Stocks continued to tumble despite news that third quarter GDP grew by almost 5%. Interest rate increases, which have been the primary culprit pushing equity prices lower, reversed. Investors were simply in a sour mood. Microsoft#, which issued a superb earnings report Tuesday evening and popped Wednesday in reaction, gave back all its gains yesterday and then some. Technicians have been saying for days that the market is sharply oversold. Yesterday made it even more oversold. But oversold conditions don’t have a prescribed endpoint. When fears rise it requires real bargains to appear for trends to reverse.
That could be happening, at least in spots. I know the focus this week is on big tech earnings and the stocks’ reactions. But one has to view this week within the context of the whole year. So, let’s step back for a moment and look at 2023 as a whole. If you look through the lens of the S&P 500 or the NASDAQ, the year got off to a roaring start for two reasons. One was the sudden emergence of generative artificial intelligence (AI) as ChatGPT exploded on the scene. Artificial intelligence, where computers get smarter as chips get more powerful, has been around for a long time. OpenAI, the company that brought us ChatGPT, was born almost a decade ago. But with all technologies, the key is finding that point where the new becomes more economically useful than the old. You probably had no reason to buy a digital camera when the first ones appeared at Best Buy. But once the pictures were better and cheaper than those coming from traditional film cameras, they dominated quickly only to be usurped over time by your smartphone. Thus, the emergence of generative AI is real. OK, it might still write fractured book reports, but it is fast emerging as a dynamic productivity tool in addition to promoting better user interfaces. To work well, AI requires the ability to scrape over mounds of data quickly. Thus, not only was it a boon for software developers, it was a boon for semiconductor manufacturers, cloud service providers and a host of other companies. While the hype may have been overblown, it was largely real.
Generative AI caught Wall Street’s fancy, but it wasn’t the only early 2023 story. We all underestimated the staying power of the consumer as the Fed kept increasing short term interest rates. By some estimates, the stockpile of savings created by overly aggressive fiscal policy during the pandemic provided the energy for sustained elevated consumer spending. As yesterday’s GDP report showed, that energy hasn’t dissipated yet. The picture of 2023 was complicated by economic waves still rippling from the pandemic. Early beneficiaries, like vaccine manufacturers, vendors allowed to stay open during quarantine, and companies that stocked home offices with PCs and the like, all saw ensuing vacuums of demand that lasted well into this year. On the flip side, companies that suffered from broken supply chains got an extra boost of energy as those chains were repaired. All this overlayed the ongoing strength in consumer demand.
There were two more related overlays to 2023. First was the slow retreat of inflation. That pushed interest rates higher and will likely keep them elevated into 2024. Compared to 2020-2021, rates spiked. Compared to the last 50 years, rates returned to normal. The accompanying overlay was the impact on price-earnings ratios. Earnings themselves have remained fairly flat over the past two years buoyed by better sales and retarded by pressure on profit margins. But the P/Es, the valuation factor applied to earnings, has fallen as interest rates rose. At the peak in 2021, the P/E was over 22. Today it is closer to 17. That’s still not cheap. But not everything sells at a market P/E. There are still many stocks selling at 30x earnings or more and there are many selling at 10x earnings or less.
There are obvious reasons why Microsoft sells at a higher multiple than Cisco# and why Tesla sells at a much higher multiple that General Motors. But the spread in valuations between the high growth stocks and the value stocks has rarely been greater than today. Growth stocks thrive when interest rates are low, when capital, adjusted for inflation, is virtually free. But that is changing. While the pain in the stock market has been rather universal over the past two weeks, the high growth names have suffered the most. It wasn’t because of bad earnings. With few exceptions the growth names have delivered. Some of those that disappointed actually had pretty good results; it’s just that expectations got too far ahead. Alphabet#, for instance, was selling near its all-time high Tuesday just before it reported on the expectation that it would continue to gain market share in the cloud. While its cloud business still grew, when it grew less than expected, even as advertising revenues rebounded strongly, the stock got hit hard. It wasn’t that Alphabet had a bad quarter; it just was a perfect example of what happens when expectations simply get too high.
While the tech names and strong consumer spending pulled the markets higher in the first half of the year, the stocks of most other companies lagged. With the correction of the past three months, most equal weighted averages are now down close to 5% for the year. The NASDAQ itself is now in correction territory, having fallen more than 10% from its July peak although still up solidly for the year-to-date. The bottom line is that, in the end, higher rates, and fears they might go higher, combined with an expectation that the growth in Q3 can’t be repeated has increased investor caution.
We need to separate this from an environment like 2008 when lending exuberance was foreshadowing a financial crisis. Today, banks are in fine shape. Yes, there are some concerns around the edges but what we face today is nothing like 2008. There still might be a recession in front of us. But if that happens, it will be one manufactured by the Fed to slow inflation. The pace of Fed Funds rate increases has slowed dramatically. It may have even stopped. Large deficits need to be funded and that could cause rates to stay elevated a bit. But talk of 10-year Treasury yields going to 6% or higher isn’t likely to happen. Why? Because at some point, the real returns offered by elevated rates will be so tempting that demand will rise and rates will come down. Nothing cures supply/demand imbalance more than price. Long-term inflation expectations remain well anchored in the 2.0-2.5% range, totally consistent with history. Term premiums are rising as volatility increases risk. But there is no history to suggest term premiums can sustain above 2%. It hasn’t been above 2% since 1995. If it were to get there, it would almost certainly lead to recession and demand to borrow would dry up.
That brings me back to today. Valuations have retreated back toward normal. They are still a smidge high and nothing can stop P/Es from falling well below average for a brief period. Growth continues. About 1.9 percentage points of Q3 GDP growth was from inventory building. That is unlikely to be repeated. Student loan repayments didn’t begin again until Q4. Credit card balances now carry an interest of over 20%. Small businesses are borrowing at 10%+. Growth will slow. As for interest rates, the Fed Funds rate will stay under 5.75%. It is now 5.25-5.50%. An extra quarter point, one way or the other, won’t matter much. The 10-year yield jumping to 5% from 3.7% in July has spooked investors. But almost any logic would suggest the damage is mostly done.
Could it go to 5.5% if the economy stays stronger for longer? Of course. But look at what is happening to the yield curve that has been inverted for so long. The spread between the 2-year and the 10-year yield is now less than 20 basis points. From 5 years out, the curve is no longer inverted. This reversion of the curve to a normal shape where yields rise as duration increases almost always happens when the economy is at the cusp of slowing materially. The bond market is saying emphatically, that Q3 was the peak growth rate. When it falls toward zero or through zero is still an open question. It is unlikely to turn negative as long as the economy adds over 150,000 jobs each month.
These are nuances. The key today is that the catalysts for the correction we are in, namely inflated valuations and rapidly rising long-term interest rates, have normalized where we should be. In some cases, the correction has overshot. In some cases, more correction is needed. But, at least in my opinion, we are back in the neutral zone. What does that mean? Jeremy Siegel’s research going back many decades shows rather definitively that stocks return close to 6% plus the rate of inflation in the long run. If we are back in the neutral zone, then purchases today should generate those kinds of returns over the long run. That doesn’t tell me what tomorrow brings. Short-term, I would wait for two good days in a row to have firmer conviction. In the short run, emotion always trumps rationality. So, stocks could decline further. If they do, they just get cheaper. Don’t guess the bottom. But get your shopping lists ready and start nibbling if this correction goes much further.
Today, Marla Maples is 60. John Cleese turns 84.
James M. Meyer, CFA 610-260-2220