Q1 2024 Commentary
The momentum from 2023 carried through into the first quarter of 2024.
After rallying more than 20% last year, the S&P 500 added another 10% in the last three months alone.
While we found reason in last year’s price action, the latest leg higher must be treated with far more concern and skepticism.
Stocks ended 2023 at steep multiples, which had only briefly proven sustainable in late 2020/early 2021. At that time, high multiples were somewhat justified by an ultra-low interest rate environment buoyed by unprecedented monetary and fiscal economic stimulus. Even if those past multiples proved sustainable on a nominal basis, they still set up markets for double-digit percentage real total return (inflation and dividend adjusted) declines. Those declines were realized in 2022, which was one of the worst years for combined equity and fixed income returns in history – an extremely unrewarding risk/return experience.
The rally to start 2024 has brought stocks back to valuations only seen during the tech bubbles of 2021 and 1998-2000. Equities are above the highest sustainable valuations from both periods. In other words, we are now in territory that has always been followed by losses.
Despite the worrisome comparison, investors are thrilled with the returns and projecting that enthusiasm onto their forward expectations. The AAII sentiment survey of retail investors saw bullishness rise to 50% at the end of the quarter. This is more than one standard deviation above the norm, and while not yet at an extreme, bullish readings this high correlate to above average drawdown risks.
We see similarly high optimism across the spectrum of sentiment surveys, and that optimism is also reflected in household equity allocations. According to the latest Goldman Sachs analysis of Federal Reserve data, households have 48% of their financial assets allocated to equities. That surpasses the levels we saw at the end of 2021, nearly matching the record high equity allocations at the peak of the dotcom bubble.
It is not coincidence, but an unfortunate reality, that those times that investors have chosen to hold the largest percentage of their wealth in equities have been some of the riskiest times to invest in equities, inevitably followed by large losses.
Beyond the mere magnitude of the returns, we see three other contributors to investor optimism: the path of returns, the narrative, and actual profits.
The rally from last October’s lows has been historic, and by some measures, unprecedented. In that 22-week stretch, equities have only seen one weekly decline in excess of 0.5%. That is only the third time in the last fifty years that we have seen a rally with such limited downside volatility. Even among those rare streaks in the past, upside never surpassed 20%. This time around, the S&P rallied 27%. Investors seem optimistic that more of the same lies ahead, and while momentum is a real factor, it is extremely unlikely that markets are able to piece together anything similar to what we have witnessed in the last 100 trading days.
Investor optimism has been buoyed by the financial media. Pundits have presented a fairly unified narrative throughout the first quarter, one that is predicated on falling rates and the potentials of an AI-driven productivity boom.
Today, with ChatGPT and other large language models at our fingertips, we all have a sense of the power of “the next big thing.” The recent (2021) tech bubble was built on a much more amorphous belief that we were on the cusp of a new innovation economy. That broad hope/speculation led to a wide-ranging bubble in well-hyped, but largely profitless companies, including a proliferation in SPACs – assetless shell companies. Today’s market features some of the same blatant speculation that we saw in 2021, but we are seeing significantly more focus on companies tied to a more tangible AI future. Most importantly, attention is falling on companies that are generating profits, such as Nvidia and Supermicro. We will take profitable companies over pure speculation any day, but just as the internet was able to deliver its revolutionary potential in a way that “dotcom” stocks were not, it is quite possible (and in our view, likely) that AI delivers in ways that today’s market optimism cannot match.
The other half of the popular narrative, that 2024 will be a year of falling interest rates led by easing monetary policy, has taken quite a hit. At the beginning of the year, the 10-year treasury yield was below 4% and markets were expecting rate cuts by March. Instead, yields have risen steadily, and rate-cut expectations have been pushed out to the second-half of the year. Even if rates had remained below 4%, there is no historical precedent to justify price multiples this high without interest rates below 1%.
If the popular narrative falters, rates remain high and AI skepticism proves prescient, asset prices could still run significantly higher. Price/Peak earnings multiples surpassed 30x in both 2000 and 2021 (33x and 30x, respectively). At today’s valuations, stock prices could outpace earnings growth by 15-25% before touching those levels.
If we continue to follow the same path as past bubbles, we will see the emergence of false reassurances that “everything is fine.” In 2000 and 2021, multiples peaked before markets and earnings, leading to widespread assertions that companies were “growing into” their valuations. Both bubbles saw the most speculative assets (largely profitless tech) sell off first, transitioning leadership to profitable companies and other sectors. In both instances, relentless bulls pointed to these shifts as signs of market normalization. Unfortunately, these extended markets normalized in a longer, more painful process that involved falling prices.
We could look to these analogies with some optimism, noting that we have not yet seen multiple contraction, but we have seen some evidence of tops among the most speculative assets. If we use the ARK Innovation ETF as a proxy for speculative tech, the sector peaked at the end of December. Market leading, profitable tech companies Nvidia and SuperMicro closed the quarter well off of their highs (-7% and -18%) and have fallen further since. Despite a strong quarter, technology gave up its leadership to communications and energy. This is precisely the type of shift that is lauded for normalization, but could simply be early signs of a stalling rally.
With earnings expected to begin setting new highs later this year, there is a good chance that we see multiple compression without falling prices. Again, we can view this as normalization, and as long as prices are rising we will certainly hear many such claims. Historically, however, while this may be how normalization from high multiples begins, it is not generally how it ends.
Though we remain very wary of high multiples, there has been some mounting evidence over the last decade that we may live in a world of higher sustainable multiples. Even if we do live under a new pricing paradigm, and even if we witness the fruits of an AI driven productivity boom, at today’s multiples, outcomes would have to exceed all historical precedent simply to avoid losses. Hopes of average returns or above-average returns necessitate a significantly better outcome than anything financial markets have ever seen.
Despite all our concerns about equity markets, we feel good about the economic landscape. The labor market is strong. Some of the more concerning data we addressed last quarter has improved (manufacturing data, employment revisions). Inflation is proving to be stubborn, but as noted in past commentaries, markets can perform quite well in inflationary environments, absent significant inflation shocks.
As we have demonstrated throughout the last eight years, expensive markets will not preclude us from making strategic and prudent entries into high-quality stocks. The stable economy, rising earnings and potential upside provide a reasonable setup for maintaining some equity exposure. We continue to allocate about 30% to out of favor high-quality equities across traditional Time Overlay approaches, and we do not anticipate any significant reduction to that level in the foreseeable future.
The cheaper areas of the market remain attractively valued, as do several high-quality names. While we will not chase prices higher, we could add to our positioning on pullbacks.
Robert B. Drach, Drach Advisors LLC