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Past Commentaries

12/21/2023

Current Commentary

To My Clients, Friends & Observers:

The Truth Will Set You Free

Most of my time is spent reading information. Call it paying attention. Filtering out propaganda and crowd noise still leaves a lot of inconclusive indicators. And the shear volume of data can be overwhelming, leaving one with the gnawing question, “what am I not seeing?” This is not to anticipate events, it’s to make sure that we are doing the right things, timely, to follow the system.

Jeff Kleintop, Schwab’s Chief Global Investment Strategist, was recently asked how to verify economic data reported by the Chinese Communist Party. He said one of the most reliable sources was measurement of industrial emissions into the atmosphere which are monitored by various U.S. agencies. Another measure is the number of outbound container ships. U.S. companies operating in China can reveal economic conditions there.

The stock market does not coincide or coordinate with economic indicators. It anticipates. One of the takeaways from a recent call with Liz Ann Sonders, Schwab’s Chief Investment Strategist, is that “the very unique pandemic economic cycle warrants a more nuanced approach to analyzing recession indicators.” Nuanced indeed. We are still recovering from the seismic dislocations of the pandemic and responses to it, particularly the tsunami of money sloshing around in the economy (all bought on the national credit card).

December is historically the best month of the year for the market. We have finally recovered to the 2022 S&P 500 high close just under 4,800 in December 2021. In 2022 the Index fell almost 20%. Is this a Santa Claus rally? Animal spirits? Year-end window dressing? Anticipation of the presidential election year (generally a very positive year regardless of the outcome)? Is it because the Fed has declared an end to rate hikes? How about the recession that has yet to appear?

Leading economic indicators plunged to 29 in October; roughly coincident indicators fell to 50; lagging indicators remained at 50. (American Institute for Economic Research) The yield curve is still negative, predicting a recession.

Analysts’ expectations of 4th quarter corporate earnings are being downgraded, frankly surprising me somewhat. The predominant pattern of 3rd quarter earnings has been net income (profits) up, revenues (sales) down. This reflects corporations raising prices as inflationary costs took hold. Now consumers are not buying as much, reflecting their own weakening finances. Credit card balances and credit card defaults have increased.

As of September 30th, over 60% of S&P 500 companies had not recovered half of their 2022 declines. As of November more than half of all (tech heavy) NASDAQ constituents were still down 50% or more from their 2021 highs (source JP Morgan). This reflects the severity of the 2022 correction.

And according to Sonders, 31% of the Russell 2000 Index of small cap companies are zombies. Zombies are companies which do not have enough cash flow to pay their debt service. This shows the impact of interest rate hikes and is another recession predictor.

I conclude that the market rally is a manifestation of animal spirits – the market does not like to stay down for very long periods, seasonality, and anticipation of a positive 2024. It also is driven by a presumption that the Fed will cut interest rates 5 times in ’24. However, a Fed pause is not a Fed pivot and I would be surprised to see more than 3 cuts. Interest rates are going to stay higher for a long time in my opinion.

But what would 5 cuts look like anyway? A Fed funds rate of 5.25% dropping .25% 5 times to settle at 4% - a reasonable, even normal, Fed Funds rate. There seems to be a consensus for 3% by ’26.

My own opinion is that – barring some extraordinary calamity – 2024 will be a positive year in the markets, with 3 rate cuts, significant positive returns from fixed income, and high single-digit returns. Welcome back, balanced portfolios.

Stocks do not appear cheap at 26 times earnings (and earnings are declining) and a dividend yield of 1.45%. However, Price/Free cash flow ratios have been very strong and free cash flow as a percent of sales has doubled to over 10% in the last few years.

Knowing Where to Look

There are three phases to technological revolutions.

  1. Discovery, invention, and start-up
  2. Application and adoption
  3. Proliferation, acceptance, standardization of a new paradigm

Artificial intelligence (AI) has been developing for 20 years and it has grown as searchable data and processor speeds have grown and probably at the same exponential rate. The anticipation of an AI revolution is largely driving tech stock prices. It’s still in phase 2. I question its ability to predominate human capabilities. Too often, when confronted with a tech problem, or a credit card or bank issue, the only effective resolution is to communicate with another human being who cares enough to resolve the problem. Further, the last tech revolution was blockchain, and then cryptocurrency – which relies on blockchain technology. Why then do I keep reading of cryptocurrency hacks and thefts?

Regardless, AI is here to stay and its application is driving the need for better and faster chips and increasingly adaptive software. In 2022 the capital expenditure for AI infrastructure was $40 billion. It is predicted to be $390 billion in 2027 (CFRA Research). Our system always overweights 4 of the 11 S&P 500 sectors: Industrials, Finance, Technology and Utilities. Tech is the heaviest weighting in our aggregate presently. A sample of companies I’m interested in are Broadcom, Micron Tech, Nvidia in chips; Lam Research and Applied Materials in fabs; Microsoft and IBM in software as a service (SAS); and Oracle, Amazon, and Alphabet in the broader applications markets (advertising, AI, cloud). By the way, digital advertising in 2023 exceeded 70% of total ad spending – a new record.

I want portfolios to have P/E ratios lower than the S&P 500 Index, so investing in high P/E companies like these has to be rationalized. Nvidia at 65 time earnings looks pricey but this is an exceptionally profitable company that has consistently doubled its revenues and earnings, and is actually accelerating its cycle time between new generations of chips. To mitigate its effect on portfolio P/E, I will position less. But it’s a core holding.

Sustainable Withdrawal Rates

In October I attended an excellent lecture by Michael Kitces, a retirement planning expert, on Sequence of Returns and Sustainable Withdrawal Rates (for 30 years) in retirement. I share some of the salient points.

A ½% increase/decrease in inflation will reduce/gain portfolio life by 9 years. Please note that the Brae Head, Inc. first principle and value proposition is “to grow and protect purchasing power over time.”

From 1969 through 1999 the market returned 13.4%, but inflation was 5.3%. Real return was 8.1%. A 60/40 balanced portfolio average return was 11.5%.

From 1966 to 1980 the real return, inflation adjusted, was ZERO. 15 years, no growth. Imagine being retired in those circumstances.

The stock market will keep up with inflation over time as corporations pass cost increases on to their customers. If a portfolio is balanced between market assets and fixed income securities a current initial withdrawal rate of 5% would be prudent start, using 6% as a ceiling and 4% as a floor, varying with market returns and household expenditures. He recommends budgeting expenditures in two buckets: one for essentials and one for discretion.

His model used a 15 year average market return as a base, and historical P/E ratios compared to subsequent returns. One particular slide was disturbing in that regard: investing at a historically high P/E ratio at initial withdrawal of 4% resulted in a complete portfolio exhaustion in less than 30 years, 100% of the time. Address the sequence of returns and withdrawals cautiously.

Wishing you all a world full of love in 2024.
Peace,

Dennis M. O’Connor