Bull Marches On

The broad markets have continued to advance starting the new year as the bull marches on. But there may be some signs of complacency as we see the fear index (VIX) hovering near multiyear lows and a bit of divergence below the surface. This is officially the 20th month of the current bull market that began in June of 2022. There have been a few corrections along the way and it’s our guess we will see a few more this year. In fact, beneath the surface there could be a stealth correction currently taking place. The number of stocks making new highs peaked six weeks ago even though the broader indices have advanced higher since then. This advancement has been carried on the backs of the mega cap companies like Meta, Google, and Nvidia while smaller companies continue to lag.

Additionally, there have been other indicators of weakness. The dollar, which has been inversely correlated to the stock market recently, has shown some resiliency to start the year. That might begin taking a toll on corporate earnings as our goods get more expensive to overseas customers. Also, we are seeing a shift toward consumer staples and away from consumer discretionary companies. This is typically what you see in belt-tightening, recessionary times as consumers forego the impulse buys and stick to the basics of TP, soap, and the like. The question is whether these are signs of an impending broad market correction or just normal volatility of the marketplace.

Some areas we turn to for further confirmation of strength or weakness in the markets are the charts of the main drivers of the economy: banks, industrials, semiconductors, and homebuilders. And currently all of these industrial leaders are above their former highs. If there is actually trouble in the economy and this stealth correction turns into a broader one, we will start to see these main sectors begin to falter. It would also not be surprising at all to see broader weakness in the near term, since February is typically one of the worst months of the year for stocks. And why wouldn’t it be? Many consumers are tapped out after the holiday rush and winter storms slow down economic activity. If February does turn out to be poor for the market, we will just be buying more quality names and diversified funds at a cheaper price. Regardless of what happens, don’t let seasonal weakness or all-time highs in the market scare you from investing. Even on a short time scale of 6 months, buying at the market top produced better returns than buying on any other day, and the out-performance gets even greater 1, 3, and 5 years later. Record highs often precede better long-term returns.

We’ve stated it before and it bears repeating: It’s not timing the market, it’s time in the market that counts the most.

The Pessimistic Rally

In the last market letter we discussed how we were embarking on the most profitable time of the year in terms of market returns. And so far, that seasonality trend has played out. The S&P 500 rallied over 8% in November and the broader markets are nearing their all-time highs, but still investors remain overwhelmingly bearish. From looking at market sentiment data and put/call ratios, it remains clear that investors are still betting on, and waiting for a market crash. Granted, small-cap stocks are still well below their peak, off nearly 25%. And high-tech innovation funds that were all the rage during the pandemic are still down a dramatic 70% from those vaulted valuations. The Nasdaq and S&P, however, are a mere 2% away from where they were at their peaks in January of last year, implying that much of the bearish sentiment seems unwarranted. Betting against this market is weighing on the returns of many small investors and large institutions alike. Especially those not invested in large-cap tech names, which have been the darlings this year. The likes of Google, Apple, Meta (Facebook), and Tesla have helped push the Nasdaq index up over 45% so far in 2023.

There will always be reasons to worry or doubt a market and this year has been no different. Interest rates are near 15-year highs, inflation has been soaring to levels not seen in decades, wars broke out on multiple fronts, and a looming recession was promised by year-end. But somehow investors and many market commentators missed one of the most important fundamental drivers of the market – earnings. Earnings in the S&P 500 have risen over 8.8% to new record highs. When earnings go up, typically stock prices go up too. And why wouldn’t they? Charles Munger, the famed and brilliant investor famously said to his longtime partner Warren Buffet at Berkshire Hathaway, “If people weren’t wrong so often, we wouldn’t be so rich.” Sadly, he passed away a few days ago but he left us with a tome of invaluable wisdom. He was an expert on human behavior and how it relates to business and investing. Behavioral economics is something we take very seriously at HWM, especially investor misbehavior. We use this to our advantage quite a bit. Twelve months ago, market strategists were forecasting a down year for stocks and the largest commercial hedges (bets) on record were placed for that to happen. We read: institutions are selling now so they can buy later. Fast forward to today and lo and behold, they could not have been more errant with their bet. All that money that was placed on the wrong side of the trade had to either unwind and enter the market or watch their options decline in price or go to zero.

It’s hard to go against consensus, but it’s also one of the few proven ways to consistently make returns in a chaotic marketplace. Cash levels alone tell us that investors are still very pessimistic, if not outright scared of being in the market. There is currently close to $6 trillion of US investor money sitting in money market accounts. With yields of around 5.25%, it’s not the worst place to hide out. Eventually sentiment will shift, either because rates will fall or investors will simply grow frustrated missing out on double digit market returns, and all that money will come flooding back into stocks. Happy holidays.

The Most Bullish Time of the Year

In our last market update we started the discussion of seasonality and pointed out that historically September and October are poor months for stocks. Unfortunately, that held true again this year with both months posting declines for the major averages. The good news is that as the holidays approach we will be heading into the most bullish time of the year. In fact, since 1950 nearly every dollar earned in the Dow Jones index happened during November through April. If you had invested $10,000 in November of 1950 and sold at the end of April and reentered the market the next November and did this every year, your initial $10,000 would be worth more than $1.2 million today. If you invested at the opposite time, you would have made virtually no money at all over the past 73 years. We don’t mean people should actually go out and start investing like this, since in any given year markets can do wildly different things, not to mention the tax consequences that would be incurred. However, it is meant to illustrate that human behavior and investment behavior are different during different times of the year. Daily life changes and yearly cycles impact all of our behaviors, including investment behavior.

This week marks the beginning of what is historically the most lucrative six-month period of the year with the strongest months being November through January as investment behavior, in a sense, gets more cheery. Compounding this seasonality trend is another historically bullish cycle we are entering: the presidential election year cycle. Typically, incumbent administrations will do everything they can to juice the economy and put off politically unappetizing, painful economic decisions until after the election or let the new administration deal with it.

To further put the recent seasonal weakness we’ve seen over the past several months into context, a 10% drawdown in the stock market within any given year takes place 63% of the time. It would be unusual not to see a pull-back of this size. It’s worth mentioning that the drawdown we are currently experiencing (since roughly the end of July) is now very close to reaching oversold levels that have historically led to significant short-term bounces. Perhaps the Fed meeting next week will trigger one of those rallies? No one knows for sure, but several pieces are falling into place to allow for a profitable quarter and a shift in investor sentiment and behavior. For example, the Fed’s preferred measure of inflation, Core PCE, moved down to 3.7% in September. This was the lowest level since May 2021. The Fed funds rate of 5.25% is now 1.6% above inflation. This is the most restrictive monetary policy we have seen since 2007 and likely means the Fed is done tightening. Ending the interest rate hike cycle would be welcome news for the overall stock market, and especially good for young companies and high-tech stocks that rely on borrowing to fuel growth.

Won't Back "Dow"n

September and October are seasonally weak, and many of us can recall major market meltdowns during the fall. But a major reason behind market weakness lately might simply be that the market is behaving rationally.  Buyers were jumping back into stocks earlier this year after a rough 2022 as inflation was coming down, interest rates stalled, and the dollar fell. Since that time buyers have been frightened off and selling has accelerated after the last couple of Federal Reserve meeting press conferences. The markets may have finally realized the Fed is not bluffing about keeping interest rates stubbornly high into 2024 to fight inflation. The Fed is not supposed to care about the stock market, and with unemployment hovering around 3.8% they can afford to fight hard. The Fed is communicating a clear message that they will not back the Dow and will not back down from their inflation crusade. They have no reason to cut rates before inflation gets to around 2% for several months, unemployment spikes, or something breaks (like we saw with the Silicon Valley Bank implosion in March).

As conflicting reports emerge about where the economy is headed many investors have chosen to either stay on the sideline or make short term trades. This has kept the stock market in a tight trading range for several months. One of these days we will see a break-out as a clear direction takes hold. Some market pessimists are talking about a 1987 style meltdown as high interest rates cripple the economy or the Ukraine-Russia war turns into a US-Russia war. But prognosticators like this are a dime a dozen and are often said to have predicted fifteen of the last two recessions. On the bull side some are predicting the AI revolution to continue pushing stocks like Nvidia and Microsoft to eyewatering valuations as they transform the economy and the world. In reality, we will likely continue to see strength in companies making real leaps in the AI space but also continue to see a rotation into some forgotten sectors that are still churning out loads of cash, like oil and gas. In 2022 we saw record profits in the energy sector, and we are seeing another spike in commodities prices that should push profits even higher this year.

The market tends to surprise consensus opinion and current consensus is relatively negative. It wouldn’t surprise us to see markets continue showing weakness as the current correction accelerates, but it would surprise us if we didn’t see bounces along the way. Just don’t hold your breath waiting for the Fed to bail out the market. Also, keep in mind that nothing goes down in a straight line and there will always be buying and selling opportunities. Stocks are still stuck below that overhead supply level we discussed in previous commentaries, but they are also well above recent lows seen last October with an overall trend pointing higher. In short, we anticipate short-term weakness as Fed-induced high interest rates slow down the economy, but long-term strength as production continues to grow and jobs remain plentiful.

Looking for a Reason

In previous commentaries we have discussed how markets drive narratives and not the other way around. But that doesn't stop many investors from trying to force narratives on markets anyway. Currently, investors are looking for a reason to continue buying into this run that we have seen over the first half of the year, but over the last month stocks have been failing to truly break out higher. We are seeing a classic example of what running into overhead supply looks like. The story goes like this. Stocks go up and attract more and more attention and buyers until a time when they start to decline. They decline for an extended time. But throughout this decline investors who bought in late near the top are unwilling to sell at a loss. So, they hold. And they continue to hold through the next market rally but remain worried and pessimistic throughout the entire rally. When their stock gets near the original price the investor paid, they get antsy and want to relieve their loss anxiety. Suddenly, there is a large supply of stock ready to be sold. This is overhead supply, and we are seeing it in semiconductors (even though Nvidia continues to rip higher), homebuilders, technology, and industrials. All these sectors are stuck just below their previous cycle highs. These previous investors are unwilling to buy back in until they see good reason to do so. To go along with this, greater numbers of people are often sellers this time of year anyway.

In many years we see markets pause or decline in the fall, and seasonally it makes sense. As one market strategist put it, people party all summer and the bill comes due in the fall. As do the bills for tuition payments, home repairs for winterization, and all sorts of things that may have been put off during summer vacations. On the flip side is the year-end rally that often follows this market swoon. Investors don’t like to be on the sideline forever and sometimes it doesn't take much to remind them of all the reasons they wanted to own that stock or index in the first place. We don’t know what the narrative will be that will accompany the next market move higher, but we can take an educated guess on what might actually be the reason.

Markets ripped higher two days ago coinciding with the largest move lower in interest rates since early June. It’s news to no one that interest rates are very high right now. Mortgage rates are around 7.25%, credit cards are near 30%, and on down the line. Everything is more expensive, especially the cost of money. Currently, there is the largest open short interest on bonds in history. Translation, people think rates will continue to go higher. However, this is historically speaking a very powerful contra indicator. All of these “shorts” are guaranteed buyers that will have to drive interest rates lower. If and when that happens, stocks will have their day in the sun again and break out to new highs.

Second Half Regime Change

When the Fed wrapped up its most recent meeting they announced another quarter point interest rate hike and the markets barely blinked. Markets have been on a tear and the rate rise did not deter them. Also, the tone coming from the Fed was much more accommodative than it has been over the last year. A lot has changed in that timeframe even since just six months ago when recession fears were peaking and major stocks like Google and Facebook were in freefall. Fed chairman Powell stated they would be “data dependent” regarding whether to raise rates again.

Over the past year and a half, the Fed has been at war with inflation. Raising interest rates has been their key weapon. The war is now essentially over as the current inflation rate is 2.97%, compared to 4.05% last month and 9.06% last year. Nevertheless, the Fed does not want to take their foot off the brakes just yet and cause inflation to pick up speed again. Also, the economy is showing that it is healthy enough to withstand higher rates for longer. Lending has picked up relative to a month ago, commodity prices are higher, and home prices are ticking up. It’s likely that the Fed won’t ease up on rates until these prices fall and job losses mount.

An economy with steadying or even decreasing rates should be good for stocks, but this new normal might be already priced into the larger players. In the second half of last year almost every sector of the market was already on an uptrend except for large-cap growth (AAPL, GOOG, MSFT, META, etc). Then in January we got a regime change and money rotated into these mega companies and out of most everything else. Many of these stocks made huge gains, but now it may be time for another regime change where a different sector or market cap (company size) takes the lead. The Nasdaq and S&P are both pushing up against the recent highs of last October where they ran into resistance and then fell until January. If technology is not participating in the upside during the second half of this year, then the overall markets are going to have a tough time as well. This does not mean there is no money to be made in this market, however. Industrials are already making new all-time highs, and we are seeing strength in the small and mid-cap space as well, as companies with market capitalizations below $10 billion play catch-up.

From a purely valuation perspective, stocks still look more attractive than bonds and non-tech stocks (like industrials, banks, and energy) look undervalued relative to their technology counterparts. At the end of the day, it’s all going to come down to the dollar. If the dollar is still falling in value, then stocks have room to run higher. And a more accommodative Fed should keep this trend on track. A cheaper dollar means higher profits for US multinational companies as they have pricing power over competitors. Over the next several months which regime will reign supreme? Tech has strong tailwinds, but we are keeping a watchful eye on other pockets of value.

Sector Rotation

 Investors are hearing a lot right now about how weak the overall market is. Pundits are saying that only a few stocks are carrying the indices higher and that if you look more broadly, stocks are in a bear market. But this simply is not the case. What’s actually going on is classic sector rotation. In the second half of last year (after a horrific first 6 months), all sectors other than tech started advancing. Oil and gas companies had banner years, banks did well, and so did consumer staples and industrials. As interest rates rose through 2022, companies that relied on lots of cash to fuel growth and operations suffered greatly. Then two powerful forces came together and changed their fate. Inflation began to ease (bringing interest rates with it) and the AI revolution kicked off. Growth stocks surged as money flowed back into the technology space and out of defensive, low volatility stocks. So when analysts look at the markets this year, they see a narrow area of performance and remain overly pessimistic. But this is not a market breadth thing, it’s just a rotation thing. Conversely, when tech underperforms, the broader market outperforms on a relative basis. However, this does not mean there is more market participation or that the markets or economy are healthier. When Apple and Google do well, of course the indices are going to be lifted even if other companies aren’t advancing as much. It’s just like in sports, your best players are supposed to score the most points and carry the team. And the best players in the economy right now are mega-cap growth companies.

Within the growth and technology space some trends are emerging. Semiconductors are leading with Nvidia becoming the first chipmaker to reach a trillion-dollar valuation. Apple is near its all-time high as it too makes chips and time spent on mobile devices per day has gone from 25 minutes in 2010 to over 4.5 hours today. Software stocks are also at 52-week highs (still down from their COVID peak) led by Microsoft, Salesforce, and Adobe. And any company that is AI adjacent is getting a huge pop.

There is a chance that AI will be as large a force and shape our lives as much as the internet did in the late 90s. If this is the case, then we are at the very early stages of this economic shift. The bulk of the market moves to come will likely feel like “irrational exuberance,” as Alan Greenspan put it during the dot com bubble. There will also be some quick and nasty pullbacks in AI and tech along the way. But pullbacks rarely come when people expect them. Look at Nvidia. It had nearly doubled year-to-date heading into earnings. Many trades opened short positions, betting against the stock thinking it was overvalued. Then the earnings were announced (which were stellar) and the stock jumped 30% - the largest post-earnings gap for a mega-cap stock ever, adding over $200 billion in market cap in a single day. The dips will come when everyone is on the AI and tech train and bought into the story. And the dip will be so brutal investors will question the narrative. This will be another good entry point for the sector.

Note on Interest Rates and Earnings

Many have inquired about interest rates and what that may mean for them and the markets. On Wednesday, the Federal Reserve raised the federal funds rate by an additional 0.25%, the 10th time it has done so in just over a year. This is the fastest pace of interest rate hikes in history and is leading to increased borrowing costs everywhere. Credit card rates have reached an all-time high of over 20%, home equity lines of credit are averaging 8%, and 30-year mortgages are around 7%. We expect this to be the last increase for some time as the higher rates lead to decreased economic activity and lower inflation. The entire goal of the rate increases is to lower inflation, and all indications are that it’s working. The good news is that interest rates on savings and money market accounts are dramatically better than they were a year ago. The average money market yield is over 4%, offering an alternative to bonds and dividend paying stocks for conservative investors.

While we are seeing decreased lending and GDP growth, companies themselves are still making money. The banking sector has been under pressure as a result of these rapid rate increases as evidenced by the Silicon Valley Bank collapse, First Republic, and now possibly PacWest Bancorp. But broadly speaking the economy has been resilient and fully 70% of companies reporting earnings are beating estimates and giving positive guidance. Yesterday, market bellwether Apple reported better-than-expected numbers on earnings per share, revenue, and profit margin – bringing in over $94 billion dollars in the first quarter. Having patience and investing in quality assets is a good way to weather these interest rate cycles.

The Rise of AI

The financial markets have been under siege since the Fed started raising rates over a year ago. During much of that time investor sentiment has been poor with little reason for optimism. As we have previously discussed here, growth stocks are getting beaten up the most with the fear being that their reliance on cheap loans to fuel growth is unsustainable in a rising interest rate environment. Meanwhile, industrial and oil companies have been the darlings even as consumers and countries alike transition toward new technologies and more sustainable energy solutions. But this past December attention was once again turned to tech as Silicon Valley and San Francisco unveiled Chat GPT-3, an artificial intelligence large language model, or LLM. The titans of tech stood up and took notice. We are already familiar with aspects of language models and chat bots. Think of Siri or Google Home. But this one is much more robust and offers far greater computing power. Alphabet (Google’s parent company) sent out an internal memo and held an emergency meeting after the release and Microsoft went a step further and bought a $10 billion chunk of the company behind the new technology.

It remains to be seen what applications will spring forth from this new AI, but anyone who has played with it can see the potential. Tech stocks have broadly rallied on the renewed optimism of AI and hopes that the Fed may be nearing the finish line of their rate hiking campaign. Technological advances often put downward pressure on inflation, which the Fed is currently fighting. But what’s good for consumers might be bad for the incumbent companies. It appears Google might have the most to lose since at its most basic level Chat GPT offers direct answers to questions rather than pointing one to sources that may have the answer (as Google search does). It can also provide these answers in creative ways if you ask for it. For example, I asked it to write me a poem about the basic rules of investing. Here is a portion of what it created:

Here are some basics that’ll help you invest, and make sure you do your best.

First, diversify your assets, don’t put all your eggs in one basket,

spread your investments across different classes, so that losses in one won’t hurt your masses.

The real breakthrough is that this tool can do work. The above is an example of it working to make a simple poem, but it can work to organize your spreadsheets, do very complex math problems, write essays, and even code. The productivity increases in some industries could be staggering. What used to take teams of computer scientists dozens of hours can now be done in minutes. The major breakthrough applications probably have not even been thought of yet. Just as the invention of GPS (completed in 1995) would lead to the creation of Uber and dismantle the taxi industry some 20 years later.

As the saying goes, “there is no free lunch,” so enhancements in one area will likely cause destruction in other areas. Whichever jobs are made obsolete, it is my hope that new and better opportunities will arise to fill those spaces. In a time of high inflation and the uncertainty of war, a new technology that is fun to use and will drive down costs is most welcome.

Instant Feedback and Long-term Goals

January brought a much-needed bounce to stock portfolios, rising about 5% on the S&P 500 and around 10% for the tech-heavy Nasdaq. Major indices finished 2022 down around 20% with many stocks experiencing much deeper declines as investors grew more and more bearish. So, as prices began recovering to start the year some stocks soared dramatically when traders who shorted them rushed in as buyers to cover their position. Economically, not much had changed over the past 30 days, and yet this price action was all too normal for investing and for human behavior. Since stocks prices are set by traders’ future expectations this inherently leads to speculation and volatility. As we can all attest, humans are by and large impatient. We also have inherent biases that guide our actions. We might think we have a great idea, one that we put lots of time, effort, and thought into and then quickly abandon if it doesn’t immediately yield results. We are fickle and quick to extrapolate what we have just seen into long trends. Unfortunately, these deeply ingrained instincts can get in the way of our long-term planning and goals. The instant feedback loop of the stock market is hardly useful except to a small minority of traders with the skill to capitalize on the price action and consistently win. Every price movement can feel like a compliment or criticism of our decisions, clouding our judgment and resolve going forward.

As long-term investors, the daily price quotes that provide instant gratification or humiliation are actually of little value and have almost nothing to do with the long-term quality of our decisions. It is possible to make terrible decisions that result in terrific short-term returns and vice versa. There is no perfect method to combat the harm of instant information from the financial markets. Value investors who internalized the teachings of Benjamin Graham and Warren Buffett waited over a decade for their thesis to play out last year. It’s important to zoom out and remember that healthy portfolios are built to withstand and profit throughout many market cycles. Whether markets are ripping higher or slumping lower it is always best to mentally slow down and anchor to something psychologically other than daily price quotes. Trust in the process of consistently saving and investing. Don’t deviate if motivated by greed or fear. Many times, we have seen an investor or hedge fund go bankrupt because they borrowed money and chased returns on the way up and got caught overexposed on the way down or shorted a stock on the downside only to see conditions improve and the stock move higher. We may be preaching to the choir, but these tenets of investing are not well understood or rather not well internalized. Humans will always overvalue instant feedback because it was necessary for our survival evolutionarily. It is up to us to have the discipline to understand when instant feedback is useful and when it is meaningless noise distracting us from our long-term goals.

In the meantime, enjoy the returns of the past month but check yourself if you start thinking stocks only go up. Also check yourself if you are still reeling from the hangover of last year, thinking stocks are dead. Easier said than done.