5. Medical advances, particularly related to drug development are monumental. mRNA, and CAR-T technologies are revolutionizing the ways we look at diseases from cancer to ALS. mRNA suggests medical treatments in the future could be customized.
6. Education reform will accelerate, whether it be charter schools or universities. Higher education is under increasing attack relative to its economic value. For decades, the cost of higher education has risen faster than the rate of inflation. For many institutions the economic value of a diploma relative to the cost of attaining it, makes college an uneconomical choice. Sites like Coursera are a small step in the right direction but the model is still flawed. Over the next decade, accelerated by the growth of AI, higher education will likely change dramatically.
These are just examples, some random thoughts. Munger would strongly insist that one shouldn’t buy what one doesn’t understand. Warren Buffett first bought Apple# in 2016. The first iPhone was introduced in 2007. It took him almost a decade to understand its importance and the sustainability of the iPhone platform. Oh, by the way, he has made 5x his investment in Apple since. It would have been nice to buy Apple earlier, but to be a successful investor, it wasn’t necessary. What was necessary was to stick with Apple during 20%+ corrections understanding that Apple’s core investment value hadn’t changed.
So, be patient. When you go to the race track, you have to bet on the right horse. Sometimes, the payback is small. But betting on the wrong horse that comes in fourth is a wipeout. Radio Shack introduced the first laptop. AOL popularized email. Yahoo was the first leader in search. In every case, bigger stronger companies crushed the pioneers. One also has to remember that there is a big difference between a hot product and a great company. Great companies build successive great products.
Great companies also have deep benches. Look at the top tech companies, from Microsoft, to Nvidia, to Alphabet. None are run by founders. All are run by executives who come from within. That’s also true for McDonalds#, Procter & Gamble, and Charles Schwab#. Sometimes, a successor CEO proves unworthy. When that happens, the Board goes back to its bench and finds a better replacement. Very few of the biggest and best companies have to go outside to find a successor CEO. After Apple replaced Steve Jobs with John Sculley, it corrected its mistake by bringing back Steve Jobs!
The bottom line is look ahead. Always look ahead. Look at the big picture and focus on big opportunities. Managers need to prove they can perform in good times and bad. They have to pivot when required. Zuckerberg moved Facebook from the desktop to the smartphone. Nardella moved Microsoft# from Windows-based to the enterprise, from the server to the cloud. Most of all, it’s a lot easier to back a best-of-breed company than one with today’s hot product. It isn’t all about technology. For decades, McDonald’s has been delivering that hamburger and fries better than anyone else while constantly refining how it does it, always better and faster while offering maximum economic value. Happy hunting.
Today Giannis Antetokounmpo is 29. The hot streaming series this past summer was “Suits”. Sarah Rafferty turns 51 today.
James M. Meyer, CFA 610-260-2220