Divided Markets

JUNE 30, 2023

The Big Seven had such a huge impact on reported returns for the quarter and year to date in part because of their dramatic returns, but also because they represent such a large share of capitalization weighted indexes. Apple, for example, ended the first six months with a market capitalization over $3 trillion. This figure is larger than the entire Chinese or British markets, and three fourths the size of the Japanese market. Because of this heft, a 1% increase in the Apple share price would move the S&P 500 as much as a 683% increase in the share price of Advance Auto Parts, another S&P 500 company.

At the end of May, the contribution of the Big Seven to the total return of the S&P 500 was close to 100%. During the third week of June, the market broadened, albeit to a still very restricted list of stocks…. By the end of June … just three stocks, Apple, Nvidia, and Tesla, accounted for 40% of the gain…. The entire first half had set a record for narrow breadth. Only 25% of S&P 500 stocks had outperformed the Index, and only a handful of the winners had contributed most of the gains. 11% of S&P 500 companies and 3.2% of NYSE companies were at 52-week highs, the latter up from just under 3% at the end of the first quarter.

Divided markets have in the past provided a negative market signal because they have preceded bear markets or taken place during bear market rallies. Notable examples include the run up to the Great Depression (RCA the poster stock) and Depression bear market rallies, the run up to 1968 (Manhattan Fund the poster fund), the “nifty fifty” collapse of 1973-74, and the dot-com/tech collapse of 2000-2003. This reflects the combination of fear and greed that typically prevails before and during severe bear markets. Today’s market is the most divided ever. 

Despite the off-the-charts first six months, Nasdaq as a whole remained underwater for the 18 months beginning in 2022. By contrast, S&P 500 energy stocks that declined 7% during the first half were still up 46% for the 18 months. Apart from energy, only cash and gold preserved their positive nominal 18 month returns. Long bonds and Bitcoin dropped 31% and 34% respectively and even more after inflation.

What Produced Simultaneous Bull & Bear Markets During the First Half?

We concluded at the end of September 2022 that the S&P 500 was “oversold” and due for what would likely be a sizeable rally. The rally followed very shortly thereafter in October. By February 2, this rally had reached a top that looked like it might be terminal. Despite many attempts, the S&P 500 as a whole could not exceed its early February peak until the very end of May, when it finally went to new highs. Why did it go to new highs? Why did the Nasdaq 100 go even higher? And why did the average stock struggle to record any gain?

Among the Factors:

After the frightening plunge of 2022, the Big Seven appealed simultaneously to the fear and greed of investors. They initially appealed to fear, because of their cash and balance sheets and strong market positions. As their prices responded to the fear buy, this also inspired a greed buy.

The arrival of Chat GPT and other Artificial Intelligence Products at the very end of 2022 created a new stock market bubble on top of the “Everything Bubble” which had appeared to burst earlier that year. The apparent lack of AI opportunities outside of Nvidia and Microsoft directed the new bubble toward the giants. This exciting opportunity really sealed the merger of the fear and greed buy….

Nvidia revenues declined from $8 billion in Q2 2022 to $7 billion in Q3 2022 and then to $6 billion in Q1 2023. On May 4, the Company reported that it expected major revenue growth in AI related chips, up to $11 billion annualized in the second quarter, with earnings more than doubling, which triggered a virtual buying panic and an increase in share price of 27% by the end of the day.

Increased interest rates may also have had unintended consequences. Although much higher mortgage rates chilled home selling, since owners did not want to lose their low mortgages, it stimulated home building and builders, whose products were often the only option for buyers. In addition, despite Fed doctrine that higher rates reduce consumer demand, higher rates also generate income, which can increase consumption.

Buying these “proven” stocks feels a lot safer than “speculating” on “meme” stocks, SPACs, crypto, or obscure Hong Kong stocks that mysteriously levitate 2000% before crashing, some of the themes from the bad old days of 2021. On the other hand, some “meme” stocks rose sharply after June 30, so the old days can always return.

Investment manager surveys, such as from Bank of America, agree that firms increased stocks in May and June and increased exposure to the Big Seven. When this is done after a rally, it is referred to as a “pain trade.” During the last week of May, and at other times, there were short squeezes and during June some “window dressing” as quarter end approached. For whatever reason, “buying big tech” remains the most popular trade. Buying long bonds (whose yields are at 23-year highs) is the least popular….

Is The Divided Market Sustainable?

Valuations

Valuations today are equivalent to 1929 and 2000 and just a bit lower than the all-time peak of 2022. Nvidia is selling for 38X sales (sales, not earnings. How long would it take to get your cash back from Nvidia? At today’s dividend yield, you would have to wait 2,656 years. This figure of 2,656 years may also be described as the current duration of Nvidia. It contrasts with a current duration of 77 years for the S&P 500 and 27 years on average for S&P 500 duration over its history.

No one, of course, expects the Nvidia dividend to remain where it is today. It is hard to imagine that any company could grow at 30% a year for ten years, but let’s assume Nvidia did and thereafter grew at 10% a year, also very unlikely based on history. In this scenario, you would have to wait 42 years for your cash back. Because dividends are taxable, you would actually have to wait another fourteen years for a total of 56 years.

You may object that it is irrelevant to analyze cash earnings or dividends because you expect to make your profit, not by holding the stock, but by selling it to someone else at an even higher price. This is known in the investment world as “greater fool” investing, and unfortunately one cannot count on the “greater fools” being there when you need them.

Well, you say, let’s not pick on Nvidia. How about Apple? It looks better. Price to sales is only 7.7X, far lower than Nvidia’s 38X. Apple also has an impressive 175% ROE, driven up by share repurchases that have reduced equity. But here is the rub. You are currently paying 48X book value. If you bought at book value, you would get 100% of the ROE. But because you paid so much, your share of the ROE is only 2.7%. That is less than what a treasury bill or bond is currently paying.

Is there another way to look at this given the share repurchase distortions in equity? Yes, we can look at return on investment (long term investment plus long term debt). For Apple, that is currently about 67% per year. The multiple you are paying today on investment capital is about 21X. Your share of the return on assets and debt is thus 3.1%.

The iron law of investment mathematics is that the higher the price you pay, the more you are capitalizing the future return and paying it to the seller. The lower the price you pay, the more of the future return you will yourself receive, whatever that return is. There is no escaping this reality.

Earnings

… Of particular concern to us at the moment is the quality of earnings. Given the length of this report, we will not discuss all the myriad ways that premier companies seem to us to be manipulating earnings, but depreciation adjustments, unsustainable layoffs, employee share compensation, and stock buybacks are just some of them.

Share Buybacks

Buybacks obscure how much of earnings are going to employees rather than owners, increase reported return on equity, and support share prices. Apple had a huge cash hoard set aside for this purpose, 28% of market capitalization in 2016, now reduced to 1.7%. Microsoft, an AI leader, reported a first quarter year-over-year free cash flow growth of -11%. Including stock-based compensation (which is understated) reduced this to -15%. Meta reported first quarter year-over-year free cash flow growth of -17%. With its stock-based compensation up 22%, adjusted free cash flow fell 33%. For the trailing 12 months, free cash flow was -80%. Amazon has no free cash flow, but it would be even more negative with stock-based compensation….

Projected AI Revenues and Earnings Growth

At this stage, it is impossible to forecast the growth of AI or how long it will take to realize the financial gains…. It is not an easy path even for eventual technology winners. Apple nearly went bankrupt in the 1990s. Its stock fell 50.5% in 1995, 71.1% in 2000, 34.6% in 2003 (2000 and 2003 single bear market), 56.9% in 2008, and 26.4% in 2022. Apple is now the best performing stock of all-time, but investors had to choose it among many other plausible tech stocks that failed and then patiently wait through all the setbacks.

Venture Capital and IPOs

Venture capital in general is not validating the current tech rally. It is still in the deep doldrums, with many promising companies dying from lack of funding…. IPOs are also very much in the doldrums and thus have not validated the current tech rally.

Inflation

We predicted the re-emergence of inflation in 2022 and also that it would subside, which it has.  We noted that it might subside all the way to 2%, where the Fed wants it, but if so, it would surprise most people by heading back up again, either for a few months or for a longer period.

The last reported annual figure of 3% will be hard to reduce in July because July 2022 was flat. This means that any reported inflation in July 2023 will increase the 3%....

Banking

The general perception that the banking crisis is over is not accurate. Government guarantees for uninsured deposits represented a giant step that made banks even more a department of the government, but many banks are still in poor financial condition…. Ironically, the “bank” in worst financial condition is the Fed itself which, by earning 2% and paying out 5%, has made itself technically insolvent. The Treasury ultimately stands behind the Fed’s losses, so a promissory note to the Treasury is deemed sufficient to plug the gap.

Financial Fragility

Pressures continue to build. The Fed reports that as many as 37% of US businesses are struggling to pay their debt, much of it variable or fixed with a near term maturity. “Private credit” is now all the rage on Wall Street and among institutional investors. The former will likely be the only winners. One “attractive” feature is that, as the name implies, it is private. Much can be covered up for the moment, including bogus financial reporting….

Market returns follow a Paretian, not a Gaussian pattern. This means there are “fat tails” of deflation or inflation. An investor unprepared for such gales can easily be knocked out of the game, especially if invested in only a few stocks, or worse, loaded with leverage.

Investors who can stay in the game usually do well over time. Those who lose large sums or, worse, everything may never recover. If you are down 100% or more (usually because of debt), there may be no second chance. Warren Buffett had two partners in the early days, one who took on a lot of debt, one who did not. Only the partner without much debt survived to become a billionaire.

Given these realities, we always maintain deflation and inflation hedges. We expand or contract them based on the risks we see. At the moment, we remain cautious.

The stocks we pick are always of good financial quality, without excessive debt, capable of surviving rough times, located anywhere in the world, and once we buy them, we tend to hold them for a long period of time. We do not buy a stock with the expectation of holding it a short time or buy something overpriced with the hope of selling to a “greater fool.” Our core portfolios are highly diversified. Our “special situation” portfolios are much less so. The ratio of the two will also change based on our outlook.

Emotion moves markets in the short run. In the long run, financial facts prevail.