mattee2264

Cost of living crisis is starting to ease. I'm also seeing grocery prices starting to fall. And energy prices have fallen as well. Even rents are starting to come down a little. So this is a positive. Although some of the additional funds available will be used to replenish savings or pay down credit card bills and other debt. And to the extent that consumers did take on additional debt to survive the cost of living crisis they will need to service that debt at still very high interest rates. And spending power might also come down because consumers have probably exhausted by now any excess savings built up over the pandemic so are limited to what is available from their income after taxes, debt service etc. We are at full employment and there are some indicators that labour markets are starting to weaken and that is going to have a negative impact on consumer spending. And most recent real consumer spending growth was 2.4% which is going to be a hard comparative figure to match. And in nominal terms with inflation coming down as well nominal spending growth will almost certainly be lower and that will have a negative impact on nominal corporate earnings. Although agree that absent a massive increase in unemployment it is difficult to imagine consumer spending falling off a cliff and that increases the chances of a soft landing. Agree that multi-trillion dollar deficits are also going to be very supportive to the economy. It is a very underestimated factor and probably explains a lot of the comparative strength of the US economy compared to the ROW. And in an election year they are going to continue. Not so convinced about cost cuts. Over the last year or two cost cutting supported earnings growth even as revenue growth softened. But as most of the easy efficiencies have probably been achieved by now further cost cuts will be more difficult and may require reductions in headcount which is a negative factor for the overall economy and therefore corporate earnings generally. And again comparatives will be tough because in 2022 and 2023 earnings benefited from cost cuts and revenues held up better than expected because the economy avoided recession. If there is some kind of soft landing next year it will mean even weaker revenue growth and absent major cost cuts that is going to mean much lower earnings growth than in previous years and we have all seen that the stock market punishes that harshly.

Central banks have always been terrified of deflation. That is why you have a 2% target and not a 0% target. So yeah if we undershoot the inflation target rates will quickly come down. I cannot imagine the Fed blithely saying "Oh the deflation is transitory so we will wait and see what happens". Other thing that probably isn't generally realised is that both fiscal and monetary policy operate with lags. So today's rapidly disappearing inflation was caused by yesterday's stimulus. And today's contractionary monetary policy and less effective fiscal policy (no longer giving direct stimmies) could be tomorrow's deflation. Deflation clearly isn't good at all for government and private sector debt even if it does make it cheaper to service. I also think that data will get revised and indicate that the economy isn't as healthy as recent figures suggest and while the Fed is still worrying about inflation the market has probably correctly realised that interest rates are heading lower but perhaps will be taken by surprise if we do fall into a recession that is deeper and longer than expected.

Might be worth resurrecting this thread given that WMT made a point of using the "D" word and there are some signs of emerging weakness in US labour markets as well and the full impact of monetary policy is also likely to be felt in the coming months and already we are starting to see rising credit card delinquencies and defaults and bankruptcies. And a lot of inflation was driven by food and energy prices which are falling. Already in groceries I am starting to see lower food prices. There will be a lot of discounting in the holiday season as well. Rents are also starting to fall. And it is pretty clear that a lot of companies were quite opportunistic in putting through large price increases and got away with it because the economy held up pretty well and labour markets were tight and consumers had a lot of excess savings from the pandemic and it takes time to change your spending habits. If sales start to fall they will come under pressure to reduce prices. Deflation is still very unusual and there are still inflationary pressures in the economy coming from fiscal profligacy and union wage bargaining and resource shortages. But these are unusual times and a deflationary bust probably has some probability higher than zero. Thoughts?

Everything going back 5, 10, 15 years is going to underperform a market cap weighting because we are still in a long secular bull market led by Big Tech and to a lesser extent quality stocks (aka bond proxies). Value stocks tend to be more economically sensitive and economic growth has been anaemic and with tech eating the world there has also been a lot of creative destruction with the new economy benefiting at the expense of the old economy. Chart below is quite interesting. Suggests that an equal weighted S&P 500 index tends to outperform early cycle and market cap weighted S&P 500 tends to outperform late cycle. But not particularly useful as economic uncertainty has been incredibly high post pandemic. And Mag7 are still seen as all weather stocks by most. Higher for longer? In a speculative market investors will still turn their nose up at a 5% guaranteed return. And Mag7 have pricing power so moderate inflation and moderate economic growth supports double digit nominal earnings growth that investors have come to expect. Soft landing? If we return to a low inflation low economic growth low interest rate environment then we've already seen that massively favours secular growers. Hard landing? Tough to call. But amidst recession fears cyclicals have already sold off and Mag7 is seen as a safe haven by many. The higher quality ones are seen as utility like selling essential goods and services. The lower quality ones have such exciting long term growth themes that investors will probably look through a few recession years. And in a hard landing inflation and interest rates will probably come down which is bullish for Mag7. Take off? If we do see robust broad-based economic growth then that will favour small caps and cyclicals and with growth becoming less scarce that might moderate the multiples investors are willing to pay for Mag7. But then again growth was pretty strong in Q3 and Mag7 on the whole posted very impressive growth figures and with Tech Eating the World they will participate in any economic growth and still do well. The main scenarios to worry about would be a stagflationary recession (which seems unlikely) or Mag7 collapsing under their own weight as they prove incapable of living up to the high expectations and lose their lustre. But as religion stocks and one decision stocks it will take a bit of time for investors to lose faith.

Saw an interesting chart that ex-US global stock markets are below their 2007 peak. US stock markets are three times higher. It really has been a case of tech eating the world. Historically that kind of divergence of performance would argue for loading up on EAFE and Jeremy Grantham is a big advocate of avoiding USA. Fairly neat way to avoid all the question marks about US debt and whether tech can continue its outperformance with current starting valuations.

It does make you appreciate even more how investors like Warren and Charlie can share so much wisdom about how to invest but also how to live.

If stocks are worth 20x earnings at 5% yields and 25 times earnings at 4% yields then not surprising why we are seeing big swings based on rate cutting expectations. Especially in growth stocks like Tesla and Nvidia where most of the value is in the terminal value and therefore very sensitive to discount rates. But of course the above arithmetic assumes no change in earnings. If rate cuts are accompanied by falling earnings or slower growth then that is a negative valuation factor. And I think the market is being a bit too optimistic in thinking that we can get lower inflation and lower rates and continue to grow at 3% a year. And if growth does slow to 0-1% then that is going to have a negative impact on corporate earnings and growth rates.

The other important difference is that in the 1920s the USA was a developing/emerging economy. So technologies that allowed mechanisation of agriculture and automation of manufacturing and so on allowed for more rapid industrialisation and massive productivity improvements. And freed up labour so it could be moved into higher value uses. In this sense the new technologies were very much complementary to society. The difference with AI is that it would be replacing a lot of low skill tasks and in a world of billions of people there are no obvious other low skill tasks for them to engage in. So you could just end up with a lot of structural unemployment and a lot more government debt as the welfare system will have to expand and you cannot tax AI the same way you can tax labour and it is also far more difficult to tax companies than it is to tax labour. Certainly AI is a deflationary technology. But I am not convinced it is going to lead to massive increases in world GDP.

The Fed will cut as it always does when a rate hiking cycle pushes the economy into recession. Historically though the negative impact on EPS dominates the benefit from lower interest rates. And the market usually bottoms about a year after the first rate cut. But this is the era of fiscal dominance. The irony of course is that the stock market places far too much importance on everything the Fed says and does. When aside from causing a few localised fires which they can put out via bailouts 500 bps of rate increases has had very little impact on the economy because it has been swamped by the stimulus that trillion dollar fiscal deficits are giving the US economy. And why would the US government get responsible during a recession? Especially when an election is coming up. And if there is a recession it is much easier for them to overcome the flimsy checks and balances to increase spending. And without a recession, unless something else breaks in a major way, you aren't going to get a major decline in stock markets. It is true that the Fed has less influence over the long end of the curve especially when bond vigilantes are doing their upmost best to impose fiscal discipline. But they always have the option of yield curve control and can print unlimited amounts of money to achieve that. Whether there are long term consequences from seemingly reckless fiscal policy is anyone's guess. But everyone was convinced that QE would lead to disaster. And while it certainly distorted the economy and encouraged a lot of speculation it didn't cause hyperinflation and has juiced stock market returns. I suspect much the same will be true of fiscal policy.

Agree re the safety of real assets in an inflationary world. However does that apply to Magnificent 7? If you look at 2022 the inflation shock absolutely savaged Big Tech. 50% declines on average. The V-shaped recovery was because there was a seemingly immaculate disinflation (with an added kicker from AI). You get some protection from their pricing power but if their customers are getting squeezed by inflation there might be a limit to its exercise. And the very high multiples are predicated on double digit growth as far as the eye can see and law of large numbers is starting to work against them. But I am not really seeing a future of high inflation. Perhaps in pockets such as food prices and natural resource prices due to scarcity. But fiscal spending will slowly get diverted into debt service and become less effective in stimulating demand and the higher interest rates necessitated will crowd out private sector spending and we will probably have another decade of sluggish economic growth and moderate inflation (say 3-4% averaged over the economic cycle) until the AI productivity miracle occurs.

Yep does seem like another flight to safety to Big Tech underway. Same playbook as during the pandemic when economic uncertainty during the summer led to a a melt up of technology stocks and a sell off of old economy stocks.

I think it is very difficult to compare multiples over time because the composition of the market is always changing. Current market is 30% Magnificent 7 and they are the top 7 companies by market cap despite all being at heart technology companies. Jeffrey Gundlach did an interesting memo in Q2 that talked about how weightings can be useful bubble indicators with the Japan share of MSCI World and energy company share of S&P 500 in early 80s among the examples used. Clearly if you strip out Magnificent 7 then the market multiple comes down a lot and is more in line with historical averages. Then again economic growth prospects are probably worse than historically. I think if we do end up with higher for longer then there will be some adjustment to multiples even for Magnificent 7 stocks. But I think markets are still in denial and eager to leap onto any reassuring words from the Fed and any softness in the economic data to indicate a pivot is coming. Other thing is there is probably a better correlation between inflation and PE multiples rather than interest rates and PE multiples. In the initial inflation shock in 2022 Magnificent 7 had an epic collapse. But the immaculate disinflation set the stage for a V shaped recovery. And what happens next probably depends on whether we end up with stagflation or just a slowdown. And a slowdown with lower interest rates is probably very favourable to Big Tech because the slowdown will be assumed to be temporary whereas the lower discount rate is projected to infinity.

It is exciting for sure. But what is underappreciated is how much upfront investment is required and how long it might take to get a return on it. Currently the economics of Big Tech are incredible. Capital intensity is very low. Pricing power is very strong as everyone is hooked on their products. Even as revenues are slowing they are still posting double digit earnings growth. They are free cash flow machines and a lot of that free cash flow has been allocated towards share buybacks and reinvesting in their very profitable core businesses with fairly limited risk. If they start investing a lot in AI there is a lot more risk. Big Tech have an edge because they have incredible financial resources and are already pretty proficient in the use of non-generative AI. But IBM was a behemoth and lost its way as technology changed. And new technologies sometimes benefit users more than the providers. There was a lot of excitement as the 90s tech giants built out the internet. But it was only much later that very profitable internet companies emerged that were able to harness the technology for their benefit.

There is a bit of circular reasoning going on. Fed backing off a bit because it sees long bonds doing the rest of the tightening. Long bonds yields promptly slide sparking a rally.

US fiscal deficit $1.7TR. That probably goes a long way towards explaining resilience of the US economy compared to the ROW. That is a pretty massive fiscal deficit to be running when the economy is at full employment. By contrast 5% interest rates are pretty much neutral. So no surprise who is winning the tug of war.

It seems obvious to me that there is a lot of unutilised retail and office space as a result of the shift towards online retail and flexible/remote working patterns. Surely this could just be converted into flats? Also when there is a housing crisis you should have disincentives against buy-to-let and foreigners using US property in big cities as effectively a bank account. But agree that those in power are property owners and have vested interests that make them want to keep house prices high.

Worth factoring into that assessment that for much of the early period the world was on a Gold Standard which was pretty effective in keeping inflation low and allowing for lower rates. 2nd half of the 20th century 5% was the bottom of the range rather than the average. 21st century it was the top of the range but that reflects that in the 21st century monetary policy has been pretty irresponsible. Who knows what the future holds. Some argue for higher structural inflation driven by food and other resource shortages, de-globalisation etc. Others argue that technology will continue to have deflationary impacts as will slower growth necessitated by pursuit of net zero targets and the deflationary impact of massive amounts of debt.

What is interesting is that because policy operates with lags you are still seeing the benefits from the unprecedented easing during COVID while the full impact of the rate hikes/QT and less effective fiscal policy (still trillion dollar deficits but not helicopter money the way it was during the pandemic) is yet to be felt but will weight on the economy in 2024 and 2025. All bets off of course if the Fed does a shock-and-awe pivot but monetary policy is so reactive that it will only do that when a recession is confirmed by which point the market will already be down considerably. As for the US government they will come under more and more pressure to reign in spending and even if the Democrats stay in they will probably cut back post-election.

Amazing how Big Tech earnings are so good but they are still selling off. Goes to show just how high expectations are from these market darlings and that sentiment has shifted from "AI is the future, the sky is the limit" to "Is this as good as it gets and concern about forward guidance for the core non-AI businesses".

We haven't had the hard landing yet. And based on the resilience of the economy unless something major breaks then Powell's envisaged scenario of a period of below trend growth will probably be how things play out. Especially if some fiscal discipline is imposed by bond markets. But as a minimum you'd expect some repricing of financial assets as the long bond rate goes higher to establish a proper term premium and optimism about a pivot in 2024 starts to fade as people realise that so long as employment remains strong and nothing major breaks Powell will stay the course. And even if people don't believe in higher for longer then if anything that increases enthusiasm for bonds because it means there is a limited time opportunity to lock in a long term return of 5% + as well as enjoy some capital appreciation if rates do fall. Or for the more speculatively minded with the TLT down 50% there are bottom fishing opportunities. Either way equity allocations are bloated so it wouldn't take much of a rotation into bonds to result in quite a bit of downside to equity markets. The economy is probably as good as it gets at the moment. So the idea things will get better and there is a broad based rally encompassing non-tech stocks seems unlikely. And even if the economy only gets a little worse it will continue to depress the prices of non-tech stocks and if sentiment sours and tech results disappoint then a lot of the YTD gains could be given up and when Magnificent 7 are 30% of the index and have gone up 70-80% on average YTD then that again adds to the downside risks.

Yeah I think "wealth effects" are massively overrated. Asset price appreciation has been insane since the depths of the GFC but until the US government started running trillion dollar deficits we struggled to get GDP growth anywhere near 3%. Also the wealth effects during the 90s leading up to the dot com bubble top did little to prevent the house of cards from collapsing. Most people have however seen a reduction in their real wages and are finding it a lot more difficult to spend more than they earn now that credit is a lot more expensive and banks and other lenders are starting to tighten lending standards. Also the stuff that people actually spend money on such as rent, energy, food etc has gone up massively so the reduction in real wages is greater than the inflation figures suggest. It is difficult for the Fed to lower rates so long as the economy remains resilient and the US government continues to run trillion dollar deficits. And I think that a lot of the apparent economic strength does reflect that fiscal policy is so ridiculously expansive.

The double whammy comment was specifically in relation to the Magnificent 7. MAG 7 have an average PE multiple of over 45 times earnings. And for some context the lowest multiple was around 20x set at beginning of 2019 and in the depths of COVID which with benefit of hindsight were excellent buying opportunities. Their current price is only about 5% below the end of 2021 peak. As we all know their stock prices are up 70-80% YTD. So not difficult to imagine a lot of downside if earnings disappoint.

10 year valuation is misleading when you consider that the last 10 years were in a very low interest rate environment. And an equal weight deserves a lower multiple considering that the highest quality stocks generally dominate indices and therefore your average stock probably doesn't have much of a moat. But agree that most of the overvaluation reflects the Magnificent 7 who are now about 30% of the S&P 500 by market cap. I think if we avoid recession there might be more of a rotation as a lot of people are treating Magnificent 7 as safe havens. But if there is a recession then you'd imagine even Magnificent 7 would see a fall in earnings and market has some distance to fall because lower earnings and a lower multiple is a double whammy.

I don't think that is true at all. We've already seen ~10% price declines from the peak with very little change in unemployment. And somewhat higher price declines in more overvalued housing markets like Australia and Canada. In a market with not much liquidity it doesn't take that many people to decide they need to downsize or move to a cheaper area to bring prices down. And even fairly modest job losses (and remember we are at full employment so I am hardly advocating for mass unemployment) would probably do the trick. Another driver of house price declines would be buy-to-let investors selling out because they reach the limits of passing on higher costs to tenants and facing negative cashflow decide to sell. Of course you are right that in major cities foreign cash buyers would swoop in and that would moderate the decline and be a negative. But it is the society wide myth that house prices can only go up that encourages so many investors to buy real estate to the detriment of potential owner occupiers.

It is not the number that is magic and of course 2% is somewhat arbitrary although as explained there is some reasoning behind it. The magic is that if you have a target that central banks are accountable for achieving and it cannot just be changed anytime it suits then that anchors long term inflation expectations which has economic benefits both from an efficiency but also an equity (fairness) standpoint.