Stocks edged higher yesterday reversing several days of losses. In particular, tech stocks, which had been the big losers earlier in the week, reversed course and rallied. Bonds remained within a tight range. Overnight futures suggest the recovery may not last.
The S&P 500 is up about 14% year-to-date, a gain that if annualized would be close to 30%, not dissimilar to gains recorded in 2003 and 2009, years that followed major bear market collapses. But there the similarity ends. 2022 was a bear market but nowhere near the severity of the ones associated with the bursting of the Internet bubble or the Great Recession. The economy actually grew in 2022 and is still growing in 2023 despite increases in the Fed Funds rate that has lifted short term rates from near zero to about 5%. While the S&P has risen 14%, the NASDAQ Composite is up 30% and the top 7 stocks within the S&P are up close to 90%. The Dow Jones Industrial Average, in contrast, is barely up 2%. Thus, upon closer examination, this has been a very narrow bull market pulling many of the leading averages along for the ride. The 7 stocks at the top of the S&P 500 aren’t the only winners, but the vast majority of stocks have not followed suit.
What exactly is going on? First, the economy is slowing, but in a rather uneven fashion. Consumer spending remains OK, but it is focused on experiences and necessities, not discretionary goods. To get there, Americans are using savings accumulated during the pandemic, savings that exploded thanks to government handouts at a time when money couldn’t be spent. It’s hard to know when those savings will be used up, but clearly the savings rate is now well below multi-decade averages while credit card debt is rising.
Employment keeps growing, confounding experts. Most of that growth, however, is coming from lower paying jobs in sectors that remain hot like restaurants and hotels. Non-cyclical sectors, like education and health care, also continue to add jobs while more cyclical areas like manufacturing are starting to show declines. Sales-to-inventory ratios are climbing suggesting an unwanted buildup of inventories may be near. Continuing unemployment claims are also rising, almost always a precursor to recession. Finally, money supply, the fuel for any economy, is shrinking at the fastest pace since the early 1930s. That may not matter if existing money circulates faster. But stress on the banking system is starting to make it harder to get loans, hardly what one wants to see if the goal is greater monetary velocity.
Finally, back to the big seven names at the top of the S&P 500. Earlier this year a consistent theme was maturity. The laws of large numbers seemed to be catching up to most of them. Smartphone sales were flattening. Growth rates for cloud services were declining. Digital advertising growth slowed. Lesser names within the social networking universe were losing traction. Search ads were getting cheaper. Inventories of computer chips swelled and memory prices collapsed.
Then along came something named ChatGPT, a new generative form of Artificial Intelligence that took the world by storm. As always, the hype was overdone and visions of a whole new world are a bit exaggerated. But with that said, generative AI is transformative, perhaps just as transformative as the microprocessor, the personal computer or the smartphone. It will reignite growth potential at the big 7 as well as many other companies. But there are lessons here, lessons that may be overlooked amid the early hype.
1. Generative AI may be transformative, but it won’t happen overnight.
2. While some beneficiaries are obvious, early pioneers are usually not the long-term winners. Where is Radio Shack today? Or Yahoo? Or Nokia and Blackberry? Many of tomorrow’s winners haven’t even been born yet!
3. Fundamentally, economic growth is a product of demographics and productivity. One can argue that technological advances could move the productivity needle positively, but demographic growth is in permanent decline worldwide.
The reality is that the world faces slowing growth. Technology will help some companies and some sectors, but it won’t make China’s growth accelerate. That growth rate is in permanent decline. Some want to suggest that India and Saudi Arabia are the next Chinas. But China’s GDP today is almost 5 times the GDPs of India and Saudi Arabia combined.
The bond market seems to be more in tune to these realities than the leading equity averages. Inverted yield curves and the threat of even higher short-term rates suggest tougher economic times ahead. But slower growth or even a modest recession isn’t a catastrophe. Earnings forecasts this year are close to flat, an improvement over forecasts just a few months ago. If I look at the Dow or an equal-weighted version of the S&P 500, gains year-to-date of 2-4% are more in synch with economic reality. Buried within those gains are some mini-bear markets in sectors like regional banks, energy, utilities and REITs.
Thus, maybe markets are more rational that they appear on the surface, distorted by the AI hype. It is way too soon to separate that hype from reality. But almost certainly today’s promise and tomorrow’s reality will prove quite different. A lot of money was spent in the 1990s chasing the dreams created by the emergence of the Internet. But of the early dreamers, only Amazon emerged as a long-term winner. Today, clearly Nvidia# makes the fastest chips and names like Microsoft# and Amazon# dominate cloud services. 30 years ago, Intel’s perch atop the semiconductor group seemed unassailable. In a fast-changing world, domination is transitory. Just look at electric cars. Tesla is no longer #1 in China. Companies from Ford to Lucid are chasing the same dream. Can Tesla stay #1 worldwide and retain today’s level of profitability? It’s an unanswerable question right now. Is Elon Musk today’s Henry Ford or today’s Michael Dell? Time will tell.
As for the overall market, growing signs of a slower economy and lower inflation will be key drivers in months ahead. Clearly the top 7 stocks in the S&P 500 aren’t going to increase in price at the same pace as in recent months. It’s hard to see a market surging without profit growth. As the AI hype settles down a bit, expect more choppiness ahead.
Today, actress Frances McDormand is 66. Justice Clarence Thomas is 75.
James M. Meyer,
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