The Madness of Crowds
Equity markets had an uneventful week, with the S&P 500 up a modest +0.61%, the Nadaq gaining +0.21%, and the Dow leading the charge (+1.45%) as subtle signs emerged of a growth to-value rotation taking shape. A lot of ink has been spilled over the past several weeks about the narrowness of this last leg higher in equities and the unprecedented concentration within the equity market, not to mention Nvidia’s climb to becoming the largest company in the world. With that in mind, wouldn’t it be fitting and classic crowd behavior that all the hype and excitement marked a near-term top for the semiconductor space and Nvidia in particular? Nvidia reported its fiscal Q1 earnings on May 22nd, with the stock trading around $95/share and went on to rally above $140/share as of last Thursday (June 20th) – a nearly 50% rise inside a month. However, since that high last Thursday, Nvidia has slid 15% and is trading around $118/share as I type. Time will tell whether this is just a cleansing of the excesses and froth of investors that chased the stock over the last several weeks or we’re finally reaching a point of recognition that price has outpaced long-term fundamentals. I’m in the latter camp, and I say so while admitting that we own Nvidia in client portfolios – it’s a great company that has out-executed its competitors for years and has the results to prove it, but at $140/share a lot of this superiority is already in the price.
What is also interesting about the last couple of trading days is that we’re seeing a “good rotation” take shape with Technology and the Nasdaq being sold and capital rotating into Energy, Healthcare, Financials, and Real Estate. This is the recipe investors want to see to maintain the 15% year-to-date advance in the S&P. An advance, I might add, where 60% of this year's return has been driven by five companies (Nvidia, Microsoft, Meta, Alphabet, and Amazon). Coming into today, the Dow was up +4% year-to-date, and the Russell 2000 was down -0.3%. A catch-up in the laggards while the previous winners consolidate is a best-case scenario.
Incoming data on the economy continue to show signs of growth decelerating. The Citi Economic Surprise Index is down to -28.1 from -5.5 two weeks ago and is now at its lowest level since August 2022.
This metric is a read on both incoming data and forecasters’ expectations, so the extent of deterioration in this metric confirms both weaker data and lofty expectations. Nevertheless, economic growth is slowing, and what makes this year different from last year is that fiscal policy is less of a tailwind. Not that our deficits and spending are lower than last year, but that the laws of diminishing returns seem to be setting in. The CBO just released its latest deficit projections where it estimates this year’s budget deficit will come in at roughly $2 trillion, some $400 billion above the forecast it put on in February and $300 billion larger than last year’s deficit. This deficit level is equivalent to 7% of GDP, which is just mind-boggling when you consider that it is higher than what we have seen in prior recessions (when policymakers are bending over backward to implement countercyclical stimulus).
It is eye-opening that we have this level of deficit spending, yet the pace of economic activity is weakening. It just goes to show that there are limits to everything, but it does raise the concern of what the government will have to do to combat the next recession with its fiscal room so constrained. This also tells me that the Fed needs to start backing off its hawkish rhetoric and begin laying the groundwork for ‘calibration’ cuts. I know, I know the second they drop that hint, capital markets will overreact by pricing in more loosening than the Fed wants, but this is the animal they created for themselves. The balance of risks has definitely shifted, and it's time for them to be more forthright and forward-looking before they have to be more aggressive down the road because they waited too long to get started.
Let's return to the national debt for a moment because it truly is disconcerting how cavalier and selfish we are about this issue and the inequity we’re placing on future generations. The New York Times published a piece last week that is a must-read, “U.S. Debt on Pace to Top $56 Trillion Over Next 10 Years,” highlighting the trend in U.S. debt-to-GDP, which is set to soar from 99% to 122%. It is sad that we are all aware of this travesty, yet very few of us are willing to step up, come together, and make the necessary collective sacrifice to get us on a more sustainable future path. Neither party is remotely running on a platform of fiscal probity, and why should they, as they know that even mentioning a policy that would cut entitlement spending is a surefire way to lose an election? Over the next several months, equity markets will be handicapping the odds of the Trump tax cuts getting extended where if they do it will cost the federal government $5 trillion over the next decade. On the other hand, Biden has an agenda chock-full of unfunded spending programs, including tax relief to low- and middle-income households along with a $100 billion cancellation of student debts.
Look, don’t shoot the messenger here. I don’t have many answers, and I am not willing to get out from behind this desk and do something more to make a difference. Sure, I can analyze the situation, make inferences about what may happen, and do my best to profit or risk manage the outcome, but at the end of the day, I’m like every other talking head on this subject – full of opinion, but too chicken-s*#t or complacent to do anything about it. Sorry for the colorful language, but I find myself getting more passionate about politics and policy as I age – I’m sure many of you can relate.
Nevertheless, the gap between the policy agendas of Trump and Biden is ‘huuuge’ and will have an impact on capital markets when we find out who is going to be leading this country over the next four years. One side wants to take the corporate tax rate down (20%) to the lowest level since 1938, and the other wants to raise the corporate tax rate (28%) – each percentage point is worth roughly $130 billion in tax revenue and incremental business profits over the coming decade. Other tax goodies from 2017 are also about to sunset by the end of 2025, including tax breaks for individuals, the child tax credit, and the state and local tax deduction (by 2026, some 60% of households will be facing a higher tax burden). Trump’s plan would be bullish for the dollar and equities but would be bond-bearish, seeing as he intends to pay for the tax cuts with an across-the-board 10% import tariff. Of course, a lot will depend on which party has control of the House and Senate, but one thing is clear: we remain in a ‘populist’ era where both parties have their ways of passing out goodies to their spending priorities.
Let’s pivot back to markets, another subject in which everyone has an opinion but is much less likely to trigger a fistfight if that opinion differs. Something that helps me from time to time is to step back and look at things from a longer-term perspective. When you sit in a chair day in and day out observing and analyzing markets, you can get caught up in focusing too much on the near term. Looking at the latest flow of funds data, which breaks down the asset and liability profile of U.S. households, I wonder if most investors realize that the S&P 500 has risen by 25% over the past year. Sure, they see their account balances going up, but a 25% rise in a 52-week period is a historically strong move. Yet what looks clear in the data is that households haven’t bothered to rebalance their asset mix despite the move in equities and interest rates.
The latest data show that the household sector has the highest exposure in history to stocks (34.7%) as a percentage of financial assets. This is higher than the 31% they had leading up to the Tech Bubble in 2000 and above the post-covid stimulus tsunami of 34.5% in 2021. Now in fairness, this has been the right place to be and equities have now overtaken real estate (28%) as the largest weighting in a household asset mix.
When looking at just financial assets, equities represent an all-time high percentage at 71%, with cash at 21% and bonds at a lowly 8%.
To me there are several structural forces at work that have perpetuated this extreme: 1.) demographics, namely the relative wealth of the baby-boomer generation relative to every other age group, 2.) passive investments and the flow dynamics that go with it, and 3.) greed overwhelming fear and the need to keep pace with unparalleled asset inflation.
The nearly 80 million people that make up the boomer generation have dominated nearly every major sector of the economy, markets, policy and politics for the past five decades. Combine the size and wealth of this demographic with the mass adoption of Vanguard’s John Bogles 1976 creation of passive index funds, give it 45 years to curate, and you have yourself a capital market that used to serve a purpose for companies to raise capital evolve into a glorified savings account backstopping the retirement fortunes of the world. Over half of investors exposure to the equity market today is owned through passive vehicles (53%), which have offloaded the responsibility to conduct any analysis whatsoever on the prospects of an investment to an algorithm that transacts based on money flows and market cap weightings.
As a result, the price action in capital markets has become dominated by mechanical flows fueled by payroll deductions, stock buybacks, and passive investments, which have overtaken active investments. By definition, passive investing does not involve what you learn in the CFA courses, which provide you with the tools for making prudent decisions: the ability to separate the winners and losers, to rebalance the asset mix, or to allocate capital efficiently. In other words, what the passive investing mania ultimately lacks is flexibility. The power of FOMO and massive inflows into low-cost index funds pose some serious risks for the market that are not expressed in the media (or anywhere else, for that matter) — put simply; this is a bull market that has been built on the general public investing blindly.
What concerns me about this setup is the risk it poses when/if the mechanisms driving it relentlessly higher ever reverse, causing a similar mechanical overshoot in the other direction. Never in the history of the U.S. equity market have households had this high a level of exposure to equities nor an age profile consistent with what we see from the baby boomers. Where boomers lack the time and/or earnings power to recoup a significant and prolonged equity market downturn, like what occurred following 1929 (nearly 16 years to get back to those levels), the inflationary era of the 70’s which included a 45% decline in equities and nearly 14 years of sideways action (1968-1982), the popping of the Tech bubble in 2000 which took the S&P 500 down 50% and nearly seven years to recoup that decline, and finally the 2008 housing bubble where the S&P 500 fell more than 55% and once again took roughly seven years to get back to the previous high.
I don’t type this to elicit fear or anxiety, nor is it a bombastic call that the market is about to topple – I’m still constructive on equities through the balance of the year. It’s a reminder that risk management must be part of a prudent investment strategy. So, too, should realistic expectations and objectives. If you don’t need 15% returns per annum to achieve your financial goals, and you never expected to generate such returns in retirement, then you have no reason to get caught up in keeping up with your neighbor when they boast about how well their Tech fund is doing for them. I’m willing to bet they are not bragging about their losers, nor will they say much if we get a significant and prolonged market downturn that they are improperly positioned for. The stock market, like the bond market or any other market is a place for someone with savings to access to fulfill a return objective. It’s not the be-all end-all. It’s been the best broad-based tool to generate returns over the past fifteen years, but not the only tool, nor always the best tool.
I feel like we’re at a point where almost nobody believes we will ever see a bear market again, and nobody believes that the economy will ever slip into recession, even though, through the centuries, these things do happen. Markets, the economy, the seasons, and life itself move in cycles. I sense we are at that Chuck Prince moment: “As long as the music is playing, you’ve got to get up and dance.” He said that in July 2007, and the huge 17-month, -57% peak-to-trough bear market that nobody believed would ever happen started exactly three months later.
I’m a long-term bull on the economy, corporations' perpetual pursuit of profit motives, society, and people. But I’m also fond of history, math, and human behavior, illustrating that people, systems, and regimes are fallible. Given the intense market concentration in equity markets today and the structural dynamics at play, not to mention the historically high exposure to equities households carry today, I worry about how things unfold in the next material risk-off event. Recent history suggests that policymakers have no choice but to bail the system out – the costs of not doing so would be so much larger than if they do, but we also know that the pain point is pretty extreme before policymakers submit to such actions.
The growing dominance of passive index investing has created fragility within the system. And the fact that people in their 60s and 70s, who used to have a 30% allocation to the equity market in their asset mix during their golden years but now have double that, have either unwittingly or deliberately exposed themselves to the ravaging effects a bear market brings. This will become a huge societal problem if we have a deep and protracted equity market drawdown where the masses realize they will not come close to affording the retirement lifestyle they aspire to or currently enjoy. All of this is a long-winded way of saying there is no reason a retiree (or soon-to-be) should feel remorse for allocating part of their portfolio into 4-5% yielding risk-free investments in the interest of preserving some of their hard-earned capital. It’s a trade-off you’ll only truly appreciate when it's most needed, kind of like insurance – no one likes paying those premiums, but we’re all thankful to have insurance if that drastic event we were insuring against occurs.
As for the week ahead, the U.S. PCE and core inflation data for May, which will be released on Friday, will be the most important data point to watch. The consensus is looking for the headline number to come in at 0.0% and the core to print +0.1%. If so, then the year-over-year trends for both metrics would slide to +2.6%, which is down dramatically from the +4.4% (headline) and +4.8% (core) at this time last year. This would put the Fed’s preferred inflation metric within 60 basis points of the Fed’s 2.0% objective and just 20 basis points above the Fed’s year-end projection in their latest dot-plot. This would crack the door for the Fed to set the table at its July meeting for a rate cut in September. The recent data on housing, retail sales, and the labor market are all showing signs that economic activity is sputtering and the Fed’s restrictive stance is nearing its expiration date.
One last topic I want to hit on before signing off on this week’s missive is the growth in global electricity needs and my favorite green energy solution: nuclear power. We’ve been on this theme for some time, with nuclear power currently accounting for 10% of global electricity generation, with 440 nuclear reactors in operation, 60 more under construction, and 92 under planning. All told, the global tally for nuclear reactors is set to more than double in the coming decades, with the bulk of the current expansion occurring in Asia.
Bloomberg published a piece a couple of weeks ago, “Deadly and Wildly Profitable, Uranium Fever Breaks Out,” highlighting how well uranium and uranium miners have performed over the past couple of years. I point this out because both the commodity and the miners are in the midst of a correction, with the Sprott Uranium Miners ETF (URNM) down about 15% over the past month. This isn’t new to anyone who’s been in the space for the last several years, where this sector moves in a 2 steps forward and 1 step back trajectory. In a nutshell, the price of uranium has more than doubled in the past two years, and the demand for uranium is set to rise exponentially in the years to come, with demand forecasted to outstrip supply for the next decade. To quote a key paragraph from the article above:
“A big part of the allure of the uranium business is the sense that supply and demand are out of whack. Demand for the metal from China, India, Japan, the U.S. and Europe is rising at a significantly faster pace than miners can pull it out of the ground. By one estimate — from Treva Klingbiel, president of TradeTech, a data provider for the industry — demand could outstrip supply by more than 100 million pounds per year through the 2030s. ‘There is no substitution when you own a nuclear reactor,’ says Mike Alkin, chief investment officer at Sachem Cove Partners, a firm outside New York City that invests exclusively in uranium and uranium-mining stocks.”
The bottom line is that we continue to reiterate our conviction in the secular tailwinds behind uranium. The recent selloff in uranium and copper is a good entry point for those with a long-term investment horizon.
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