2024 has continued the trends of where 2023 left off. The growth rate of inflation has continued to slowly come down, the economy has remained steady, and the financial markets have put in a string of five quarters of gains. The biggest performers have been companies linked to AI (Artificial Intelligence) with the disruptive potential to transform entire industries and usher in an era of higher productivity for both the U.S. and world economy. While we are excited about the potential of AI, we are increasingly concerned about near term risk we see facing the financial markets. In this commentary, we will address the near-term valuation, concentration, financial, and geo-political risks that concern us.
The first financial risk we see is market valuation. We like to buy stocks when they are on sale. Currently, stocks are not on sale. Perhaps the most widely tracked measure of valuation is the P/E (price/earnings) ratio. The average historical P/E for the financial markets is 16, meaning that a company that made $1 in earnings would be priced at $16. Using forward earnings (earnings projected for the year ahead) the S&P 500 (the most widely used equity benchmark) is currently trading at a trailing price-to-earnings (PE) ratio of about 22, according to recent work from Citi. That lands in the 92nd percentile for the S&P's typical valuation over the last 20 years. As of the end of January, the trailing (using current year earnings) P/E on the S&P 500 was at 32x earnings, or 1.5 standard deviations above normal.
Another valuation measure we like to track is a tool developed by Warren Buffet. Warren Buffet takes the GDP (Gross Domestic Product) of a country and divides it by that country’s total stock market capitalization. A valuation that is 70-90% of that country’s GDP is considered to be attractively priced (the stock market is worth less than the country’s GDP). A valuation above 120% is considered to be overpriced. Currently, the U.S. stock market is worth 160% more than the GDP. The mean since 1970 has been just under 84%.
Concentration is another financial risk we see. The S&P 500 is more concentrated than it has ever been. Goldman Sachs reports that over the last 35 years, the average weight of top 10 stocks in the S&P 500 index has been 20% (meaning the biggest 10 stocks comprised 20% of the whole market). During the dot.com bubble, the combined weight of the top 10 stocks peaked at 25%. At present, the figure stands at 32%. Most of the concentration is in the technology sector. Standard and Poor’s which creates the S&P 500 index list technology stocks at 29.8% of their benchmark. During the dot.com bubble Standard and Poor’s received criticism because the technology sector in the S&P 500 grew to over 40% of benchmark which was far greater than technology’s contribution to the U.S. economy. This over concentration in technology did not reflect the actual U.S. economy and exposed investors to losses when technology stocks dropped at the turn of the century. Today, what concerns us is that Standard and Poor’s has reclassified many companies sector allocation, and in our view masking the benchmark’s true technology concentration. For example, Amazon, which gets 80% of their earnings from Amazon Web Services, is listed as a Consumer Discretionary company. Alphabet, parent company of Google, as well as Meta (Facebook), two of the leading and most recognized artificial intelligence technology companies are classified as Communications stocks. By our calculations, if Standard and Poor’s were to classify companies such as Amazon, Alphabet (Google), Meta, etc. back as technology companies (which we not only think should be classified as technology companies but also do classify as technology companies on your individual Advent reports), the S&P 500 sector weight in technology would be well over 40%, just as it was during the dot.com bubble. In comparison, Statistica group reports the United States tech sector contributed nearly $2 trillion dollars to the country's overall gross domestic product (GDP), making up approximately 9.3 percent of total GDP. Thus, the S&P 500 benchmark has well over a four times weighting in technology stocks vs the actual Gross Domestic Product (GDP) weight in the actual economy.
Meanwhile, the country’s financial risk continues to grow, regardless of which political party has been in power. Bank of America recently reported that the U.S. debt is now growing at an alarming rate of roughly $1 trillion dollars every 100 days. The published U.S. debt stands at $34.6 trillion, and the Congressional Budget Office reports the U.S. debt to GDP approaching 120%. This is important because anything above 100% is considered by economists to be a red flag. In fact, the main reason the U.S. was able to recover quickly from both the financial crises and COVID was because the U.S. was able to deploy large sums of financial resources to stimulate the economy. Japanese financial markets are just now recovering from the Financial Crises, and Europe has still not recovered from the dual hit of the financial crisis and COVID. As the country’s debt continues to build, future policy maker’s options to deal with a crisis will be much more limited. Back at the end of WWII, the last time debt approached these levels, that generation cut spending, ran balanced budgets and returned the country back to solid financial ground. Today, no one is projecting the debt to get any better any time soon. The CBO (Congressional Budget Office), reports that Medicare and Social Security, two of the biggest users of government dollars, show that the present value of both programs are both underfunded by trillions of dollars, while defense, the biggest item on the government spending list, is hard to see any cuts in the near future given current geo-political headwinds the country faces.
On the geo-political front, we see problems in Europe, the Middle East, and Asia. For this commentary, we will focus on what we see as the most pressing issues for the financial markets which we see as the Middle East and China. In the Middle East, the conflict between Israel and Hamas has the potential to expand. Iran has stated that they want to destroy the state of Israel, and Israel has stated that they will never allow Iran to get nuclear weapons. The Pentagon has stated that Iran is close to developing nuclear weapons. Iran also has missiles that can hit Israel. These very missiles have been demonstrated by Russia in its war against Ukraine and in Iranian strikes vs Syria. However, Israel has its own strong nuclear deterrent, and getting past Israel’s air defense would prove challenging for Iran.
Hamas and Hezbollah are important because they are proxies for Iran, both of which are dependent on Iran for funding and weapons. In order for Iran to attack Israel, it must use Hamas and Hezbollah because Iran would otherwise have to go thru some combination of multiple countries including Iraq, Syria, Saudi Arabia, Jordan or Turkey to reach Israel. None of those countries would give Iran permission to do so. Moreover, the Iranian Air Force is not strong enough to challenge Israel in the air. Given Hamas’ surprise attack on Israel, Israel will finish off Hamas. Last October, Sharren Haskel, who is also the former Deputy Speaker of the Israeli Parliament, said, "We need to cut off the head of the snake and that is Iran." However, if Israel decides to attack Iran, they will most likely need to attack Hezbollah first, so as not to have to fight a two front war. If this happens, we believe it would signal Israel’s intention to attack Iran and we believe it would cause oil prices to rise which would cause inflation to rise, which in turn will push out the Federal Reserves expected interest rate cuts, which would cause U.S. markets to sell off. This is also why oil prices spiked after Israel killed a top Iranian general in Hezbollah controlled territory in early April.
Another geo-political headwind is China. China’s growth over the last twenty years has been spectacular and now is the number two economy in the World. China’s growth has helped to spur global economic growth. However, under President Xi, China has decoupled from the West and has become increasingly authoritarian and aggressive with its neighbors. China has claimed the South China Sea as Chinese land and built military bases to defend it. In addition, China has also engaged in border disputes with India, Pakistan, and the Philippines while it also has stated it wants to be in a position to take back Taiwan by military force by 2027. Moreover, the amount of debt and bank loans in China has sky rocketed even while the Chinese real estate market, which is 30% of the Chinese economy, has begun to crack with the two largest Chinese developers defaulting on half a trillion dollars’ worth of loans. Chinese bank loans are now over 2.5 times larger than the U.S. despite the U.S. being a larger economy.
Stocks in China and Hong Kong have also sold off a massive $4.8 trillion in market capitalization since 2021, which according to HSBC, is more than the value of the Indian stock market. Mainland China’s CSI 300 index has fallen for three straight years, closing out with declines of 11.4% last year. Hong Kong’s Hang Seng index performed even worse, with 2023 as its fourth consecutive decline ending the year 13.8% lower. In the near term, we believe China will not contribute to global economic growth at the rate it has in the past. This will also affect 8 U.S. multi-national companies. The average S&P 500 stock gets half of its revenue overseas. U.S. companies such as Apple and Tesla, both which get roughly 20% of their sales from China have already seen a sharp slowdown. Longer term the bigger issue is whether China stays on its current authoritarian course. While we are confident in the Chinese people’s innovation and work ethic, we are concerned under President Xi, China looks more like a competitor than an ally.
While there are plenty of things that could go wrong and valuations are high, we do not think the market is headed for a 2009 or COVID type sell off. We do think a normal correction is likely. The reasons we say this are that election years are usually positive years in the market, with 20 out of the last 24 election years showing market gains.
The other reason we say that we are looking only for a normal market correction is that money market funds now total over $6 trillion dollars, an all-time high! If we did get a major geo-political event, or an economic contraction, the Federal Reserve would likely try to intervene by cutting interest rates to increase liquidity and get the economy moving again. This has been their standard playbook and it worked well during COVID and the Financial Crisis. So, if the Federal Reserve Bank did lower interest rates in response to an event or economic slowdown, the current $6 trillion dollars in money market funds currently earning rates close to 5% would quickly be reduced and the holders of those funds would be forced to redeploy those assets into high dividend paying stocks if they wanted to get a return on their money as interest rates drop. This corresponding buy power would act as a support to the stock market.
In conclusion, the last five quarters have seen strong stock market gains, but we are now seeing issues that concern us. Equity valuations have risen, the stock market is increasingly concentrated in just one sector, and the U.S. governments ability to come to the rescue in a future crisis has been diminished due to the governments growing debt load. However, we think the large amount of cash on the sidelines in money market accounts will help cushion any market sell-off. As a result, we continue to favor large capitalization, brand name equities who are providing goods and services that consumers and businesses need on a daily basis and who are returning cash back to investors as the best risk adjusted returns.
Thank you for your continued support.
Sincerely,
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