Stocks continued their upward trek. They have now risen for 14 of the last 15 weeks with the S&P 500 crossing the 5000 mark for the first time on Friday. It’s been quite a run with the S&P 500 rising close to 15% over that span.
It all started with two related events. The Federal Reserve pivoted away from a focus on raising rates to contain inflation, to one that will wait and evaluate when it might become prudent to start lowering rates as inflation and economic growth continue to decline. At roughly the same time, Treasury adjusted its forward funding schedule to skew new offerings toward short duration bills and notes. By the end of October, it appeared to many that Federal spending was out of control. Deficits in excess of $1.5 trillion were rising. Huge needs were spiking bond yields to as high as 5% for 10-year Treasuries.
Once the Fed and Treasury almost simultaneously released the pressure valves pressing bond prices higher, there was an enormous bond rally that spilled over to stocks. Quickly, the 10-year Treasury bond yield fell from 5% to under 4%. The sudden decline took place inside of two months.
But falling rates weren’t the only catalyst driving stock prices higher. Despite Federal Reserve efforts to slow economic activity via higher interest rates, U.S. GDP rose by over 4% in the third quarter of 2023 and another 3% in the fourth quarter, far higher than previous predictions. In addition, productivity spiked. That will always happen when growth exceeds expectations as one can’t add workers fast enough to keep up with rising sales. But there were other factors improving productivity. As labor markets tightened, workers were able to trade up into more productive jobs. In addition, supply chains continued to heal, eliminating disruptions that had caused previous productivity declines. Strong growth also brought with it increased demand for workers. While labor markets aren’t quite as tight today as they were a year ago, demand for labor continues to grow.
Everything wasn’t positive. The prolonged impact of the post-pandemic inflation spike pinched some, particularly those with marginal incomes. Inflation can go to zero but that won’t erase the cumulative increases in prices over the last three years. While the Fed has stopped raising interest rates, it continues to work to reduce money supply. That shows up as stresses within the banking system. The commercial loan problems that have caused a decline of over 50% in the value of New York Community Bank in less than a week, is a reminder that the banking system isn’t quite as liquid as some want to believe. Is the NYCB drama the canary in the coal mine or a truly one-off situation? We don’t know yet. But there is a lot of distressed real estate in the form of offices, strip malls, and apartment projects that have to be worked out over the next few years. While there are few signs of a pending explosion in bank failures, the stresses we have seen over the past year will likely cause banks to be more cautious lenders than they have been in the past.
This all brings us to today. Was the 15% rally in the S&P 500 simply an adjustment to a quickly changing economic backdrop? Was it too much too soon? Did fear of missing out drive prices beyond fair value? The answers to each of these questions is most likely a qualified yes. The S&P 500 is a market cap weighted index. While the S&P 500 has risen almost 6% since the start of 2024, an equal-weighted version of the same 500 companies is up only 1%. Just as in 2023, the uptrend was heavily skewed by the surge in demand for artificial intelligence solutions. The rally at the end of 2023 was propelled by the sharp drop in interest rates. However, for the past 8 weeks, the 10-year Treasury yield has stayed within a range of 3.8-4.2%. It has been a non-factor in determining the path for stock prices.
What has been pushing stocks higher is an improving outlook. Although one can’t rule out a recession, particularly if the Fed keeps rates high for too long while continuing to reduce its balance sheet at a rate approaching $1 trillion annualized, it’s hard to discuss the possibility of an imminent recession when GDP is growing by 3%. What might be the catalyst to force a sudden change in behavior? To be sure, looking at such indicators as savings rates, credit card balances and default rates, it’s hard to make a case that consumers are going to continue to spend blindly on experiences. But moderation doesn’t mean decline; it just means more moderate growth.
Thus, looking forward there are two separate questions. One relates to the Magnificent 6 and related companies where AI development is a significant factor, while the other relates to those other 494 components of the S&P 500. For the big 6 the key is to separate the hype from reality. Just a few years ago, it was widely predicted that 50% of U.S. car sales in 2025 would be electric vehicles and soon thereafter, autonomous vehicles would be on the road. Clearly, that isn’t going to happen, at least on the timetable laid out in 2020. That’s what happens with new disruptive technology. It gets to the finish line, but almost always takes more time than the early hype suggests. But with that said, companies like Nvidia# can’t meet current demand, even with government restrictions on what it can sell to China. The big cloud providers are spending many billions of dollars to expand capacity to support near-term AI needs. Thus, while we won’t live in a world dominated by smart machines tomorrow, directionally, we are moving there as fast as we can. For some, when demand exceeds supply, prices and margins take off. For others, it means much higher capex needed to reach the finish line. And for most, it has only marginal impact. Nvidia reports earnings next week. Expectations are supercharged. As noted, the company can’t meet current demand. That’s not a bad place to be. Will it have more competition in the future? Highly likely. Will prices and margins come down over time? Also likely. But Nvidia will pivot as well, developing newer chips plus related software to protect its leadership franchise. I don’t know when companies like Nvidia, or Microsoft# will stop being stock market leaders. Ultimately, price and valuation matter. But as long as these and related companies continue to grow at rates 3-10 times the average company, it’s hard to make a strong negative case against these stocks. With that said, note the experience of Intel and Cisco#. They were the darlings of the ‘80s and ‘90s. Once the Internet bubble burst, they never recovered their prior valuations, not that they stopped growing, but because they stopped growing much faster than everyone else.
That brings me to the other 494. It’s hard to imagine GDP sustaining growth in excess of 3% with money supply declining and the cost of money staying well above the rate of inflation. With that said, outlooks vary sector by sector. Some companies hurt in 2023 by post-Covid drops in demand (e.g., makers of vaccines and test kits) will see stabilization and renewed growth before the end of 2025. Bank fortunes will depend a lot on future Fed actions and the shape of the yield curve. Can airlines see the same robust demand of 2023 carry over into 2024? The behavior of the 494 in the first six weeks of 2024 suggests a bumpy uneven ride with a slight upward bias predicated on improving economic conditions as the year progresses. There will be some tailwinds. Infrastructure spending should improve as funding for projects supported by the infrastructure bill passed a few years ago finally gets released. Defense companies will be busy rebuilding supplies depleted by multiple wars. Demand for AI and EVs will create accelerated demand for electricity. That will help both utilities and industrials that support those needs including upgrading our grid.
There are also multiple concerns that may not be impacting markets today but which may become front page news this year. Front and center, as we move towards the fall, will be the Presidential race. At this point, we can’t even be sure who the candidates will be. Biden faces age and heath questions while Trump faces legal challenges. From Wall Street’s perspective, the two offer different visions. The one thing they have in common is that both like to spend. Neither is afraid to borrow. Another concern that often reaches the front page is China. Economically, it isn’t such a great moment in time there. But the big question is whether China is going to increase pressure on Taiwan to unify in some manner. Climate change is another factor. One can argue over the causes and cures, but the reality is that the costs of fires, floods, hurricanes, droughts and tornadoes worldwide are rising substantially. Higher insurance costs will divert money from other discretionary spending. When this impacts Wall Street is random. But just remember what happened when a tsunami destroyed nuclear plants in Japan. Not only did the stock market dive for a few days and weeks, but that one event changed how countries around the world viewed the use of nuclear power.
The bottom line is that AI development is revolutionary. While the full impact isn’t priced into the stock market yet, one can clearly make the case at any moment that hype is ahead of reality. Markets aren’t one directional. It’s always two steps forward, one step back. Right now, I see no other revolution to match what’s happening in the AI arena. For the rest, it’s likely to be a slow slog forward, probably improving as the year progresses, assuming no recession. The big risk is that the Fed overstays with its tight money policy and QT, causing a crisis of undefined origin that spins the economy into decline and causes stocks to fall. Right now, that’s not a risk that’s front and center, rather it’s one that bears watching.
There will be a lot of economic reports this week including CPI, PPI, and retail sales. We don’t expect too much commotion about the news but can’t rule out the unexpected. By the end of next week, after retailers and Nvidia report, it will be quiet until the March FOMC meeting.
Today, Supreme Court Justice Brett Kavanaugh turns 59. And it is the birth date of Abraham Lincoln. Those old enough remember when that was a national holiday, before the births of Lincoln and Washington were consolidated into Presidents Day (next Monday).
James M. Meyer, CFA 610-260-2220