A High Contrast Environment
As long-term investors we aren’t in the business of trying to time the markets or make bold calls on the economy. However, we do consider the larger arc of economic and market cycles to inform our understanding of risk and reward as it relates to the businesses we own. By intent, we seek to avoid undue risk of loss for our clients. This is why risk management is deeply woven into the fabric of our investment process.
The overwhelming consensus today is that the US economy remains on firm ground with a soft landing increasingly in sight. Inflation is falling, unemployment remains low and, as recently as April, Federal Reserve Chairman Jay Powell said the economic picture “continues to be one of solid growth.” During the second quarter, US stock markets paralleled this optimism as they surged to new all-time highs. Looking below the surface, however, a growing number of concerns suggest investors shouldn’t be extrapolating current conditions into the future.
As consumption accounts for over two-thirds of US GDP, one need not look further than the consumer. Credit card delinquency rates continue to deteriorate while surveys of consumer confidence imply future conditions are expected to deteriorate relative to current conditions by the widest amount in over 30 years. On quarterly conference calls, retail businesses are saying customers are increasingly trading down to lower-priced goods and avoiding large discretionary purchases. For example, Pool Corp, the market leader in swimming pool and outdoor living products, recently announced it expects new pool construction to fall 15-20% in 2024 as consumers delay large purchases. Even simple daily indulgences are being curtailed. Starbucks coffee volumes declined sharply in the last quarter and dining out trends in the US have approached stall speed. This is against a backdrop where US housing affordability is the lowest it has been in over 20 years (see below). If consumers are worried about the cost of an extra latte or a plate of spaghetti at the Olive Garden, how willing and able are they to buy a new house?
Source: National Association of Realtors (NAR)
There is a narrative that continued wage growth, strong consumer balance sheets and low unemployment can sustain consumption. While unemployment remains low, it has been ticking up this year and is quickly deteriorating in economy-sensitive areas like trucking, small business, and construction, which typically precede broad unemployment trends. How will strained consumers’ pocketbooks be replenished? How likely is an immaculate re-acceleration in growth against this backdrop? An interest rate cutting cycle can provide temporary reprieve, but history shows the damage is generally done by the time central bank rate hikes are reversed.
Meanwhile, US stock market return and index weights have rarely been so concentrated. Nvidia alone drove ~1/3 of the S&P 500’s return year to date (YTD) and 44% in Q2. At one point in the quarter, its market capitalization swelled by over $1 trillion within 30 days.
Source: Compustat, CRSP, Kenneth R. French, Bloomberg, Goldman Sachs Global Investment Research
This is more than Berkshire Hathaway’s entire market cap, which took Warren Buffet nearly 60 years to build. Seven other mega cap stocks1 accounted for another ~40% of the S&P’s YTD return; and in Q2, seven high price-to-earnings (P/E) AI-related stocks (including Nvidia) drove the entire return of the S&P 500 while the remaining companies in the index cumulatively detracted 1%. Data going back to 1974 shows that a record low percentage of stocks are now beating the S&P 500. With the equal-weighted index up just 4.1% YTD, it is underperforming the S&P 500 by ~10%, the biggest gap in the first half of a year in data going back to 1990, according to Dow Jones Market Data.
Source: Dow Jones Market Data
The earnings growth of the mega cap businesses leading the market has been extraordinary. But investor crowding around such businesses perceived as having idiosyncratic growth is the type of activity that generally occurs in the late stages of a bull market. The bigger point perhaps is that most areas of the market were down in Q2 and aggregate earnings growth for the S&P 500 excluding the Magnificent 7 was negative. If the economy is strong, then why are many economically sensitive areas of the stock market floundering?
In isolation, economic concerns aren’t necessarily a problem if they are sufficiently discounted into stock prices. In many cases, undue pessimism over the economic outlook can often create opportunities for long-term oriented investors to buy businesses at depressed prices. Risk arises, however, when market prices fail to adequately reflect the probability that reality could diverge from optimistic expectations.
Expectations, Extremes and Experience
Today, valuations remain historically high, leaving little margin for error if the economic picture diverges from Jay Powell’s view of ‘solid growth.’ Current valuations in the US suggest a very muted return outlook based on historical analysis that compares normalized starting valuations to future 10-year returns (see below). In the short term, however, valuation has little explanatory effect on market gyrations as investor sentiment and liquidity are the primary factors that drive stocks up or down.
Cyclically Adjusted P/E (CAPE)2 VS Future 10-year Annual Price Returns
Source: Robert Shiller, Yale Department of Economics; data since 1945
Unfortunately, the average person is about as excited about stocks as they have ever been. The Covid lockdowns gilded a whole new generation of risk-seeking ‘investors’ who have become enamored with the stock market. Quarterly purchases of individual stocks by retail investors have surged from <$10 billion per quarter to ~$70 billion since 20203 and they aren’t just buying steady blue chips. Beyond the resurgence of meme stocks in the second quarter, inflows into risky triple-leveraged ETFs have surged in 2024, up >3x from recent lows in 2023 and by a factor of ~10x from pre-Covid levels. Trading in speculative penny stocks, which typically account for <1% of US trading volume, have averaged ~3% in 2024, at one point surging to ~7% in May. Meanwhile, longer-term data shows retail investors have never been so heavily exposed to stocks – even relative to the peak of the dotcom bubble when market valuations were similarly high.
Source: FRED
Contrast this behaviour with the recent words and actions of Warren Buffett. In addition to trimming his position in Apple and sitting on a record amount of cash, in Berkshire Hathaway’s annual letter to shareholders, Buffett described his opportunity set as having been ‘endlessly picked over by us and by others.’ For those listening closely, this is about as bearish as Buffett gets. What then, is the average day trading retail investor seeing that the Oracle of Omaha is not? In 1999, Buffett wrote an article in Fortune magazine discussing expectations for stocks at a time when retail investors were similarly exposed:
“Once a bull market gets under way, and once you reach the point where everybody has made money no matter what system he or she followed, a crowd is attracted into the game that is responding not to interest rates and profits but simply to the fact that it seems a mistake to be out of stocks. In effect, these people superimpose an I-can’t-miss-the-party factor on top of the fundamental factors that drive the market. Like Pavlov’s dog, these “investors” learn that when the bell rings – in this case, the one that opens the New York Stock Exchange at 9:30 a.m. – they get fed. Through this daily reinforcement, they become convinced that there is a God and that He wants them to get rich.”4
Comparing the trailing 15-year annualized return on the S&P 500 to history, times have been about as good as they get. Given the enthusiasm today, investors seem to be extrapolating the good times of recent years into the future despite the market multiple having risen to near-historical highs.
Source: Robert Shiller, Yale Department of Economics
Professional investors are just as enthusiastic. Overt optimism has seeped into expectations for future earnings growth as well. Over the last 30 and 60-year periods, nominal S&P 500 earnings have respectively risen at around 7.4% and 6.6% annually. Yet today, expectations for growth over the next 5 years have ballooned above 17%, similar to the exuberance of the Tech Bubble, which proved woefully incorrect. Just as high starting P/Es are associated with low future returns, so too are high expectations for earnings growth.
Source: I/B/E/S, JP Morgan, QV Investors
Source: I/B/E/S, JP Morgan, QV Investors
High multiples, high expectations, potentially growing economic pressures and cautious signalling from the most respected investor of the last 60 years all suggest that risk remains to the downside.
Pivot Points and Blow-offs
The history of stock markets has been littered with themes that often stretch over years or decades. The last 100 years can be divided into distinct multi-year bull and bear markets; eras of rising and falling market concentration and valuations; periods when US stocks out or underperform international markets; when high P/E stocks outperform low P/E stocks and when dividend-yielding stocks outperform those without dividends and vice versa. It’s curious, if not perhaps expected to observe so many of these so-called themes converging in extremes today following secular regime changes in inflation and interest rates amid a heightened probability of cyclical economic vulnerability.
Underlying many of these themes is a common thread linked to euphoria and fear that occasionally drives stock prices far above and below their intrinsic values.
Source: Ken French Data Library, July 1927 – March 2024. Annualized return of the lowest 20% of stocks by dividend yield minus the highest 20% of stocks by dividend yield. File #0177
It’s quite possible that the current AI-driven bull market will continue its upward trajectory, regardless of growing potential risks. In the short term, momentum often begets momentum. According to JP Morgan, ‘Over the past 50 years, whenever the S&P 500 has rallied at least 25% in a 100-day period (like it has recently), the index was, on average, another 15% higher a year later and positive overall 98% of the time.’ As the adage goes, however, “Bull markets don’t die of old age, they are killed.” Disappointments in high expectations for re-accelerating corporate growth may prove to be a pinprick too much, as could deteriorating employment trends, geopolitical shocks or even the presidential election. Both the Bank of Canada and the European Central Bank began to lower interest rates in Q2. The Federal Reserve will likely follow suit by year’s end. Stock markets tend to initially applaud initial rate cuts with higher prices in the near term. But the start of a rate cutting cycle typically arises in response to underlying deterioration in the real economy and, more often than not, accompanies the tail end of an economic cycle.
Sticking to Our Knitting
We’ve always believed that some humility and a process grounded in the margin of safety that owning good businesses at reasonable valuations provides is the right long-term approach. It certainly doesn’t ensure we participate in the extremities of market-dominating themes, but it does provide a framework to generate consistent risk-adjusted returns while avoiding the worst excesses which can also accompany such forces. Today, our strategies continue to look as attractive as they did in other periods when we also worried that equity markets could be leaning too far over their skis. We think this suggests satisfactory outcomes for clients in future years despite broader market concerns.
*Includes Canadian Small Cap, Canadian Large Cap, Global Equity and Global Small Cap for all dates where data is available; 1999 only includes Canadian Small Cap data
- Microsoft, Alphabet, Meta Platforms, Amazon, Broadcom, Apple, and Eli Lilly. ↩︎
- CAPE: The CAPE formula is a valuation ratio that averages inflation adjusted earnings over a 10-year period to smooth corporate profit fluctuations over business cycles. ↩︎
- Vanda Research ↩︎
- Mr. Buffett on the Stock Market, Fortune, 1999 ↩︎
