Q2 2024 was driven by big tech posting significant gains, while the broader market is inching forward. The S&P 500 has climbed 14% this year, yet the Equal-Weighted S&P is up less than 5%. See Marketwatch for additional market data.
The majority of stocks have gone up very little, while a small select group of stocks are surging. There is a small set of 5-10 stocks that are driving a large portion of the gains. This if referred to as “market concentration”. There is a wide gap between the broad market and the elite, exciting companies. The WSJ noted, “That is the largest underperformance since at least 1990, according to Dow Jones Market Data”.
There is a growing risk that the entire market has run up too far and will experience a correction soon. 2022 was a watershed year that revealed one of the most rapid interest rate increase sequences in US monetary history. The Federal Reserve deployed harsh medicine to end an extended period of cheap money. 2023 saw inflation ebb and markets responded positively. 2024 has thus far looked past elevated interest rates, fraught geopolitical challenges and domestic political uncertainty.
As U.S. markets continue their upward climb, investor intuition will naturally dictate that prices are getting too high. One of the most difficult decisions investors face is to assess equity ownership in quality companies. Could it be better sell or to wait until prices come down?
Diversified portfolios often become increasingly valuable over time. Waiting for lower prices runs a risk of never owning the great companies of our time. Our long term, patient approach of a buy-and-hold, broadly diversified strategy may be the best approach. This allows the portfolio to stay invested, always owning great companies and never trying to time the market.
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New excitement fueling artificial intelligence (AI) companies has been a positive catalyst for tech stocks. “AI” entails a broad range of companies. From semiconductor chip manufacturers to software and design, a wave of speculative money has rushed in. The aim is attempt to profit from high-powered computers that mimic human functions, create sophisticated automation, and an entire new potential of computing based on high powered chips and data centers.
AI is billed with the promise of a transformative technology that could fuel leaps in productivity across the economy. These technologies may ultimately impact healthcare, autonomous vehicles, robotics and a wide range of business and scientific activities. There is also potential for scientific discovery and true machine learning as breakthroughs in the way these computers take on tasks that are increasingly sophisticated.
Investors are faced with a wave of excitement without much real-world proof of material impact. It may be that this is simply another incremental increase in computing technology. Portfolio managers are confronted with difficult decisions as to which companies may benefit and how much impact AI will produce.
The idea that computers can perform or assist many human functions has become a bullish catalyst. Semiconductor chip manufacturers, testing equipment and AI software developers in the sector are being driven up by the promise of dramatic productivity gains. Apple recently suggested its products would be AI centric and the stock moved up vigorously. The rapid ascent of the share prices of companies in these sectors is leaving the broader market behind.
The leader in the upswing is a chip company named Nvidia (NVDA). The value of the stock has moved up so dramatically it is provoking comparisons of the 1999 “DotCom” mania. Many of the tech stocks of the 1990s had only promises and little revenue or profits to deliver. That is not the case with NVDA, but there are questions with just how far the stock can go as the company may not be able to fulfill such grandiose valuations.
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Passive money, or index funds are also driving huge asset flows into a concentrated group of the largest companies in the US and globally. A recent study titled “Passive Investing and the Rise of Mega-Firms” begins “We study how passive investing affects asset prices. Flows into passive funds raise disproportionately the stock prices of the economy’s largest firms, and especially those large firms that the market overvalues.”
Index funds have gone from below 5% of managed money in the early 1990s to over 50% today according to MarketWatch. The concern is that the flow of money to indexing by market capitalization drives the most highly valued stocks higher without regard to the actual earning potential of the individual company.
The impact of index funds on the market should be divided into S&P 500 funds and all the rest. Once you go outside the biggest US companies, active management has a role to play. The current notion that all money will ultimately end up in passive indexes is not validated by the long-term performance of most sectors outside the S&P 500. It is much different to compile a list of international, mid-cap or small-cap companies that will have the type of predictability of mega cap US companies.
It seems reasonable to address these dynamics of portfolio concentration by staying broadly diversified across multiple styles and cultures of money management. The idea that money can be maximized by simply buying lists may be creating an environment that will only be mitigated via meticulous variety in the sectors and styles that are included in a truly diversified portfolio.
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It has been 23 years since a novel tax policy tactic was deployed by the George W. Bush administration. The idea was to create a temporary federal tax policy that included expiration dates and thus produced better projected costs. The projections estimated by the Congressional Budget Office would look much better under the assumption that tax rates would go up in the future. These actions were accounting gimmicks that allowed for the potential economic benefits to accrue in the short-term, and the costs to come later.
The party of tax cuts (The GOP) skipped the most important elements of effective conservative fiscal policy: cuts to federal spending. If tax cuts are the carrot, spending reduction is the stick. It is much easier to give out a lot of carrots and get around to the stick at an unspecified date in the future.
There was a historical belief that fiscal responsibility was expected from conservatives. The Reagan era saw a shift to the notion that somehow federal budget deficits would resolve or that they just did not matter. The tax code changes named “The Economic Recovery Act of 1981” introduced a new era of American federal policy. Reagan was enshrined in conservative lore as the great fighter for smaller government and diminished tax bills, particularly for business and high-income Americans.
The mythology of Republicans as tax cutters with Reagan as the founder ignores that these cuts were then followed by a series of tax increases that were almost as big as or even bigger than the 1981 cuts. The original Reagan cuts were not pared with spending cuts of the required magnitude and the revenues had to be made up.
Once the idea that you could implement tax cuts that were likely to be unsustainable in the medium term, fiscal discipline was further diminished. Additionally, we are in an era where each party pursues ideological policy and legislation without participation of the opposition. When power shifts to the other party, the previous actions often reverse.
On the left, there seems to be a belief that big ideas like the Affordable Care Act or broad federal government involvement in green energy initiatives can somehow be paid for in the future. Progressives seem to think that we will find new sources to tax, or rates can be raised in the future to restore equilibrium to the federal budget.
It is obvious that fiscal policy has become a dysfunctional chorus of blame with progressives seeking higher taxation and conservatives suggesting that spending is out of control. The process has become more dysfunctional as conservative thought has been marginalized and replaced with a new right-wing populism beginning in 2016.
The 2017 tax “cut” used expirations that will occur in 2025 further exposing the fiscal disorder and erratic policymaking.
We will now see arguments made to suggest that the 2017 tax law needs to be made “permanent” otherwise growth and activity will be negatively impacted. Those that make this argument should be exposed for the accounting chicanery that created the problem in the first place. Unfortunately, the tax law of 2017 was another example of giving out the candy now and letting future leaders clean up the mess.
Tax law expirations of the past have thus far turned out to be insignificant events. The markets and economy have been fortunate thus far in avoiding negative impacts during previous drama as the cuts expired or were extended. It is unfortunate that the party who has deployed this tactic has not paid much of a political price instead it has created significant uncertainty for businesses and decision makers in the private sector. Investors can only dream of leaders who arrive on the scene looking for the thankless task of explaining these issues to the voting public.
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Have you seen the Amazon delivery van that looks dramatically different and has no exhaust pipes? The van is called the Delivery 500. It has an estimated range of 160 miles while it is tuned for the stop and go of package transit. Volkswagen announced a $5B investment in Rivian on June 26, 202. Local delivery activity can be quite productive in a 160-mile range.
The “last mile” routes to your doorstep are a substantial economic opportunity for a transportation company fighting for a place in the EV future. Fully charged every morning with a payload and route calibrated to accommodate the battery range, this type of product will likely become ubiquitous as scale and refinement create cost advantages for all types of delivery. One might even imagine a link into solar generated energy stored in large-scale batteries during the day, used for charging vehicles overnight.
The cover of the weekly Economist on 6-22-24 states, “Dawn of the solar age”. From the piece:
“To call solar power’s rise exponential is not hyperbole, but a statement of fact. Installed solar capacity doubles roughly every three years, and so grows ten-fold each decade. Such sustained growth is seldom seen in anything that matters. That makes it hard for people to get their heads round what is going on. When it was a tenth of its current size ten years ago, solar power was still seen as marginal even by experts who knew how fast it had grown.”
“The resources needed to produce solar cells and plant them on solar farms are silicon-rich sand, sunny places and human ingenuity, all three of which are abundant. Making cells also takes energy, but solar power is fast making that abundant, too. As for demand, it is both huge and elastic—if you make electricity cheaper, people will find uses for it. The result is that, in contrast to earlier energy sources, solar power has routinely become cheaper and will continue to do so.”
“In contrast to earlier energy sources.” Solar could be more like a paradigm shift. Renewable energy is different and, at scale, is truly transformational. It is nearly limitless, and costs could be predictable or even decline over time. The potential for this escalation of supply and efficiency may turn out to be a watershed economic event in the realm of the industrial revolution.
Macquarie Group Ltd of Australia along with a US company named Sol Systems recently made an investment of $85m in five solar projects in Ohio and Illinois. Solar announcements do not garner the broad media headlines, but a review of the US Department of Energy solar news page reads like a good news journal. On a weekly basis investors are likely to read stories like the Brookfield Asset Management recently announcing a $6.5B investment in the French Neoen. The economic opportunity of this crucial realm is transformational. Numerous sophisticated investment firms are looking to get a piece of the pie.
The NYT recently pointed out, “Two decades ago, coal produced about half of all the electricity in the United States. Today, it accounts for just 16 percent of American power generation. The industry employed nearly 180,000 people at its peak in the 1980s, but now that figure is about 44,800, according to the U.S. Bureau of Labor Statistics”. The idea that coal could continue to be utilized for energy for generations in the United States was destroyed by the innovations that have produced cheap natural gas.
Legacy industries, in this case coal, will lobby, construct narratives, and search for any possible extension of operating profits. There are many painful examples where communities built around the economic opportunity of labor-intensive coal mines experience terminal decline. The recent republican presidency rolled back a wide range of rules and regulations on coal. The impact was minimal in the face of innovation and economic opportunity for cleaner and more dynamic energy that is likely to power the future.
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As this presidential cycle winds down, investors are confronted with another in a long line of “terrible choices” for federal leadership. The narrative that Joe B is past his expiration date is a difficult argument to refute. Beyond the frail imagery, the Democratic Party strategy so far seems to be one of explanation as to how Joe has been good for you. This is a difficult message to deliver in the face of inflation and geopolitical disarray.
A progressive vision that suggests significant intervention into the economy by the federal government has not been articulated effectively to voters. It is far from certain that these types of policies can be effective. The strategy of making bold and transformative federal government actions without including negotiated support from both parties is questionable. Legislation that is passed with no opposition support places the private sector in an awkward position as to what can happen as soon as the next election is held.
Contemplating federal policy is something most voters will never do. Opinion surveys seeking clarity on how people will ultimately vote consistently produce feedback regarding inflation as an evil scourge that has been challenging for middle America. The masses are generally uninterested in the nuance of our domestic or global economic challenges. Conversely, they have all manner of opinions as to what causes the price of gasoline to rise and the shocking notion that lunch can cost $16.
Significant amounts of federal money have been pushed into the economy in the pursuit of a manufacturing renaissance and a reclamation of domestic semiconductor production. The irony of naming a large federal spending initiative the “Inflation Reduction Act” was oxymoronic. Much of the recent industrial policy produced by the Biden administration exacerbated inflation due to demand for materials and labor.
The idea that President Biden could campaign and win in 2024 may have ended during a surreal presidential debate on June 27th. Working at a high-capacity past age 80 is something that is accomplished by a very small group of people who can remain professionally active at that extended age. The Democratic Party is under intense pressure to face up to this reality.
Former Secretary of State James Baker recently wrote a tribute to President George HW Bush on what would have been his 100th birthday. The list of traits provides stark contrast to the current landscape of vitriol and social media fueled attention seeking. George H.W. Bush is remembered for bipartisanship and measured public behavior. Mr. Baker points out that Bush “was domestically rebuked for refusing to thump his chest after the Berlin Wall fell. He reasoned that triumphalism might hinder tense relations with the faltering but still dangerous Soviet Union.”
Recency bias is persistent as investors are prone to extrapolate current trends. Fear of an era of new seasons of “apprentice politics” is unlikely to be realized if recent history is the guide. Jimmy Carter was strikingly popular early in his presidency and then opinions plummeted. The “Reagan Revolution” came to a screeching halt with the long shot from Arkansas, Bill Clinton. The plain spoken, “compassionate conservatism” of GW Bush was succeeded by a 180-degree turn, the constitutional law professor articulation of Obama.
We now reside in a federal leadership period where the left lurching and frail Biden presidency seems quite vulnerable to defeat. The ex-president seeking another term is leading an escalating level of grievances, accusations and dire descriptions of current conditions. This campaign of anger is somehow gathering a significant amount of support.
Capital Group commentary recently noted, “Investors may have strong convictions about which candidate or political party will steer the country in the right direction, but historically the party that prevails has had little impact on long-term market returns. Since 1936, the 10-year annualized return of U.S. stocks (as measured by the S&P 500 Index) made at the start of an election year was 11.2% when a Democrat won and 10.5% in years a Republican prevailed.”
Sources: Capital Group, Standard & Poor’s. Each 10-year period begins on January 1 of the first year shown and ends on December 31 of the tenth year. For example, the first period covers January 1, 1936, through December 31, 1945.
Market levels may reflect an understanding of the temporary nature of these perceived leadership inadequacies. As the world questions the leadership of the US, Europe and Asia are undergoing governance challenges. The frightening narrative that we are seeing, a lurch to the right in Europe, is unlikely to replay the catastrophic dynamics of the 1930s.
The 2020s are a much different time with its own distinct challenges. There is a tendency for pundits to pattern fit our times into history. Alarmist narratives that seek attention frequently yield to outcomes that are less daunting and closer to historical norms.
While our system may or may not produce the next Roosevelt, Eisenhower, Obama, or Reagan, the underlying economy will forge ahead. Ambitious entrepreneurs will be waking up early every morning to pursue their share of an innovative future that we cannot begin to imagine right now. Our diversified and patient portfolio strategy is likely to be valuable and receive benefits from all the hard work of our incredible American system.