By Benjamin Picton of Rabobank
Authentic Foolishness?
Another day, another record for the S&P500. This time the index closed above 5000 for the first time ever and, once again, the gains were mostly driven by the Magnificent Seven tech names. Those seven stocks posted a gain of ~1.7%, while the S&P500 ex Magnificent Seven eked out a more modest 0.25%. The rapid gains since late October last year are very much predicated on the theme of Artificial Intelligence (AI) heralding a new era of productivity and profitability, helped along by lower discount rates as bond yields fell and markets priced in an aggressive easing cycle from major central banks.
Except, we’ve been here before. New Era thinking is certainly not new, and eye-watering valuations on stocks with a compelling narrative behind them is a tale as old as time. There are loads of examples, and many of them are recent enough that we should know better. For most of us, the Dotcom boom happened during our lifetimes. Before that was the Nifty Fifty, and the Roaring Twenties before that, and the Railway Mania, and the South Sea Bubble, and John Law’s Folly, and TulipMania and so on and so forth all the way back to the neolithic. So, is Artificial Intelligence really a game-changer, or is it another case of ‘Authentic Foolishness’?
Whatever the case, the intellectual basis for the rally grows thinner by the day. The Wall Street Journal desperately asks the question ‘Stocks are at Records, But Are They Expensive?’ (spoiler: yes). We now enter the phase of New Era thinking where P/E ratios, the CAPE ratio or the Buffett Indicator are pushed to the side while alternative valuation metrics (rate of patent filings, R&D spend etc) are proffered to justify soaring valuations. It certainly feels reminiscent of measuring the number of ‘eyeballs’ Pets.com got during the Dotcom years.
So, valuations grow more stretched, expected future returns fall as prices rise, and even the easy-money tailwind from falling bond yields appears to have hit a snag as a sustained break below 4% for the 10-year continues to elude. Indeed, US 10s saw yields pump 15 basis points higher last week as markets reacted to the strong jobs report from the previous Friday, hawkish Fedspeak, firmer jobless claims figures and a revision to the last 5 years’ worth of reported CPI that saw 3 and 6 month annualized inflation creeping higher. In light of the arrayed headwinds, it’s hard not to wonder how much the huge growth in passive indexing is responsible for “feeding the beast”, or is it just a case of markets observing Chuck Prince’s infamous dictum that “as long as the music is playing, you’ve got to get up and dance”?
Given the record close for long duration equities, those upward revisions in CPI don’t seem to have scared the horses too much. The rationale being that the revisions were reasonably small and that the Fed targets PCE, not CPI. Nevertheless, market pricing on the quantum of Fed rate cuts in 2024 has shifted from 7x to just over 4x in a few short weeks, and CPI is a measure of inflation that is preferred in almost every other developed economy, so it’s hardly irrelevant to conversations of policy. The Wisdom of King Solomon says that “hope deferred makes the heart sick”, but Solomon was a hard money kind of guy, so maybe he didn’t have the effect of later rate cuts on equity valuations top of mind at the time.
Speaking of hope deferred, last week saw an interesting move in the short end of the Aussie and Kiwi rate curves. Antipodean traders wound back bets on monetary easing after New Zealand labor market figures for Q4 showed the unemployment rate rising to just 4% (instead of the expected 4.3%) and one of the local major banks broke ranks to forecast two more rate rises from the RBNZ, with the first to arrive next week. RBNZ Chief Economist Paul Conway sounded hawkish in his speech of the week before, and the new Government in New Zealand has recently trimmed the central bank’s mandate to give it a singular focus on returning inflation to 1-3% (currently 4.7%). Adding to the tone, RBNZ Deputy Governor Hawkesby today told a Parliamentary Committee that the economy “can cope with high interest rates”. Are markets being softened up for another move higher?
The RBA also tilted more hawkish at their policy meeting last week by suggesting that further rate hikes “cannot be ruled out”. Governor Michele Bullock went further in her press conference by telling assembled journalists that she sees the risk of the next move in the policy rate being a hike (as opposed to a cut) as “finely balanced”. We don’t think the RBA is likely to deliver on threats of further tightening, but the balance of risks has certainly shifted. More of our thoughts on that score here.
While antipodean central banks beef up their tightening bias, Brent crude is again trading above $80/bbl as ceasefire talks between Israel and Hamas appear to be going nowhere. Our analysts have a Q1 price target of $80/bbl on Brent, but see potential for a shift higher in H2 as the Fed begins to ease and demand catches up to supply. Of course, there is always the potential for the situation in the Middle East to get worse, and potentially disrupt energy flows through the Hormuz Strait, a scenario that our analysts suggest could see $150/bbl oil if it were to occur.
We’ve not yet mentioned the Super Bowl, or the looming end of the BTFP program and what that might mean for commercial real estate. Our Senior US Strategist Philip Marey has written an excellent note on the latter topic that you can read here. In the meantime, I’ll close by paraphrasing Lord King’s observation that the structure of our financial system encourages radical disequilibria that finds expression in soaring debt levels, soaring asset valuations and downward sloping yield curves.
Riding the asset price wave makes complete sense while the disequilibria holds, but dislocations in global trade, threats of inflation resurgence and popular discontent heighten the risk that this paradigm is not a new long-term steady state. To suggest that this really is a New Era of higher valuations, and that “this time it really is different” might be the height of Authentic Foolishness.
