Posting this for completeness but please don’t bother reading
“Esteemed Former Colleague”: I generally agree on the most likely path for equities. At nearly 27x PE, SPX is borderline unprecedented territory – seen really only in 1998/1999 and 2021. 2021 was interrupted by fed rate hike of course. Will ascent this time be interrupted by circumstances more akin to 1999 (i.e. AI bubble bursting + another ME war)? Note that on fwd basis, SPX PE is 19x but that’s based on 17% earnings growth! (vs +6.5% 2024E). It feels like equities are in for modest correction when 2025 earnings pictures becomes clearer. Though given the narrow nature of the run this time a holdings analysis – at least for the larger weights in the index – is probably worthwhile.
The discussion on finding diamonds in the rough of unloved sectors reminds me of ATM businesses we see every now and then. Indeed, many funds won’t touch them – they say it’s like catching a falling knife. But ATM manufacturers/servicers refuse to die. And with more retailers discriminating against cards (by charging a card tx fees or not accepting them at all), cash (and ATMs) could even make a rebound.
“Yours Truly”: This 17% earnings growth will be a critical hurdle to monitor through earnings season (and not looking good so far). Looking at Google last night “beating” estimates with 14% and GDP growth potentially cooling (to watch out for this Thursday) marks either earnings estimates being too rosy or Google underperforming. I have started to like looking at Google as a proxy of the service economy as its technological edge has been eroded and its growth is starting to converge in line with business needs and demographic trends, so bad start here!
Side note: Will need to wait and see if Google’s $13bn capex bet on AI pays dividends and disturbs this correlation, I think Apple has the edge in monetizing the AI race; as much as I dislike their products; with their head start around inference on device (model trained in cloud and your personal data being inferenced on your device without ever leaving the safety of your device); this could lead to a mass replacement cycle of “smart” phones for “super-duper-smart” phones and their related ecosystems for the middle class globally limited by local laws; ChatGPT & Gemini not allowed in Hong Kong for example, how on earth can I write this email now before heading over
to Hanoi????
The composition of the path for equities will be interesting to watch as we currently move through earnings with the allocation of capital away from big tech (flat now negative on the month) and into small caps (+~9%mom)/industrials(+~1%mom). I won’t touch on your interruption point for now given it seems we have every month a few events that could trigger said interruption or are setting up an interruption but I’ll cynically wager that the path of least resistance is precisely this unknown with unknown timing and probability 1 of happening, (for this I layer in hedges).
On valuations for the rest of the year and into 2025. I would simplistically say that valuations are both an input and an output (beautifully unhelpful circular reference, but think of it as a stochastic process) to the constrained optimization function that directs capital flows. One input to the said function is liquidity and more specifically the total monetary base managed by governmental entities.
An increase in the monetary base permeates across assets, duration, and credit risk curves. Historically, such an expansion leads to foreign capital flight, however, the USD’s reserve currency status has allowed the preservation and attraction of foreign capital and led to a sustained bid on risk assets. When looking at the current stretched 27x PE for the SPX (seen in 98/99 & 21) which seems in the tail of the distribution historically, might seem within the bounds of normality when adjusting for monetary expansion on a cyclical basis.
On the make of equities performance, the cooled US inflation print raised hopes for continued inflation moderation accompanied by continued economic growth (back to the 17% earnings growth which is sure to be moderated this earnings season and this coming GDP Q2 print) and extrapolated to a potentially front loaded timeline for rates cuts ushering in a goldilocksian
world, broadening multiples appreciation further down the risk curve. Added to monetary loosening, the Republican momentum in the US presidential race with D. Trump announcing a reduction of 15% of corporate taxes and a swath of economic penalties to US-China trade impacting principally the semi and semi-adjacent industries along with tech more broadly. I find for now the price reaction on Google and tech today a bit perplexing as the Google’s capex spend should skew bullish for semi’s and cloud growth should skew bullish for Amazon and Microsoft, but this might show the technical inclination for profit around earnings and re-diversifying portfolios in addition to the above line of thought.
My current view is the materialization of the US goldilocks regime with softening but sustained GPD growth and decelerating inflation providing a front-loaded path for interest rate cuts to target a reduced spread between inflation and Fed Funds which with the interpretation of the price of money would put a continued bid on risk assets.
I am waiting for Thursday’s GDP #’s and Friday’s PCE #’s for an indication of which direction to start sizing trades into. Note we also have FOMC on 7/31 and NFP on 8/02 to look forward to as other indicators of where to put trades in size. We will need to also keep a close eye on the composition of the PCE as some items such as the goods portion are in contraction, which is a poor early indicator for consumer health. This is coupled with rising delinquencies which are sustained at a faster cadence than prior to COVID and now are nominally above the pre-COVID delinquency rate on loans sitting on the balance sheets of consumer banks (correct me if I don’t have the right picture here).
I won’t use this to start recessionary predictions but something to monitor. Regional bank equities have performed relatively well post correction showing rising delinquencies are currently not being perceived as a threat to balance sheets for the time being. Another data point is the Blackstone mortgage REIT cutting dividends by a quarter due to delinquencies. Growth weakening along
with disinflationary impulses could pose an inverse not so goldilocks scenario and formulate an outcome centered around the quantity and speed of rate cuts along with influencing balance sheet health from consumer, corporate, and governmental entities noting that SP500 corporate debt to total assets is at around 25% vs 36% prior to the GFC. This also means that as equity returns
come from an increasing portion of multiples expansion as opposed to revenue growth, valuations will be primarily sensitive to changes in liquidity and can help explain the rotation narrative in equities currently.
Recall that liquidity is a function of the price of money and the quantity of money (sovereign assets). Keeping this in mind helps explain why valuation multiples have expanded in 2024 while real rates have remained steady from the acceleration of reserves in banks and bill issuances. I currently don’t see a catalyst that would constrain liquidity but we need to remain ready to review
the thesis.
Given the current market behavior around earnings, I keep tactical positioning around equities to a minimum and expect continued selling pressure broadly with most of the underperformance around tech, healthcare, and large caps and will focus on hedging my longer-term portfolios (30% tech, 50% energy&mining). Once there is more clarity on the direction of earnings and broader growth, we will know which scenario we are most likely to be in and size in our equity tactical positions accordingly. For now, I remain long Russel, short Nasdaq, long equal weight S&P, and short market weight S&P which all also function as hedges to the broader L/S portfolio. A trade I have enjoyed since the inflation prints is long the equal-weighted S&P500 vs short the market-weighted S&P500 which has reached a chronic 20% delta in returns since 2023 and now provides an attractive returns profile.
Now given I dared to use the term goldilocks, we need to also look at the fixed income side of risk. Currently, the forward curve is pricing in one to two cuts by the end of the year with Dec 24(4.5+%) and Dec 25 (~4%) delta of about 150bps of priced-in cuts by the end of 2025. Assuming that inflation reaches the god given 2% target by 2025 with a Fed target of 100bps Fed Funds over
core CPI, you still need 100bps of cuts to be priced into the Dec 2025 SOFR which implies a skewed profile for rates to rally on short durations. Given the short end has maxed out at 5%, this is a clear ceiling moving forward under both goldilocks and not-so-goldy scenarios. This provides us with the opportunity to position 2s10s bull steepeners (2s10s) on a cyclical basis if economic growth continues and is accentuated by capital moving out the duration risk curve at a later stage. On the other side if growth contracts, then a bear steepener is on the table. Given the expected steepening and uncertainty around which scenario we might end up in, fixed income should
remain an attractive allocation with long-duration risk managed and taking some exposure to the short end-of-duration risk. The bull steeper given the two scenarios is also in a position to provide an attractive risk reward and needs to be reviewed at each economic print.
Looked into your ATM example, and I am torn to describe it as Jurassic Park or The Walking Dead but illustrates your point quite well!