September 27, 2023

Legendary investor, Robert Arnott, defines a stock bubble as a stock that is trading at impossible growth assumptions and the next investor in the stock is unconcerned with the fundamentals of the company. I bring up bubbles because many would say the NASDAQ 100 stock index (heavy in technology stock) is in bubble range as it is up +33% year-to-date, even though it has declined for the last several weeks. For example, the valuation of artificial intelligence darling stock NVIDIA is trading at an implausible 33 times sales. For comparison, other quality companies, such as APPLE, are trading at a mere 7 times sales, while a very large bank, J.P. Morgan, is trading at 3 times sales.

Corporations have seemingly kept their profit figures growing but with costs continuing to rise, profit margins are being squeezed. Many analysts have shown that the quality of earnings has declined—meaning companies are keeping those earnings high through legitimate financial engineering. I say legitimate because while the practice is perfectly legal and within GAAP accounting procedures, it is a more aggressive strategy, especially given the large and growing discrepancy between reported earnings and cash flows. In addition, the dollar continues to strengthen, and oil has increased 35% over the past several months, helping keep inflation stubbornly high. Leading economic indicators have been running negative for the past 14 months while the FED has increased interest rates five full percentage points with possibly another to come. For the math whiz reading this, the 'base effects' distortion of inflation coming down so rapidly in the first eight to nine months of 2023, results, as much as anything, from lower inflation in the latter part of 2022. Thus, each 12-month look-back period showed lower inflation in 2023. Such positive comparisons for the remainder of this year will be harder to come by, and our view is that inflation will persist at heightened levels longer than many believe. Lastly, government deficits now running close to 3% of GDP have led to another credit ratings downgrade, this time by the Fitch bond rating service, and a possible government shutdown looms.

There are plenty of headlines that would seem to fly in the face of why growth stocks in general should be up 33%+ this year when much of their earnings growth is in the future, and interest rates will not return to the 2-3% range for years, if ever, for corporate borrowing. And we're not actually negative on the future! In fact, we're delighted with the amount and variety of new technologies, medical therapies, and innovations that are coming, and we believe these will be enormously beneficial to the economy, workers and organizations. But it all takes time to get there, just as the dot-com hype from the late 1990s developed 15 or more years later into a smartphone where I can now watch football games! The glass is not half-empty, it’s half-full; but certain sectors of the market seem to be trading unconnected with their fundamentals, a situation for those stocks that almost always leads to a bad outcome.

The economic highlight has been the resilience of the labor market, where unemployment has barely ticked up to 3.8%, even with much higher interest rates. Such higher rates are good news for savers as the amount of potential interest to be earned dwarfs the cost of interest paid by borrowers. We’ve all heard stories about those with massive credit card, student loans, or other strangling debts. But across the entire country, there are over $15 trillion in bank deposits alone, while the total of all revolving debt, auto loans and any other non-mortgage borrowings is under $7 trillion. The FED has committed to keeping interest rates higher for longer, until inflation is firmly within its 2% target. Whether such slowing causes a recession is unknown. To trade on a recession you have to know when it's going to start, how long it's going to last, how deep it will be, and how much of it is already priced into the market, all factors that are unknowable. Thus, we continue to believe in paying close attention to those things that are knowable and that we can control, including paying attention to your budget/cash flow, your borrowing levels, keeping your portfolio widely diversified and maintaining a steady cash cushion. We wish you and your families an enjoyable fall season.