Full Bull?
In many ways, 2024 played like a dubbed recording of 2023. The U.S. economy remained resilient, outgrowing other major developed countries, and mega-cap tech stocks led the S&P 500 to dominate global markets yet again. The ‘Magnificent Seven’ stocks rose 48% while the other 493 stocks in the S&P 500 rose just 10%. The S&P 500’s 25% return (36.4% in CAD), marked a second consecutive year of +20% returns – a feat that has only occurred seven times in the last 70 years. Canadian stocks lagged their U.S. counterparts by 14.7% in CAD despite rising 21.7% and European stocks lagged the U.S. by over 20% – the most in 25 years, amidst deteriorating economic growth. U.S. ‘value’ stocks underperformed ‘growth’ stocks by another near-record 21%, and U.S. market concentration rose to the highest in modern history with among the fewest number of stocks outperforming the broader market since the tech bubble yet again.
Source: Ned Davis Research
Since the bear market low in 2022, the S&P 500 has now risen ~70%. By size and duration, this is typical compared to the average cyclical bull market which averages 81% with a median length of ~32 months in data going back to 1960. Few other traits of the current environment remain average, however. As noted in past commentaries, U.S. market concentration, investor sentiment and aggregate valuations have rarely been so uniformly high and U.S. economic growth has rarely remained so resilient against numerous indicators normally associated with recessionary conditions.
Source: WSJ, Conference Board via LSEG
Regarding the latter, in past periods where the U.S. yield curve was inverted and the unemployment rate had both bottomed and subsequently risen more than 0.5%, recession had historically been soon to follow. In contrast, the continuing persistence of robust GDP growth in 2024 against these conditions has cemented the belief for many investors that a soft landing has been achieved for the U.S. economy.
The potential explanations are many: excess bank reserves circumvented a contraction in credit which typically follows Fed hiking cycles; stable consumer balance sheets and the wealth effect of a rising stock market have allowed for sustained confidence in consumer spending; a massive capex cycle in cloud and artificial intelligence have helped to sustain growth. Perhaps the single most extenuating factor however is the U.S. government’s rampant deficit spending at 6.1% of GDP at a time of robust economic growth. Compared to the past seven periods when the economy was just slipping into recession, the current U.S. fiscal outlay dwarfs historical deficits and has been blunting the restrictive effects of monetary policy on economic growth.
*2024 Yield Curve Spread is Q4 2024 average
Source: QV Investors, FRED
The confluence of strong market returns and persistent economic growth in 2024 has been accepted on Wall Street as confirmation of a path to further economic strength and market gains. Consensus expects earnings growth to accelerate to ~14% in 2025 from ~9% growth in 2024 while 21 of 22 big investment banks and prominent strategists predict U.S. stocks will rise again in 2025, with a median return of 14% as most bearish strategists on Wall Street have been fired or renounced their beliefs. If the history of professional stock market predictions proves anything, it’s that while no one knows what the future will hold, it’s almost certainly not what consensus expects.
Source: Bloomberg, Isabelnet.com
There is a growing narrative that the U.S. is entering a manufacturing and productivity renaissance that will drive economic and corporate growth in coming years. The November election outcome has further buoyed these expectations with hopes of deregulation, lower taxes and the accelerated onshoring of manufacturing activity intended to stimulate growth.
Global asset manager Blackrock has gone one step further, asserting that mega forces like artificial intelligence (AI) are subsuming classic cyclical forces which have historically driven economic growth and stock markets. They argue that comparing rich valuations in this ‘new paradigm’ to those of the past is ‘comparing apples to oranges’. In other words, this time is different – among the four most dangerous words in investing.
AI, deregulation and the onshoring of manufacturing are very likely to drive productivity, efficiencies and innovation in coming years. It’s also true that the economy and the stock market have structurally changed in recent decades from one of high to low capital intensity, where the largest companies today operate winner-take-all platforms with extraordinary returns on capital deserving of higher valuations than titans of past decades.
Source: Goldman Sachs
But the U.S. economy has gone through periods of rapid innovation and productivity advancement in the past and still ultimately failed to elude the vicissitudes of the business cycle or the fundamental laws of valuation. So while investors should be open to the secular opportunities megatrends will offer and acknowledge that recent momentum could compel further gains in white hot areas leading market indices higher, history suggests investors shouldn’t cast aside caution for the promise of a brave new world at any price.
What then might future U.S. stock returns look like? Over the very long term, U.S. corporate earnings have grown between 6-7%. If we were to optimistically assume a period of increased U.S. growth and productivity causes earnings to expand at around double this level, or 12%, to 2030, just 5% annual price returns would be implied at 16x price to earnings (P/E), near the S&P 500’s long-term average. To generate a more reasonable 10% annual price return, the S&P 500 P/E multiple would have to stay at the current historically elevated level of 22x while earnings grew at double the long-term average over the next six years. These are big assumptions. In a scenario where the expected productivity boom fails to ignite a meaningful step up in mid-term earnings growth from the long-term average of ~7%, implied annual price returns are just 0% to 2% between 16x-18x earnings, an unattractive outcome for the risk of owning equities at historically high valuations today. Taken together, the exercise suggests that reasonable outcomes may be possible with above average growth and valuations, but underwhelming results are implied in most other scenarios.
Source: QV Investors
(Mis)Allocation of Capital?
In both business and investing, value is created by outlaying capital in the present to generate reasonable returns in the future. Doing so in a manner that generates high sustained returns at scale is incredibly difficult and often requires specialized insight, variant perception or relatively impregnable competitive advantages. Over time, unusually high levels of profitability are often competed away, as competitors are attracted to the initial success their innovative peers enjoyed. The competing away of excess profitability is particularly true in commodity markets following periods of high prices and profits due to temporary imbalances between demand and supply as commodity producers wrongly assume such high prices and profits are permanent and respond with a surge in capital expenditure to increase production – which ironically causes prices and profits to decline again as supply eventually catches back up to demand. The boom and subsequent bust in the energy sector during the 2005-2015 era is a textbook example.
Source: Capital IQ, QV Investors
The rise of technology ‘platform companies’ that have come to dominate global stock indices has been unusual in the history of capital markets in terms of the sustained scale at which they have been able to invest capital at very high incremental returns. Much of their success can be attributed to winner-take-all business models which achieve such significant economies of scale and such integration of their products into customers’ lives that their market positions become deeply entrenched. Another reason, however, is that mega-cap technology companies have largely expanded in mostly non-overlapping end markets (search, social media, retail, cloud), where they don’t have to compete too aggressively with each other.
Since the roll-out of ChatGPT in 2022 however, the promise of AI has catalyzed the equivalent of a nuclear arms race between these titans to control this nascent but enormous market opportunity. The scale at which they are investing in this race is unprecedented. In 2025, they will invest ~$234 billion in capex, a large portion of which will go towards funding the development of AI models.
Source: JP Morgan
Certain CEOs have openly acknowledged that they may be overinvesting, implying that returns on all the capital they are spending may be elusive.
“There’s a meaningful chance that a lot of the companies are overbuilding now and that you look back and you’re like, ‘Oh, we maybe all spent some number of billions of dollars more than we had to.’ But on the flip side, I actually think all the companies that are investing are making a rational decision because the downside of being behind is that you’re out of position for, like, the most important technology for the next 10 to 15 years.”
– Mark Zuckerberg
Such massive levels of capital expenditure could indeed be rationale to ensure that these businesses capture new long-term opportunities and endure over time amidst the certain disruption that AI will cause. But they are now competing more directly than they have before in a massive capital cycle with more uncertain returns on investment. Technology venture capital firm Sequoia Capital recently estimated that $600 billion in revenue is required to pay back the capital currently being spent on AI. Meanwhile, market leader ChatGPT’s estimated run-rate revenue was $3.4 billion in mid-2024. This ‘build it and they will come’ approach may ultimately be successful given the vast use cases AI will bring, but it entails significant risk if reality fails to meet sky-high expectations.
Equity investors have also been laying out capital at record levels with uncertain outcomes. Not necessarily just in terms of what they are willing to pay to own the largest companies at the nexus of this AI revolution, but in money losing start-ups, stocks at extreme price to sales ratios and meme-coins with billion-dollar market capitalizations. They are also taking on leverage through record short-term options trading and double-leveraged ETFs on individual holdings such as a 2x levered NVDIA ETF where assets in the fund have risen by 24x in 2024. Rarely has it been so easy to get rich (on paper) by swinging at the riskiest bets.
In the short term, high valuations alone provide no certainty that deeply negative returns will follow. Rather, they often just reflect the likelihood of sustained future earnings growth. But the current broad-based confluence of investor exuberance and risk-taking alongside high valuations creates ripe conditions for unexpected losses and unsatisfactory outcomes in coming years. As noted in prior commentaries, momentum can be a powerful force which keeps asset prices high over extended periods of time. Mega-cap tech company earnings are still rising quickly. If the S&P 500’s 14% earnings growth projections come to fruition in 2025, it may be yet another buoyant year for stocks. But an incoming U.S. administration intent on major changes may breed both uncertainty and disappointment for investors. Additionally, if economic growth begins to disappoint or cracks begin to emerge in the AI-related frenzy, the reality of high market multiples may ultimately counteract expected earnings growth. While Canadian and other developed stock markets are much cheaper, they are also more cyclical and more likely to be pressured if global economic growth shows signs of deterioration during the year.
Performance
Our bond strategy continued to generate returns above the rate of inflation in 2024 despite the Bank of Canada lowering its benchmark rate throughout the year. Our equity strategies mostly generated solid double-digit returns but failed to keep up with major benchmarks in the current momentum-fueled climate despite trailing three-year returns remaining relatively attractive. Given robust underlying fundamentals among our holdings and a balanced allocation of capital across business models and sectors, we believe our strategies remain positioned to compound at satisfactory levels in coming years with less commensurate valuation risk than the broader market.
Source: QV Investors
Note: Returns in CAD, gross of fees
