Second Quarter 2024 Client Newsletter
Mid-Year Political Update
Republicans
The national political cycle is ever-expanding. Once upon a time, campaigning for the general election didn’t begin in earnest until the fall. Now, we’re tracking real-time political drama in the markets in mid-July. I can’t say it’s completely welcome, but I suppose it can be entertaining in a masochistic way.
After the first presidential debate, markets woke up to the realization that the summer is the new fall for political drama. Odds of a Trump presidency surged (blue line) from about 50% to 69% from June 10th to July 15th. It’s interesting to see what moved in sympathy, though many of the moves have since faded.
Solar stocks (purple) fell 30% as government-led subsidization programs seemed threatened. Corn (light green) fell 14% as the outlook for a renewed trade war with China brought back nightmares of falling exports. To be fair, grains also have an underlying supply problem depressing their prices.
Tesla’s stock (green) vaulted nearly 50%, as a more protectionist foreign policy might help drive the company to National EV Champion status—the budding Musk/Trump bromance doesn’t hurt either. The long-end of the treasury curve rose in relation to short-term rates (red), which indicates market pricing for higher inflation, stronger economic growth, and persistently wide deficits.
Analysts and forecasters are still eagerly awaiting details about the policies a Trump 2.0 administration would pursue. The aims are still somewhat generic – cut corporate taxes to 15% and fund the resulting fiscal deficit with tariffs. Reduce regulations to spur growth. And promote energy production. Here’s the direct excerpt from the Economics section of the new GOP Platform.
The prospect of a dramatic increase in tariffs makes market participants nervous. We haven’t heard much new news about prospective trade war targets or the intended levies. The initial indications were for a much broader and much more extreme program compared to the 2018/2019 experience. For now, the collective wisdom/wishful thinking is that Mr. Trump's style, as we’ve all seen, is to start big and loud before returning to something that resembles reasonability.
Interestingly, freight rates for global containerships are spiking again. Some attribute the rise to businesses looking to front-run tariffs that might be imposed in Trade War 2.0.
We eagerly await more granularity on the other initiatives. Much is being made of VP candidate Vance's speech at the RNC, as many of his inferred principles fly in the face of what we’d once have called established GOP policy. It’s unclear how much weight Vance’s opinions would truly carry in the prospective Trump administration.
One thing we can be sure of, though, is that if Mr. Trump wins, the daily market schedule will look something like this for the next four years: market-moving events with a specific time alongside an always-pending understanding that Trump will speak at some point in the day.
Democrats
Oh, my, what can we say about the Democrats?
When I first sat down to write this note, the Biden section was absurdly short, as his candidacy was already on the ropes. But, in the waning hours of his candidacy, it was noteworthy that he tacked left – floating the idea of capping shelter rental rates, which would need legislative approval, and doubling down on potential export curbs for chipmaking machinery headed to China.
Now that VP Harris has assumed the role of presidential candidate, the deck has been shuffled. In the coming weeks we’ll learn more about how she’ll position herself. She’s inextricably linked to Biden’s economic record (you probably think that’s a good thing, or not... and you’re right), a fact that may push her to campaign to focus on social policy differences between her and Trump. That could be good news – ‘don’t rock the boat’ isn’t such a bad policy from the market’s perspective.
The most important graphic for her campaign is the one that ultimately forced Biden out of his run. The chart below is a look at the battleground states. As of July 19th, Trump had a lead in every swing state except for Maine.
National polling already shows a return to a dead-heat race within the margin of error, yet polling in the handful of battleground states above is the most sought-after data right now.
The Merry Ol’ Land of Oz
I absolutely love tortured metaphors. It’s so satisfying when a piece of pop culture or the arts conforms to the state of play in markets or the economy.
When it was recently announced that consumer prices fell in the month of June, I started to sing (in my head) ‘Ding Dong the Witch is Dead’ from The Wizard of Oz. From there, the wheels kept turning, and I think the parallels are shockingly coherent.
For more than three years, the markets have been obsessed with inflation data. Every month, we get reports on consumer and producer prices from the Census Bureau, the Bureau of Labor Statistics, the Institute for Supply Management, Standard and Poor's, Regional Federal Reserve Banks, the University of Michigan, and maybe seven or eight other sources that I don’t care to name. These data have received an existential level of attention.
The chart below plots the increase in consumer prices over 12 and 3-month periods. When the blue line is below the red, inflation is falling at an increasing rate. It speaks for itself, and it’s good news.
Progress on an annual basis recently stalled at around 3%, though short-term momentum has again begun to drag prices lower. Let’s review the internals of the index to see which components are driving prices lower.
The price for a basket of physical goods in the US has been falling since the surge of spending in 2021 subsided. Note that short-term progress has stalled (blue bar above the red line), yet on an annual basis, goods are deflating at a -4.1% annual rate. That’s good news for consumers and for the outlook for prices.
When it comes to services, there are still pockets of rapid inflation—auto insurance has been a particular sore spot this year. But the big surprise for June was the deceleration in shelter costs—a development that economists have anxiously awaited.
Below is the monthly contribution of Core Services to CPI. Shelter costs are in orange. You’ll note that shelter inflation has returned to a pre-pandemic rate of expansion. And that reversion to normal was enough to drive the headline index down -0.1 % from May to June!
You read that right… housing inflation fell. And crushed the Wicked Witch of Inflation. Does something like the picture below come to mind?
Okay, I’m sure some folks would quibble with the assertion that inflation is ‘undeniably and reliably’ dead. Prices are up 21% since the end of 2019, and headline inflation is still running at 3.0% year over year—higher than the Fed’s stated 2.0% objective.
I’m sympathetic to that view, but the momentum is to the downside, so let’s play along with the narrative that the Wicked Witch of the East (Inflation) is dead. Good news!
The Wicked Witch of the East’s character in the movie isn’t around long. However, if she were the embodiment of inflation, we can all see why the munchkins were so happy when she died. After all, inflation inflicts great economic hardship on societies.
Unfortunately, though, sometimes the process of killing inflation can suddenly awaken the true antagonist of economic prosperity—recessions. In our story, that role is, of course, played by The Wicked Witch of the West, who appears almost instantly as her sister meets her end.
Surveys of economic activity in the goods/services sectors are signaling contraction. Manufacturing is a notoriously cyclical industry. After expanding at a record pace in 2021, it has since spent the last two years in contraction/stagnation. The services economy, on the other hand, very rarely contracts – though it is right now.
The Citi Economic Surprise Index is also signaling a deterioration in economic data. The measure looks at the relative level of data compared to economic forecasters’ estimates. Readings under 0 indicate that data is underperforming expectations. Note that we’ve seen far worse readings in the past and not sustained a recession.
At this point, it’s fair to say that economic data has deteriorated from ‘good’ to ‘okay’—something to keep an eye on.
Survey and sentiment data are helpful gauges of underlying momentum; it's the labor market where the economic rubber meets the road.
Particularly negative commentators will point out that when the unemployment rate increases by more than 0.5%, it typically moves dramatically higher. That fact owes itself to the economy's interconnectedness: once an industry’s activity slows enough to cause layoffs, those laid-off workers suddenly have less spending power, which leads to a slowdown in revenues for a successive industry, and the dominoes continue to fall from there.
While going from 3.5% to 4.1% unemployment is statistically significant for some folks, it’s tough to call it an indication that the labor market is spiraling out of control. After all, 4.1% is still much better than the classical definition of ‘full employment.’ Still, it’s something to watch.
Our friend Dr. Ed Yardeni likes to say that recessions don’t happen on their own—they require a credit crunch to trigger them. Let’s review the prospect of stress in credit conditions.
Companies that issued low fixed-rate debt during the pandemic have been insulated from the restrictive rate environment of the past two years—but when it comes time to refinance maturing debt, their interest expense will jump. Stressed companies (BB and B-rated companies) make up an increasing share of maturities in 2025 and 2026. If rates remain high, refinancing could mean a significant degradation to their economic position.
Having spent all their pandemic savings, consumers are starting to feel a cash crunch. Credit card issuers have reported a spike in card utilization and a full return to pre-pandemic default/charge-off rates.
Economic growth remains resilient, driven by consumers who are employed, able to borrow, and willing to spend. Potential credit stress risks are present, but lower interest rates would go a long way toward mitigating them.
Picture Dorothy and her friends skipping down the yellow brick road, aware of the looming threat of the Wicked Witch, but well on their way to the Wizard of Oz to seek assistance. The soundtrack you’re looking for is ‘We’re out of the woods.’
So, on they go to meet The Wizard of Oz, an enigmatic figure operating an institution shrouded in secrecy. Have you ever heard a better description of a central banker? I asked DeepAI to show me what it would look like if Powell were the Wizard of Oz. And the result was perfect, if not a little on the nose. The man is the institution.
If inflation is dead and over, rate cuts should soon be underway. Given recent messaging, it looks increasingly likely the Federal Reserve will cut two times (0.25% each) in the remainder of 2024—once in September and once in December. The outlook from there gets murky; here’s where The Wall Street Journal’s survey respondents expect the federal funds rate to be in six-month intervals.
The most dovish economist expects the policy rate to be halved by June of next year, while the most hawkish forecaster sees a mere one cut. That abnormally wide spread of forecasts persists all the way through 2027 and is indicative of heightened uncertainty about the path of monetary policy.
From where we sit, lower rates would be very welcomed by all the entities mentioned above. Mitigating the maturity wall for corporations would keep companies investing and expanding. Arresting runaway borrowing costs for the U.S. Government could keep Congress from addressing fiscal imbalances with austerity measures. Lower consumer borrowing costs would allow for continued spending. And fewer options for interest income would go a long way to justifying exuberance in the financial markets (more on that in a moment).
This is where we hope the Oz metaphor ends. In the movie, the Wizard turns out to be a feckless fraud who is unable to prevent the Wicked Witch from dispatching her flying monkeys and harassing Dorothy (and her little dog, too). Clearly, that outcome would be analogous to an economic downturn.
All eyes are on The Great and Powerful Powell.
Price is what you pay. Value is what you get. (Warren Buffet)
Buying a stock is inherently exciting – getting to join a financial fan club for a company you think has great promise is fun! Sometimes, that stock will exhibit trading characteristics that are entirely unique to its financial situation. Other times, your precious stock will simply be another boat being tossed about by the rising and falling tides of the broader market. In the market’s brutal popularity contest, understanding the investing environment can be just as important as knowing what you own.
Stock prices go up when corporate profits grow or when investors are willing to pay more for a company’s profits. These two forces usually work in unison—it makes good sense that stock prices should go up when a company becomes more profitable.
At times, investors are feverishly positive about the future and are willing to pay more for a stock despite stagnant or falling earnings. Other times, they’re so depressed that they won’t buy, no matter how much profits are expanding.
Our analysis below plots the annual long-term growth rate for corporate earnings against the price fluctuations of an index of stocks. When the red line is above the blue, prices are going up faster than profits. Conversely, when the blue is above the red, corporate earnings are outpacing stock market returns. It’s a lot to look at, but we find it fascinating to review the rewarding and punishing nature of different investing eras.
Interestingly, the two figures average out to about the same annual rate: 4.8% average annual stock price return and 4.1% average annual corporate earnings growth. It makes me happy that they’re about the same—in the long term, the price of the market should be a product of the profits produced. However, in shorter time periods, deviations from that rule are constantly developing.
Note the gap between stock price appreciation and earnings growth since 2015. That gap indicates that stock prices have been going up faster than earnings, resulting in a more expensive market. Let’s verify that with the Price/Earnings (P/E) ratio.
An oversimplified P/E rule of thumb is to think of it as the years in which it will take you to recoup your investment (see me after class for the accurate math). For example, if you buy a share of stock for $100, and that company has $1.00 in earnings, you’ve purchased that stock for 100 times earnings. So, you’ll need that company to earn $1 every year for the next 100 years to recoup your investment. That’s a lot of years!
Luckily, the S&P 500 is not trading at 100x. 
While 24x is less than 100x, it’s not exactly on the cheap side of history. Note that the other experiences of such valuation excess came during the Dot-Com Bubble and the stimulus-fueled aftermath of the COVID-19 pandemic.
The regression charts below show how investors did after buying stocks at different valuations. The starting valuation is plotted on the x-axis, while the subsequent forward return is on the y-axis.
The left chart shows subsequent returns one year forward, and as you can see, the relationship between valuation/performance is scattered. Buying the market around 21x has produced almost the same number of +20% returns as -20% returns. Over such a short timeframe, it’s not a very reliable relationship.
But, once you zoom out to the 5-year horizon (right chart), the relationship between valuation and forward returns tightens up considerably. Interestingly, the more expensive the starting point, the more predictable the relationship gets. Buying the market >23x has never yielded a positive annualized return over a 5-year horizon.
History is only a guide, but no matter how you slice it, this market is expensive.
Another way to think about the value of the market is to invert the P/E calculation to generate an earnings yield. By doing that, you can then compare the value of the market versus other yield-based alternatives, such as a two-year treasury bond, as we’ve done below.
Remember, earnings for the S&P 500 are variable and never certain, while a treasury yield is effectively guaranteed. Typically, you should expect to be more highly compensated for holding a riskier set of expected cash flows. But that’s not the case right now.
Unsurprisingly, the Dot Com Bubble was the last time the two-year treasury yield exceeded the S&P 500 earnings yield by such a wide margin. However, the spread did continue to widen before the bubble eventually popped and the Fed cut interest rates.
This time around, investors are imagining a world where rates suddenly go back to 2.0% and stocks become the only game in town. The disconnect in that thesis is that historically, when rates fall dramatically, it’s in response to economic disruption.
After producing the long-term study at the outset of this section, we became curious about how those dynamics were playing out within the S&P 500 this year. We had a presupposition, but we wanted to verify it. So, we segmented the S&P 500 into Cheap and Expensive buckets by evaluating three different valuation measures versus the index: Price/Earnings, Price/Sales, and Enterprise Value/EBITDA. Members of each basket were equally weighted to mitigate market and sector concentration concerns. Here are some summary statistics about each group.
So, Expensive stocks are growing about 80% faster and are valued about 120% more richly compared to their Cheap peers. While it’s not unusual for growth stocks to trade at premium valuations, it is noteworthy that they’ve outperformed so much, especially given relatively small growth differentials.
Here’s how the valuation baskets have performed thus far in 2024.
Other than for a few fleeting moments at the beginning of the year, 2024 has been all about chasing the most expensive stocks – a 5x performance gap. It’s an eye-popping dispersion between investor preferences. If the conventional wisdom is to ‘buy low and sell high,’ this phenomenon is akin to ‘buying high to sell higher.’ It’s a strategy that has periodically worked throughout history, and I’m not bold enough to predict when the flavor of the month/quarter/year will change. But it’s always worth noting extremes in markets.
Luckily, as an active manager, we’re not constrained to adhere to specific growth/value factors. In our mission to produce attractive risk-adjusted returns, we have the freedom to take advantage of value/growth equities, bonds, cash, or commodities. And we’re looking forward to the opportunities and challenges ahead in the second half of the year.
We’re here to keep the conversation going; please let us know what you think and if you have any questions!