What a difference a week makes. Last week, sailing into the end of 2023, the Dow and other leading averages were on their longest weekly winning streak in years. But that streak is likely to end this week as investors turn from riding the tail end of a momentum wave that followed a Fed pivot, to a more sober outlook of what lies ahead. The bond market has also responded accordingly, with yields rising again despite all signs that inflation is on its way back toward 2%.
A few other factors are in the mix. Corporate stock buybacks have largely halted pending release of 2023 full year earnings. Hedge funds were also notably absent from trading late in 2023 having wrapped up a strong year. Tuesday started a new battle and many are acknowledging via their initial investments that what worked in 2023 may not work so well in 2024. Within a few months, we may be using the term Magnificent Seven less frequently. Rational investors know that stocks that rose by 50%+ the year before on earnings and revenue increases that were far below that pace, are unlikely to replicate the same performance the following year.
Let’s start with the reality facing us today, at least the consensus picture representing reality. Growth should slow. Whatever excess savings post-pandemic that still exists represents a more depleted pool of money than a year ago. Savings rates are down and credit card balances are up. Interest rates of 20%+ are a reminder that there is a cost to spending beyond one’s means whether gainfully employed or not.
We also know that the Fed is finished raising interest rates. It can never say that explicitly, but all the body language and facts to date say short-term interest rates a year from now will be lower than they are today. The Fed, however, doesn’t dominate the long-term rate arena like it does short-term rates. Longer term rates are influenced by the paces of growth and inflation. Both are abating. That has already been reflected as 10-year Treasury yields have fallen from 5% to 4%. Have the declines been fully reflected? That is open to debate.
So is the question of whether a soft landing or recession lies in front of us. The seeds for both are in place. The outcome is still a toss up. While that debate continues, the argument that earnings can rise faster than revenues in a world where growth slows, inflation recedes, and pricing power evaporates, is a puzzling one. We may hear more about this as companies begin to report earnings in another week or two.
Then there’s the hype. A year ago, ChatGPT reached the market and proved to be a game changer. Generative AI was going to take over the world just as PCs and the Internet did generations earlier. That will prove to be true. But the texture of the outcome is likely to be far different than originally perceived. For one, the number of corporate winners will be far less than investors originally assumed. When the PC revolution started, the biggest names were Radio Shack, IBM and Apple#. Radio Shack faded quickly and is long gone. IBM is still with us but sold its PC business long ago to Lenovo. As for Apple, it became a huge winner but not because of its PCs. In time, names like Dell and Compaq became big winners while others like Commodore, Atari, and Toshiba fell aside. The real winners of the PC revolution turned out to be Intel and Microsoft, not the PC manufacturers themselves. The hardware was quickly commoditized.
Similarly, in the 1990s, we all started using the Internet. Wall Street became enamored with names like Yahoo, AOL, My Space, and Amazon#. Amazon became a home run. The rest followed the PC makers to the graveyard. With AI, we know some early winners. Since AI requires lots of computing power, the makers of the fastest chips, notably Nvidia#, are doing very well. But Nvidia won’t have the AI chip market to itself forever and generative AI will morph in unseen ways over the next few years. Rarely are the early winners the long-term champions. The moral of the story is that much of the 2024 hype is misplaced. It’s misplaced because investors simply don’t have enough facts yet to make final conclusions. Look at EVs and streaming. We know that Tesla and Netflix are going to be major contenders for many years to come. But that’s about all we know. The dream that more than 50% of cars sold by 2025 will be electric is fantasy. Actually, aside from Tesla, American consumers don’t particularly like the EV offerings today. As for streaming, it’s a foggy mess. No one besides Netflix makes money. Streaming content itself keeps changing. Is it original movies, limited series, reruns of old TV shows and movies, short-term homemade movies, sports, or video games? My guess is that the mix of what we buy and how we buy it in five years will be materially different than what it is today.
Back to the market and economy for 2024. We are pretty convinced that 2024 is going to be a tepid economic year. While fiscal largesse fed inflation in 2022 and 2023, supply chain disruptions were probably the biggest reason for the spike in prices. As these disruptions were fixed, inflation fell back toward a more normal path. Beyond 2024, it won’t be the hottest topic of economic conversation. 2024 is also a big election year. But who becomes President is unlikely to be the dominant economic factor for the years that follow. The election won’t suddenly heal a bifurcated Congress. Biden, or whoever the Democrat might be will try to yank it left and Trump, or whoever the Republicans nominate may try to yank it right. But think back over the past decade and try to align legislative actions to stock market performance. One could point to the 2017 tax cuts as consequential as well as the excess spending of the Covid and post-Covid era. But that is about it. With deficits now approaching $2 trillion, more fiscal largesse is unlikely whoever wins. Tax law adjustments are always possible but, again, anything major has to be measured against looming large annual deficits. Thus, politics may dominate the front page, but it is unlikely to dominate the business section.
Thus, what markets are doing today are sober reassessments of what lies ahead. And what lies ahead is neither overly optimistic nor pessimistic. But clearly it is not euphoric, as one might have believed over the past 8-10 weeks. Within a slow growth economy, the winners will be companies most in control of their own destiny. That could lead one to head back to the tech winners of last year, except valuation is likely to get in the way. Some pause waiting for the fundamentals to catch up to the hype makes logical sense.
How about the safe stocks, those harbors of safety like consumer staples, and utilities? They may be OK for a while, but they aren’t cheap. Many sell for 20x times earnings or more. I don’t look for them to be leaders either, although they could outperform during certain periods should equity markets undergo a meaningful correction. It also would appear to be too early to pile into cyclicals unless one is convinced that a recession simply is off the table. The net is that I believe equity markets for the next several months are in for a bumpy ride as hype and euphoria surrounding a Fed pivot fade, replaced by a sober reality that profit growth, at least early in 2024, will be difficult. Trying to forecast long-term interest rates may be beyond my pay grade, other than to say that growth of 1-3% and inflation receding toward 2% are consistent with where rates are today. They ended 2023 where they started. I see no logical reason why they should be far different at the end of 2024 than they are today.
Jeremy Siegle notes that stocks over the long run return about 6% plus the rate of inflation. Nothing in the economic winds suggest that is going to change. But we also know that 2023 was an above average year and valuations today are stretched by any historic measure. So, some giveback should be a reasonable expectation. With that said, don’t lose sight of the big picture. 8% annual returns mean doubling one’s money in less than a decade, quadrupling it in less that two. Certainly, one would like to step aside during times of financial crisis. But that is easier said than done. Each January, markets remind us that simply riding what worked last year isn’t going to repeat very often. The overall landscape may not change all that much. But where there was a Sears, now there’s a Wal-Mart. The Plymouth dealer is now a Tesla store. The Apple store attracts those who used to frequent Radio Shack. Corporations don’t live forever. Portfolios need adjustment. We aren’t perfect investors. Taking some profits in January allows 11+ months to offset those gains with mistakes we will all make over the months ahead. Being proactive in January is likely to reap some benefits next December.
Today, Bradley Cooper is 49. Diane Keaton turns 78. Robert Duvall reaches 93.
James M. Meyer, CFA 610-260-2220