mattee2264

Also yet another thing that will frustrate the usual transmission of monetary policy. What is the use of bank lending contracting and bank lending standards tightening if PE firms rush in and pick up the slack? Already credit spreads are much lower than you would expect them to be.

I think Yellen is the one pulling the strings pushing her agenda. And having worked on the other side she knows that the Fed will have to accommodate irresponsible fiscal policy which is why you are already seeing an accelerated taper and talk about cutting rates. One thing is clear, the US government is well aware that the voters still perceive inflation to be a major problem but refuse to accept any culpability for causing the inflation when it is Economics 101 that expansionary fiscal policy when the economy is at full employment is inflationary. Will be interesting to see how this plays out.

Fed could easily cut rates if the US government stopped printing multi-trillion dollar annual fiscal deficits. That is the real problem. But unfortunately there isn't an easy solution. Lower rates might massage the inflation figures temporarily but it would also trigger a spending splurge as people try to maintain a lifestyle via credit card debt that they can no longer afford as everything is so much more expensive post-COVID.

Shiller-CASE house price index peaked at 184 in 2006 and got back to that level by 2017 and then went to 215 before COVID hit. Currently stands at 312. So no evidence of massive building resulting from ZIRP post-GFC. But plenty of evidence that zero interest rates by increasing affordability resulted in house price inflation that took house prices well above the 2006 bubble peak even before COVID and that was during a period in which there was very little inflation or wages growth and that is clear if you look at house price to average earnings ratios which have been increasing throughout the post-GFC era. Lower interest rates would cause even higher house prices and even more positive wealth effects which is the opposite of what the Fed is trying to achieve even if it might massage the inflation figures to make them look better. There are vested interests that want house prices to stay high and therefore the housing shortage is unlikely to go away and with inelastic supply demand is going to drive house prices and lower interest rates increase housing demand. That is economics 101. And there is a problem if we are in a world where the middle classes can no longer afford holidays, nice restaurants, nice housing and all the other things that used to be part of a middle class lifestyle. And if the middle classes are struggling to get by then the working classes are in an even worse position. But the people living off government handouts are doing just fine. The tax burden is also a lot higher as a result of fiscal drag. And all the asset price inflation is massively increasing wealth inequality and also intergenerational equality.

2022 was an inflation shock. Long duration assets such as tech stocks and long bonds got destroyed. But we avoided a 73-74 scenario because of the pace of the disinflation and the economy holding up a lot better than expected. Yes there were signs of inflation before 2022 but everyone including the Fed assumed it would be transitory and the Fed didn't react. It was when the Fed realized it wasn't transitory and reacted by starting a rate hiking cycle that markets headed south. I also do not think it is relevant to talk about 2022. It was a shock that resulted from too much stimulus (demand side) before the supply side had the chance to recover fully from COVID. I think now we are probably in a moderate inflation environment. Ignoring valuations for now stocks tend to do well in such environments because they can usually pass on moderate cost inflation to consumers and grow earnings at a robust rate. Some bears have valuation concerns believing that equities are still priced for a return to a low interest rate low inflation environment. But outside of Big Tech valuations are probably already there and higher interest rates aren't an issue if they are because economic growth is more robust over the next decade compared to the anaemic growth post-GFC/pre-COVID. And arguably if AI does deliver its promise the rest of the market is undervalued as it will mean higher productivity growth and higher margins. As for Big Tech even if interest rates and inflation remain around 4-5% if they can grow earnings at a double digit rate (and again AI might extend the growth runaway the same way Cloud did) then they also look very reasonably valued if not cheap. I think the main worry for equities is that AI turns out to be a mirage and the real-world benefits are relatively limited. In this case higher inflation higher interest rates higher tax rates and having to refinance cheap debt will be major headwinds for the average stock. And for tech stocks they will be doubly punished: first, for making unproductive investments and second, when growth slows down in their core businesses and AI revenues fail to pick up the slack.

I'm not really seeing the appeal of intermediate or long bonds right now unless you are anticipating some kind of deflationary bust. But in that scenario long duration stocks such as Big Tech and bond proxies probably do a lot better. In a "higher for longer" scenario real returns will approximate zero in bonds and if the yield curve un-inverts the way it should then you could end up with unrealised losses until your bond matures. Equities generally do pretty well in a moderate inflation environment especially as it usually goes together with healthy economic growth. They can increase prices and volumes and that makes for very healthy nominal earnings growth. Many people thought the end of ZIRP would lead to multiple compression. But it hasn't in a meaningful way. And if inflation accelerates and interest rates need to go higher....well just think what happened to TLT in 2022 falling 50%.

I think Google and Microsoft results have done a lot to soothe investor concerns. Even Meta results were good and it was only the guidance that spooked investors a bit. We all know that Big Tech are investing heavily in AI. And the payoffs from those investments are uncertain and could be far down the line. But so long as the core businesses continue to grow strongly and there are some signs of incremental earnings growth from AI offerings then investors will be patient and continue to load up on Big Tech stocks. And it is a virtuous cycle (that could turn vicious)-the capex of companies like Microsoft, Google, Meta is the operating cash flows of NVIDIA and other hardware companies. For now the operating cash flow growth of chip companies gets rewarded by markets who extrapolate it far into the future (with no consideration over the fact that eventually capex spend will moderate or will get in-sourced to some degree). And the heavy capex spend (and resulting deterioration in FCF) of Big Tech is ignored or even welcomed by the market because optimism over AI means the expected payoff is supposed to be both imminent and high and the core businesses are still growing fast. And with Big Tech representing 1/3 of the market the considerations above are going to dominate the macro even if below the surface for the average stock the combination of stagflation and higher for longer interest rates and geopolitical tensions is a major headwind. The Mag7 index has gone up about 150% since the nadir in autumn 2022. The rest of the S&P 500 and other global stock markets have only started to see a meaningful recovery over the last six months as a result of central banks teasing a pivot and the emergence of some grass shoots in Europe and general optimism over AI.

If a company has a conservative capital structure such as a debt/equity ratio of less than 50% then P/E and P/FCF should work just fine. As for the OP's original question I've always felt you should anchor on what is real i.e. reported earnings. These should then be normalized for one-offs, cyclical factors etc. And then you consider qualitative factors such as growth prospects, competitive position etc in deciding what an appropriate multiple should be. Or if you have confidence in predicting the next few years earnings you can go a few years out and then apply an appropriate multiple. But as others have suggested better to come up with your own forward estimates rather than rely on Wall Street estimates as Wall Street isn't interested in accurate valuation it is interested in selling stocks. and no one sells stocks by indicating they are overvalued and forward multiples are great at making the valuation of fast growing stocks look more reasonable. And they play the same game with the S&P 500. At the end of every bull market Wall Street are still proclaiming that valuations are reasonable and forward PE ratios around in line with the historical average.

You are comparing nominal and real variables. Except for monetary regimes of financial repression (e.g. post WW2 and post GFC) the 10 year nominal yield has always been well above the real GDP growth rate (historical average around 3-4%). However if the yield curve un-inverts in a meaningful way there might be some scope to reduce rates 50-100bps or so. Anyway none of this really matters for the market. Fed fund rates has been above 4% for the last year and a half and during that time period a Mag7 ETF has gone up 150%. And with those kind of returns no one is going to care what your risk-free rate is or what inflation is. And even if you do think we are higher for longer and inflation is going to be sticky at around 3% to 4% why would you invest in a long bond and get real returns of approximately zero?

It comes with the territory. Investors do not just want high returns they want high returns without the volatility. They also want to get rich quick so find it hard to tolerate the inevitable downdrafts and dry spells. It is why people are such suckers for Ponzi schemes. And it is why companies feel pressured to manage earnings and waste a lot of time providing "guidance", "whisper numbers" and employ expensive investor relation teams. If you are going to be a growth investor the real money is made identifying companies with good long pull growth prospects and then buying and holding them for decades. Over that time period there are going to be lean years and fat years and many false alarms that indicate the growth is coming to an end encouraging a rush to the exits. For a quality growth stock you are much better off erring on the side of overstaying your welcome the way that Buffett often gets accused of doing.

Inflation isn't going to get back to 2% until government spending is brought under control and there probably will need to be a recession to achieve meaningful further disinflation. Unfortunately the Fed seem to have no further appetite for rate hikes and the US government will continue to spend because there is no one to stop them doing so. I can understand the desire to avoid the pain of a recession. But the alternative of getting stuck with 4% inflation for the next decade is much worse for the average joe even if investors will probably do just fine (it is high inflation not moderate inflation that kills the stock market). But what is pretty interesting is that we only managed 1.6% real GDP growth in Q1 with a government deficit of over 1/2 a trillion for the quarter with the economy at full employment (if you believe the official figures). Resilient consumer spending seems to be what is keeping the US out of recession growing at 2.5% for the quarter. Question is how long that can continue with job losses starting to rise and the saving rate at new lows.

Fed have already said that a worsening unemployment situation could justify a cut even if inflation remains sticky. But it is hard to imagine unemployment rising significantly when the US government continues to run massive fiscal deficits at full employment. So I expect US GDP growth to remain strong and US inflation to remain sticky and with that being the case agree that it is difficult to imagine more than a few cuts this year and probably towards the end of the year rather than in the summer. Something that does concern me a little is whether there is a "boiling frog" scenario. So far high interest rates haven't been a massive issue because a lot of companies and consumers are still benefiting from low-cost debt raised during ZIRP. But refinancing cannot be delayed forever and there is a lot of leverage in the system as companies and consumers and governments took advantage of ZIRP to pile on debt.

Stagnation is the Japan scenario. It isn't going to happen to the USA which continues to have the most dynamic and innovative businesses. You need declining multiples AND earnings over a long period of time. So long as the medium to long term trend of USA corporate earnings is upwards (albeit with cyclicality) stagnation will be avoided. A sideways market is more benign and results from a combination of multiple compression and earnings failing to grow enough over the period of measurement to offset this. The Shiller CAPE is around 35. But for much of this century the CAPE has been in the 20-30 range. And since 2015 it has spent most of the time in the 25-35 range and that is even with two bear markets. So I think bears overestimate the potential for multiple compression. So multiple compression is a necessary but historically not a sufficient condition (unless you are comparing market levels at bull market peaks and bear market troughs). What you also usually need is for earnings to go on a long and interesting ride to nowhere over a long period of time. For that to happen you need major recessions that take years to recover from. And again the bear markets have been wrong in their prediction for a hard landing. Of course you do not need a major economic recession. 2000-2002 was a good example. The economic recession was mild. But the corporate profits recession was severe because it turned out that dot com earnings weren't sustainable because they reflected the peak of a boom and bust investment cycle and a fair degree of creative/fraudulent accounting which got cracked down on after all the scandals. But difficult to see that analogy playing out either. Difference this time is that the mature Big Tech companies (ignoring Nvidia/Tesla etc) have their earnings power backed by free cash flow and very strong moats. And even if AI doesn't provide much benefit to their earnings just from their core businesses they should do just fine. And if we avoid a major economic recession then the rest of the market should do just fine as well as their valuations are about average and their earnings will grow in line with nominal GDP growth over long periods.

Lower interest rates must also be a factor in higher margins. And we haven't really seen the full impact of reversion of interest rates to more normal (if still quite low) levels because most companies were smart enough to pile on low cost long term debt during the pandemic before the rate hiking cycle began. Financial engineering has also been a factor in stock returns exceeding earnings returns as companies were able to borrow cheaply to fund stock buybacks and a shrinking share count supports higher prices and provides a constant bid for the underlying shares. And something else that has been helping margins is that companies have been able to use inflation as an excuse to increase prices by 50% from pre-pandemic levels and even though their input costs have now come down and they've been able to make cost savings by cutting staff numbers and limiting wage increases to well below the rate of inflation these haven't been passed on to consumers. A reflection of how concentrated most markets are these days. And of course there are composition changes. You'd expect S&P margins to be higher when tech has gone from 10-15% to 30-35% of the index and in this cycle there has also been a shift in investor preferences away from low margin value stocks and cyclicals and towards high margin if low growth consumer defensives.

The main area in which competition authorities screwed up is by allowing a lot of acquisitions by Big Tech that essentially bought out potential or actual competition and greatly increased their market share. There has always been a soft touch to tech regulation on the basis that they don't want to discourage innovation and creative destruction will supposedly ensure that strong market positions are not permanent.

It is easy to see why Fed will cut rates at the first opportunity: -They want to get Biden re-elected -The government has huge amounts of debt to service and lower rates and a period of financial repression makes that a lot easier -There is a looming commercial real estate crisis as so many loans are underwater and they will want to avoid politically unpopular bailouts -Consumers are hooked on debt e.g. mortgages, credit cards and are suffering -Lots of companies will struggle to refinance cheap debt refinanced during the pandemic Disinflation stalling at around 3% is a minor inconvenience to them. And they can still claim that if they reduce by 75bps (the 3 cuts pencilled in) that policy is still restrictive and real interest rates are positive and they can explain away hot economic data by saying it is in the rear window and they see weaknesses in the economic outlook

Where a lot of these guys go wrong is they believe too much in mean reversion and the "lessons" of market/economic history which makes it difficult for them to accept that maybe this time it is different and they forget that economic laws are not like the laws of physics and are not immutable. These guys anchor on valuations being in the top 1% of the historical range with a CAPE of 35. But when over the long pull valuations trend upwards then it isn't as scary as it sounds. 100-150 years ago America was an emerging economy mostly engaged in the primary and secondary industries that were very competitive. So valuations were correspondingly low. These days America is a hyper advanced modern economy with globally dominant technology and service companies with fantastic market positions so it is not surprising valuations are a lot higher. Also the Fed's desire to maintain excess liquidity in the financial system and flood the system with liquidity at the first sign of trouble is very supportive to valuations because all that money usually ends up in stocks. Likewise financial repression seems inevitable given the size of the Federal debt which again supports higher valuations by keeping the cost of capital low and enabling financial engineering such as debt funded buybacks which create additional scarcity (reducing the sharecount) and give a constant bid to share prices. And ditto with all the pension contributions flowing into stocks as institutions increasingly favour higher equity allocations. Besides market valuations are distorted by Mag7 that constitute 30% of the index. Ex-Mag7, valuations look pretty reasonable if you believe that we are still in a low to moderate inflation and interest rate environment. And downright cheap if you think that AI can increase productivity for old economy companies. Mag7 stocks may be valued at PE ratios two to three times the median PE ratio. But their margins, returns, growth rates are way higher than the rest of the market. Of course they argue that their valuations, growth rates and returns and margins will eventually revert to the mean which will create large losses for investors. Hussman's latest missive is a well written description of this argument: "In the short run, there’s no question that strong demand for new, scarce products, such as AI chips, can enable a company to enjoy extremely high profit margins. Still, it’s dangerous for investors to treat these high profit margins as permanent, and to value stocks as if those profit margins will be sustained indefinitely. Put simply, the combination of a high growth rate and a high profit margin has never proved to be permanent. The current crop of “glamour stocks” increasingly relies on both here" But again there are some logical flaws. The profit margins and growth rates do not have to be permanent. You just need a long enough period of high earnings and earnings growth to justify the DCF valuation. And that is where Big Tech companies have excelled. They have achieved earning power and market caps that were previously unthinkable because as well as dominating their own large global markets they have disrupted multiple other markets and have navigated various technological changes to stay at the forefront and fend off competition. As a result they have managed to avoid the fate of most growth companies which see their growth slow down or even turn down as a result of encroaching competition, market saturation, maturity of their product and industry life cycles and mismanagement. Cloud and now AI have been godsends for them and if the pace of AI progress continues AI could be the gift that keeps giving as they will enjoy multiple product upgrade cycles and an adoption curve that gives an incredible growth runway so long as some start up doesn't come out of nowhere and steal their market share.

People conflate Mag7 with the market because Mag7 is 30% of the S&P 500 and the S&P 493 has basically gone nowhere over the last five years while Mag7 has increased about fivefold. And at this stage most investors are either indexing (or closet indexing) or buying call options on tech stocks. And it isn't difficult to understand why. John Authers in the article I referenced earlier discussed the concept of a "bubble" in fundamentals. Over the last 5 years or so Big Tech have grown earnings around 20% a year and their stock prices have increased by a similar amount. So not that bubbly from a valuation perspective and indeed valuations are far lower than those reached by Nifty Fifty and during the Dot Com bubble. Nvidia is a more extreme example but again a lot of its stock price increase is driven by earnings growth rather than multiple expansion. But the question is whether this earnings growth is sustainable going forward. Eventually the law of large numbers will catch up. And while AI is seen as extending the fast growth runway for Big Tech and delaying incipient maturity the reality is that aside from Nvidia no one has a moat in the AI space and eventually the hype will need to be supported by evidence of monetisation. And AI is bringing Big Tech companies into direct competition. And if AI does deliver productivity improvements and allow companies to reduce their headcounts then a lot of companies within the S&P 493 are going to get a double whammy from better earnings and a higher multiple.

https://www.bloomberg.com/opinion/articles/2024-03-12/nvda-vs-csco-a-bubble-by-any-other-metric-is-still-a-bubble?utm_source=website&utm_medium=share&utm_campaign=twitter Bit of a more balanced commentary from John Authers. Agree with the general point that a big question is whether the acceleration of earnings growth of Mag7 post-pandemic and in the case of Nvidia over the last year or so is sustainable and that probably matters a lot more than valuation which are rich but not to the same extent as Nifty Fifty or Dot Com levels.

Grantham bearish as usual on the US stock market but sees good opportunities in climate related investments https://www.gmo.com/europe/research-library/the-great-paradox-of-the-u.s.-market_viewpoints "Climate-related investments: With increasing climate damage and the increasing willingness of governments to take action, I believe climate investments will have top-line revenue growth that is guaranteed to be above average for the next many decades, although with no guarantees as to the smoothness of that growth. But, with all the cost of solar, wind, etc. being up front and little of the cost being operational, climate investments are exceptionally discount rate-sensitive, which has hammered them over the past two and a half years. And in its usual way, the market has overreacted to the trend of rising rates, making these investments real bargains today. Today, solar stocks are priced at over a 50% discount to the broad equity market, and some of the best clean energy companies in the world trade at levels that imply negative real growth" Anything climate related bubbled up in the aftermath of the pandemic and then got killed when interest rates rose. But therein perhaps lies the opportunity. Especially as market attention has switched to anything AI related and cryptos are back in favour. Of course renewables have always struggled to stand up on their own two feet without subsidies and other government grants and the energy transition isn't going to happen overnight which doesn't jive well with investors increasingly short time horizons. But over the long term we are going to have to get a much higher share of our energy from renewables. https://www.ishares.com/us/products/239738/ishares-global-clean-energy-etf seems a know-nothing investor way to play this theme. And the chart below shows that its price has returned to pre-pandemic levels irrespective of the fact that ESG reporting is becoming a way bigger deal and climate change is being taken increasingly serious. But interested if anyone on here has any specific names they favour.

Isn't it a little worrying for Mag7 investors that a start-up founded only a few years ago can release LLMs that compare favourably to the ones put out by OpenAI/Microsoft and Google? Reinforces the point that in AI no one really has a moat at this point. Mag7's ability to stockpile chips gives them an edge and they can outspend everyone on R&D. But in the internet age it was Google who ended up with the dominant search engine not AOL/Netscape/Microsoft. Any company with a good idea/product will have little problem attracting funding and users aren't locked in to a specific LLM at this point so will switch if something better comes along. And so far it is LLMs that are generating all the buzz and drawing in all the users and seeming to have the most practical use as a lot of people are using LLMs to write emails, assignments, research papers, marketing copy etc.

Does seem to be a bit of a race against time. Can the supply side benefits of Artificial Intelligence and immigration get inflation down quickly enough to allow the Fed to cut interest rates to a level where debt servicing costs are more manageable? And will GDP be able to grow at a 4-5% rate over the next decade or two which would greatly help reduce debt to GDP and reduce reliance on fiscal stimulus to keep the economy firing on all cylinders?

https://www.axios.com/2023/11/03/productivity-growth-us-economy https://www.reuters.com/markets/us/us-productivity-rises-fastest-pace-three-years-third-quarter-2023-11-02/ https://www.ft.com/content/61b8574d-724c-4486-b6b0-21191c22d476 https://www.brookings.edu/articles/machines-of-mind-the-case-for-an-ai-powered-productivity-boom/ https://www.bloomberg.com/opinion/articles/2024-02-23/us-productivity-is-on-upswing-again-ai-could-supercharge-it-for-good-or-ill?leadSource=uverify wall Quite a few hints that US productivity growth is on an upswing and that is even before widespread adoption of AI by businesses. If so it really would be a holy grail as it would result in faster economic growth and lower inflation (and therefore allow lower interest rates). Economic growth and productivity growth was anaemic for much of the post GFC period with most of the EPS growth of the S&P 500 driven by financial engineering, secular growth from Big Tech and tax cuts. So if this isn't a false dawn then this could indeed be the roaring 20s with the S&P 500 already up almost 150% from the pandemic lows and a long bull market can take markets up 300-500%. And that is a prospect that would keep even the most hardened perma-bear up at night.

Luca is also right. If AI results in a productivity miracle it is going to be the users who benefit. The technology really isn't that proprietary. Lots of companies are coming out with LLMs including start ups no one has ever heard of. For now Nvidia has a technological lead in GPUs but it may not last and you are already paying a high price on the assumption it will. And while Big Tech have deep pockets that doesn't guarantee success and in recent years they've become better at monetization than ground breaking developments and the woke bureaucracy in these organizations is undermining trust and getting in the way of product development.

I can't imagine the average low skill white collar worker has much money to buy Mag7 stocks especially with the cost of living squeeze ongoing and wage increases nowhere near sufficient to compensate for all the post pandemic inflation and even less likely now that companies are planning to automate work and reduce headcount. And if a lot of low skills do lose their jobs they will probably end up liquidating their portfolio of Mag7 stocks they bought with their stimmy checks. Same way most people aren't buying BTC because of considered concerns about the explosion of the money supply post GFC and unsustainable path of US government debt. When inflation was in the double digits everyone was dumping bitcoin. To the extent people are buying perceived AI beneficiaries and bitcoin it is because people like to chase what is hot and going up. And this is especially true of retail investors who do not have the patience to hold something like Berkshire that will get you rich slowly compounding 10% a year like clockwork. The main fear that drives investors in a bull market is FOMO. And that is helping to drive up multiples. Case in point there is apparently a huge increase in custodial accounts being set up with brokerages that allow teenagers to buy stocks because they don't want to miss out on the action. But yeah there is a broader point here that capitalism is a bit broken when it is difficult to get ahead doing honest work with wages barely increasing in real terms prior to COVID and post COVID probably falling in real terms (who's had 20-30% wage increases over the past few years?) while anyone with a stock portfolio has been making double digit real returns over the last 15 years and anyone owning real estate has been building huge amounts of equity given their interest payments were next to nothing for much of the GFC period. Putting whatever meagre savings low skill workers have into Mag7 stocks which they will probably have to sell to feed their families when their jobs get automated and they become redundant isn't the solution. What we really need is to find a better way of taxing corporations and HNW individuals who will milk it if AI fulfils its promise so some of the wealth created can get redistributed via a universal basic income or at least generous benefits until a way can be found to repurpose low skill workers. Of course tech optimists talk about agriculture and industrialisation and de-industrialisation and say that new jobs will be created. But that ignores the issue of structural unemployment. Think about all the mining towns and factory towns that decades after de-industrialisation still have high unemployment rates?