Good morning and Happy New Year to all.
Markets were mixed yesterday although the Magnificent Seven of 2023 didn’t have a magnificent day. Market analysts can debate whether the outlook for these companies or artificial intelligence changed over the weekend, but probably the simplest explanation is profit taking. Investors with enormous gains, averaging well over 50% last year in these names alone, took profits.
What is important for the overall market is if these stocks aren’t going to be the leaders in 2024 that they were in 2023, where is this year’s leadership going to come from? Many would like to think that after a few days of profit taking, these behemoths will retake the leadership role again. After all, AI is going to be a huge opportunity for many years. But while these names had huge years in the stock market in 2023, their bottom lines weren’t growing nearly as fast as the stock price movements indicated. In fact, away from the semiconductor group, most of the other companies last year saw deceleration in revenue growth rates. Apple#, the biggest of them all, actually saw a decline in revenues. One leading brokerage took the opportunity yesterday to downgrade the stock to a sell based on a perceived lackluster reception to the latest iteration of the iPhone.
These are trillion-dollar enterprises. Trillion-dollar enterprises don’t grow by 50% annually. The law of large numbers makes that impossible. Equity valuations are built on assumptions of long-term sustainable growth rates. In 2022, these same names took a hit because they were spending at unsustainable rates, throwing money at moon shots that might help accelerate long-term growth. Wall Street didn’t like the idea. The poster child for this was Meta Platforms#, formerly Facebook, which wanted to bet the moon that the metaverse, whatever that was to be, would become something magnificent quickly. Gamers might wear goggles and play with avatars in their imaginary worlds, but for the rest of us, there are easier and more practical ways to navigate the solutions to the world’s problems. When Wall Street crushed Meta Platform’s stock after a quarterly conference call where CEO Mark Zuckerberg proclaimed he was all in on metaverse spending, he did what any good CEO would do. He listened. He reversed course. He didn’t stop spending on the metaverse but he dramatically cut spending realigning it with decelerating revenue growth. The net result was that in 2023, his stock was the performance leader.
But now it is 2024. All these companies have now shown some degree of spending discipline. They got rewarded for it last year. One old saw on Wall Street is that markets don’t discount the same thing twice. 2023, in the bottom line, was all about margin expansion. But if one is going to grow at high sustainable rates long term, it isn’t going to happen because of cuts in spending.
None of this suggests these seven names and their companions won’t deliver superior growth in the future. None of this suggests that growth won’t ultimately be rewarded. But today, as 2024 begins, the valuations of their stocks build in loftier expectations than a year ago. Yes, AI will help sustain or even accelerate growth. But we all know this. And if we all know this, then it is largely already built into stock prices.
Wall Street, historically is a sucker for hype. You name it. Casino stocks, bitcoin, PCs, flat screen TVs, electric cars, and now AI. Can the hype exceed reality? It can, but almost always it doesn’t. Yesterday, I read a piece by a leading brokerage suggesting bitcoin would be $150,000 by the end of next year. Hey, why not. The piece made no case for growth in bitcoin as a currency or for some other use other than speculation. I can’t argue for or against a $150,000 target. If bitcoin fundamentally is a speculative instrument, who am I to say speculative fever two years from now won’t be higher than it is today. Or lower, for that matter. My point is that Wall Street buys the hype and that works until the bubble bursts. AI is not a bubble like bitcoin, at least not in my mind. But let’s get sober. We all own PCs, smartphones and flat screen TVs. The size of all those markets reached or matched expectations. Ultimately, we will all own EVs or some other car that runs on something other than fossil fuels. With that said, the reality is that whether the car is powered by fuel or a battery, it’s still a car. Lots of companies will make them. It will be a competitive market. Profit margins ultimately won’t be different than they are today. EVs aren’t a new market; they are a replacement market just as flat screen TVs replace cathode ray tube TVs.
Which brings me back to the overall market. As noted in recent letters, we face an overall environment where revenue growth will slow. It will slow because real growth is going to slow along will declining inflation. While AI offers long-term productivity opportunities, don’t look for that to kick in meaningfully in 2024. Lower top line growth will pressure margins. Lower inflation means a loss of pricing power, almost by definition. Look for slow employment growth if not actual declines as businesses realign top and bottom lines. Just revisit the Meta Platforms story at the top of this letter. I still don’t know if there will be a soft landing or a recession. Right now, it doesn’t matter. What does matter is that stocks are near all-time highs amid much more optimism that existed a year ago.
Over the New Year’s weekend, the media was filled with articles asking the question, “what did we all miss about 2023?” A year ago, the mood was dour. The Fed was still raising rates and the consensus expected a recession that hasn’t happened yet. Today, the mood is much more optimistic. Recession seems less likely. The Fed is likely to cut rates this year. Is there too much optimism priced in or not? No one knows for sure. But with prices high, the risk/reward changes. January is a good barometer for the rest of the year. Yesterday gave us a few hints. We will learn more over the coming days and weeks as we head into and through earnings season. It’s funny how a calendar change can alter perspective. For hedge funds, the new year starts with a clean slate. Long-term is next December 31. The real question, therefore, is how will everything come together a year from now versus today? A year from now, I suspect, inflation will be lower, the Fed will be trying to normalize the Fed Funds rate at a level less than where it sits today, and the country will have elected a new President and Congress. The AI dream will be more fully developed. World hot spots will change in ways probably none of us can imagine. But I can offer the following- stocks are expensive today by any historic measure. The Fed Funds rate will be lower, by how much depends on whether there is or isn’t a recession. Without predicting who becomes our next President, the odds favor the Republicans retaking the Senate with the House remaining a dog fight. Wars will still dominate the news for many months but hopefully the Middle East won’t escalate much farther. Finally, corporate managements once again will prove their agility in navigating most of the hurdles placed in front of them. Markets don’t often piece two 20%+ years back-to-back. If normality returns and the economic outlook for 2025 seems favorable a year from now, investors should be happy if they achieve a normalized gain in the high single digit range with most of the gains happening in the back half of the year. If a recession occurs, still a real possibility, the outcome may be less robust. While short-term rates are almost certain to decline, a year from now, I would expect long-term rates to be near where they are today. A good center point is the sum of expected GDP growth plus inflation, or something close to 4% give or take 50 basis points.
Today, Eli Manning turns 43. The Giants could use him. John Paul Jones of Led Zepplin fame is 78. Congratulations also to Ezra and Ezekial Humphrey. Twin brothers, Ezra was born in a Voorhees NJ hospital at 11:48 on New Year’s Eve. Ezekial took a bit longer to emerge, arriving just after midnight on New Year’s Day. Twin boys born on different days in different years. You won’t see that very often! Both are doing great.
James M. Meyer, CFA 610-260-2220