Multivariable Calculus
Last week, we used some of our own arithmetic to explain the correction that tech stocks were experiencing and the fierce rotation into other sectors. That was looking at what was happening. When we look forward at these next few months, we believe it requires graduating from arithmetic to multivariable calculus.
Among the important variables (and their respective fluidity) that one must consider in trying to solve markets are: Liquidity, Economic Data, Interest Rates, Earnings, Valuations, Animal Spirits (the behavioral dynamic between fear and greed, and momentum), and of course, Politics.
Liquidity Is Still Supportive
Certain important liquidity measures that we have discussed in our letters this past year are still expanding, albeit more slowly than in 2023. Nonetheless, the liquidity cycle that bottomed in late 2022 should continue to see expansion through 2025, supporting markets and asset prices.
Recent Economic Data Point To A Slowdown
Labor and consumer data show falling economic growth rates and moderating inflation pressures. While still growing, the overall economy is slowing. However, for millions, it is not just slowing; their economic situation is deteriorating -- especially at the lower end of the socioeconomic ladder where the previous years’ inflation hit the hardest, job security is lowest, and shrinking savings have given way to growing credit card balances. All that being said, the economy is growing fast enough for well-run companies to generate real earnings growth.
Interest Rates Have Peaked, But What Does This Mean For Stocks?
Market forces have been taking interest rates down for months. Investors and traders have been closely hawking the U.S. inflation and employment data (July data get released tomorrow, August 2nd) for clues as to when the Fed will actually start cutting interest rates.
During this week’s meeting, Fed Chairman Powell made it clear that the Fed sees growing evidence that rate cuts are their likely next move… but not quite yet. While the initial reaction to Powell’s comments by investors and traders was to cheer and take stocks higher, it is fair to ask whether they should be so bullish. As we look back over the past 50 years, history shows that the period following the first Fed rate cut can be difficult for stocks. Some of the market’s worst drawdowns are during rate cutting cycles. Conversely, the period we are in right now (between the last Fed hike and the first interest rate cut) has proven to be a much better period for stocks.
What About Earnings?
Earnings expectations have gotten quite high for certain leadership stocks/industries, and this often sets investors up for disappointment. We are in the middle of earnings reporting season and so far, the stocks that we follow closely (and own for our investment management clients) have generally been reporting strong underlying fundamental trends. Innovation is rapid, and the technology stocks driving it have been doing a decent job communicating that spending on AI and other advancements continues to be robust.
A key part of our research process is going through the company press releases and listening to management conference calls. In addition to looking for new opportunities and looking for signs of accelerating earnings, it is just as important to sniff out signs of deceleration in the businesses. Our radar is always searching for signal changes.
While Earnings May Be Good, Valuations Are Still High
As we review updated earnings projections and look at where the stocks are trading, we notice that the recent pullback in the leaders has brought P/E ratios down; but many of the best stocks are still not what we would call “cheap” relative to how fast they are growing. In general, we expect we will get better opportunities to buy in the coming months.
“Animal Spirits” Were Running Wild Until Early July
Momentum impulses in the markets can be capricious, and can come and go without an identifiable catalyst. For example, as July began, the “mo” train was running, but there were growing concerns about how: the indexes were becoming too concentrated in a few big names, everything had gotten way too expensive, there were too many “crowded trades,” or “everyone was on one side of the boat,” etc.
Then, in the span of a week, this disequilibrium started to correct itself. Smaller companies, cyclicals, and other areas of the market saw gains, while the momentum leaders (companies benefiting from disruptive trends like AI and GLP-1s) saw big pullbacks in share price. As this was taking place, (or as “everyone on one side of the boat” started to move around and reposition themselves, the boat got a little wobbly and stock indexes sold off. The positive to this is that when this adjustment is through, the overall stability of the boat (market) should be enhanced.
The market broadening out in July has narrowed the wide dispersion in stock index returns in 2024, and corrected what many were calling an imbalanced market.
We believe the recent rotation has been helpful in removing some of the froth in the market. A few market “pundits” refer to the market as being more “balanced” now that some of the laggards have had a nice rally. As balanced as it may be, there will still be haves and have nots, so we will look in select areas with stronger fundamentals for growth at a reasonable price (GARP) opportunities.
Politics Could Matter, A Lot
Politics may be the key variable that sets the overall tone in the next few months.
The wide swings we have seen in poll numbers these past few weeks may be with us until November. Sentiment about political developments in the U.S. this fall could meaningfully affect all other variables discussed, with the exception perhaps being global liquidity.
Economic growth expectations are certainly affected. One party seems to prefer increased government involvement in the economy, and the slower economic growth that comes with it.
Interest rates could end up being a wildcard for either political outcome. Generally, slower growth would bring lower interest rates; but if the policies are inflationary and stagflation is the result, lower rates may not persist.
Earnings expectations for each sector and industry could be greatly affected by whoever is perceived to prevail in November. Earnings forecasts could move a lot for certain groups depending on who is perceived to be winning.
Valuations (the price which an investor is willing to pay) could follow changes in earnings forecasts in an exaggerated manner, like the end of a whip. Each industry’s and sectors’ share prices will respond to the wide swings in poll numbers as traders try to get in front of perceived outcomes.
There is an opportunity for politics to unleash either upside or downside momentum. The latter brings “animal spirits” that nobody wants.
Do Stocks Have Any More Upside Given All the Complexity?
We see many reasons to remain bullish on technological innovation, the increasing efficiency it spurs, and the economic dynamism that results. Solving the investing puzzle these next few months requires analyzing and processing some complex, organic, and fluid issues.
We are optimistic, but not myopic. We will always advise investors to have an investment plan for the wide possibility of potential outcomes.
Thanks for listening; we welcome your calls and questions.
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