2024 Market Overview
“Opportunities Outside the AI Bubble”
November 1, 2024
The hallmarks of a bubble:
The equity markets continue to power ahead. Echoing the stock market’s rise of 2023, equities as measured by the S&P 500 Index remain dominated by a small number of AI thematic companies. As highlighted below, from the beginning of 2023 through September of this year, the Magnificent Seven (NVIDIA, Apple, Microsoft, Alphabet, Amazon, Tesla, and Meta) have risen 199% as a group.
It is noteworthy that the Mag 7 comprises 30% of the market capitalization weighted S&P 500 Index. Their concentrated contributions to the total returns of the Index are unparalleled. For instance, during the first half of 2024, the Mag 7 generated nearly 70% of the total return of the S&P 500’s 15.3% year-to-date increase. By the end of the third quarter, NVIDIA alone contributed over 33% of the S&P 500’s 22% year-to-date rise. Meanwhile, NVIDIA, Apple, and Microsoft had a combined market capitalization of nearly $10 trillion – a value exceeding more than one-third of the United States’ entire economy of $28 trillion as measured by GDP (gross domestic product).
The concentration of the Mag 7 has exhibited a profound impact on the total returns of every equity portfolio. Just as the year before, 2024 is shaping up to be one of the narrowest markets in the past 34 years as only 30% of the stocks in the S&P 500 have actually outperformed the overall Index. Historically, the median percentage of stocks that outperform the Index is nearly 50%.
Those that do not believe we are in a bubble are not paying attention:
As asset prices steadily rise, most investors remain optimistic equities will continue their uninterrupted trajectory. U.S. equities witnessed an inflow of $140 billion dollars during the most recent month, the largest monthly inflow in market history. To put this monthly figure in context, it equals over 150% of the current U.S. savings rate (4%) per month and swamps the early-2021 investor enthusiasm that existed prior to the recent SPAC/IPO/NFT peak.
Concurrently, U.S. households now have their highest equity allocations in over 70 years.
The unrelenting excitement embraced by investors for AI equities and tech related investments has resulted in a enormous amount of capital flowing into a small group of stocks. In merely 32 trading days, NVIDIA added more than $1 trillion in stock market capitalization. For perspective, in six weeks NVIDIA’s equity market gain was greater than the total market capitalization that Warren Buffett’s Berkshire Hathaway achieved after six decades. For tech funds, a record $8.7 billion was added in the week ending June 19 of this year, continuing a record setting pace for annual capital inflows.
Excluding the Mag 7 and tech sector, nearly every other asset class has performed poorly over the past three years:
While large sums of capital are directed at AI and technology funds, the net result is investment funds have been withdrawn from a wide assortment of equities and asset classes, both foreign and domestic. As the Mag 7 rose during a period of rapidly increasing interest rates, most asset classes as represented by their passively managed ETF equivalents performed poorly as the cost of capital rose steadily. Shown below, over the past three years most asset classes posted negative annualized total returns. Only a few, such as U.S. T-Bills, gold, and select agriculture assets generated positive returns.
Strategic Asset Allocation vs. Modern Portfolio Theory:
These three year annualized returns highlight the benefits of active strategic asset allocation. The key dynamic over the past three years was a well telegraphed direction to the marketplace that the globe’s central banks would increase short term interest rates to counter the increase in inflation. In a period of rising interest rates, the valuations of nearly every asset class decline as higher discount rates are applied to future cash flows and asset values. In this environment, few asset classes perform well. Holding an oversized position in U.S. T-Bills and high quality equities generated very attractive risk-adjusted returns in comparison to wealth management models that dictate investors at all times be fully diversified in a wide spectrum of asset classes.
Below the surface, the hidden risk of market structure:
Unknown to most, the internal dynamics of the equity markets have been materially altered by the proliferation of capital management strategies and products that do not employ fundamental analysis in their frameworks. The more prominent are passively managed Exchange Traded Funds (ETFs), quantitative factor investment strategies which use data and mathematical models to select investments, and algorithmic investment approaches that range from simple rule-based systems to complex machine learning models.
In concert, assets held by passive funds have grown substantially. During the current equity market cycle passively managed funds have outperformed their actively managed counterparts and now control a much larger pool of capital. Subsequently, the majority of daily stock trading volume is generated by passive funds. Viewed on an hour by hour basis, during each trading day a disproportionate number of equity transactions occur during the first and last 30 minutes of each trading session as ETFs rebalance their positions.
Passive ETFs, such as the popular SPDR S&P 500 ETF Trust (SPY), are some of the most widely held equity assets. As noted, AI related companies now comprise thirty percent of the entire market capitalization of the 500 companies within that Index.
For ETF investors, as the Mag 7 rise in price, their 30% weight within the Index lifts the prices of the remaining 493 companies. For each $1.00 invested in SPY, $0.30 of that capital is directed to buy the Mag 7. This same dynamic exists in a large number of passively managed equity funds constructed to mimic equity indices. Note the Mag 7 comprises nearly twenty percent of the total market capitalization of the MSCI All Country World Index (ACWI). For investors that own passive equity ETFs, their future returns are heavily influenced by the direction of just seven stocks.
Equity markets are cyclical:
In today’s ETF momentum driven environment, fundamental valuations and business metrics are of little relevance. Unless the rules of economics are no longer applicable, over time equities will trade at their appropriate fundamental values. Currently, the largest stocks in the S&P 500 Index are trading at historically high levels. Measured on a 12-month forward P/E basis, this technology driven market cycle is priced higher than the one that existed during the 1990’s Dot.Com bubble.
The S&P 500 Index is near its upper valuation bounds on a wide assortment of fundamental metrics. Shown below are several historical percentile rankings. The higher the percentile ranking, the closer a parameter is to its all-time high valuation.
In past writings, we highlighted future forward returns from similar elevated valuations led to very low, or even negative total returns for extended periods. From the peak valuations of the Dot.Com bubble, nearly ten years passed before the S&P 500 Index returned to its previous price level. A similar pattern existed after the Great Financial Crisis (GFC) of 2007-2008. From peak to trough to peak of the cycle, the S&P 500 Index took six years to regain its former highs.
Investment management styles are also cyclical:
Rhyming with equity market cycles, investment management styles repeat as well. Viewed in terms of three year rolling time frames, the last time passive funds enjoyed such a strong trajectory of outperformance relative to active managers was during the Dot.Com bubble period that ended in 1999-2000. Should markets refocus upon the underlying fundamentals of the businesses that comprise their holdings, active managers that possess a disciplined approach to portfolio management may once again rotate to the forefront.
Opportunities outside the bubble:
Far from the AI orbit, there are a large number of equities whose businesses have consistently performed extremely well despite exhibiting returns that trail the popular equity indices. In general, each of these companies enjoy the following characteristics: have high barriers of entry, demonstrate duopoly or oligopoly economic properties, possess unique assets, have pricing power that exceeds their outlays, and generate returns on capital that are greater than their cost.
These opportunities are found in many different industry sectors. One is the railroad industry. There are immense barriers to entry – there will never be another railroad built in North America. The railroad industry is intertwined with the U.S. and North American economies and will continue to grow and gain market share transporting a wide assortment of goods throughout the region. As global trade patterns adjust for both logistical and geopolitical reasons, more manufacturing will be produced in the market friendly confines of North America.
Compared to trucking, railroads are much more cost efficient transporting goods over long distances. Moving cargo by rail also has the benefit of being more environmentally sound. One gallon of fuel can move one ton of cargo nearly 500 miles. By comparison, a gallon of fuel for trucking moves the same goods approximately 130 miles. Transporting goods by rail reduces greenhouse gas emissions by nearly 75%, an advantage that appeals to both politicians as well as regulators.
Another prominent investment theme in our portfolios is companies that rebuild and refurbish critical infrastructure assets, both domestically and globally. Long overdue, in the U.S. infrastructure spending is now the highest it has been in the last twenty-five years.
Nearly every country has a drastic need to improve their domestic infrastructure in order to expand and improve power generation and energy transmissions; upgrade their roads, highways, bridges; and expand communication systems.
The aerospace industry is another very attractive investment opportunity. Global passenger traffic volumes grow at twice the pace of worldwide economic growth. The capital requirements to participate in aerospace are immense and present a huge barrier to entry. There are only two global manufacturers of scale that produce commercial and military aircraft: Airbus and Boeing.
Airbus has several attributes appealing to long-term shareholders. One is a current order backlog of over 8,000 aircraft which may take nearly ten years to fulfill. Airbus’s main issue is receiving the parts and components required to complete its orders such as jet engines and cabin interiors. The company recently lowered its forward earnings and cash flow guidance due to equipment shortages – a high level problem which impacts short-term financials but not long-term economics. Airbus is also a leading helicopter manufacturer and has exposure to the defense and space industries.
In addition to high quality individual companies, now that the developed market’s central banks have signaled an intent to embark on an extended cycle of interest rate reductions, a number of asset classes are evolving into fundamentally attractive risk-adjusted investments. Dependent on one’s investment objectives, it is prudent to begin to rebuild allocations in areas such as emerging markets, small capitalization equities, and select alternative asset classes.
Summary:
In the end, stock prices are driven by human behavior – a variable no one can predict. Guided predominately by high expectations for Artificial Intelligence, investor excitement remains elevated although AI’s true economic impact has yet to materialize. Ignored for now, but should the lofty growth in earnings and profit margins for technology companies begin to wane, it is reasonable to anticipate that the steady rise in the Mag 7 and their AI related contemporaries could reverse course and pull down the stock prices of a large number of companies in the equity markets.
We, nor anyone else, know when the AI equity bubble will come to an end. What we do know is long-term wealth is created and preserved by successfully navigating the cyclical nature of the financial markets. As enthusiasm grows within the equity markets, the inherent risks associated with stocks are rising as quickly as their share prices. The key question for investors is determining their investment framework to maneuver through the upcoming market volatility. Will that investment process be based on fundamental economic parameters or be driven by price momentum strategies? Regardless, it is important to keep in mind that asset prices have always reverted to their intrinsic values during a full market cycle.
All the best,
John H. Payne, CFA
Managing Partner
Chief Investment Officer
Arumayta M. Arguello, CFA
Partner
Portfolio Manager
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