US stocks continue to defy bearish predictions, with the key bellwether indices showing remarkable resilience. The S&P 500 has recovered smartly from the lows in March, when stocks tumbled during the height of the regional banking crisis, and is now up 9.5% for the year (at the point of writing). And with record amounts of cash sitting on the sidelines — short-term money market funds are seeing surging inflows, now totalling US$5.3 trillion ($7.2 trillion), according to a recent report by the Bank of America — we suspect more than a few investors must be wondering if they should throw in the towel and capitulate in fear of missing out (FOMO). After all, if stocks continue to rise, so will the cost of holding cash (see Snapshot below). We are not convinced that the worst is over and think caution is warranted based on prevailing risk-reward propositions.
First, simply looking at the headline indices is misleading. Yes, the S&P 500 is up year to date and the Nasdaq Composite is performing even better, having gained nearly 24% since the beginning of the year. However, this rally is increasingly narrow, driven by just a handful of mega big-cap stocks including Apple, Microsoft and AI-themed stocks such as Nvidia and Alphabet.
Economist David Rosenberg wrote in a recent note to clients that 90% of the S&P 500’s gains this year came from just seven mega-cap stocks. Case in point: Nvidia added US$184 billion in market value on May 25 alone, pushing its total valuation to nearly US$1 trillion — after the company gave a robust demand outlook for its AI chips. The stock has gained 167% so far this year. Apple and Microsoft, the two largest weighted companies in the S&P 500, are up 35% and 39% respectively, while Tesla (+57%), Alphabet (+41%), Meta (+118%) and Amazon (+43%) have all outperformed the benchmark indices.
In short, mega-cap tech stocks have done really, really well — and the rest of the market, not so much (see Chart 1). In fact, excluding the seven mega caps — Apple, Microsoft, Nvidia, Alphabet, Tesla, Amazon and Meta — the S&P 500 has been flattish to marginally negative this year and prices for many mid and smaller cap stocks across sectors have, in fact, been “quietly” trading even lower, to reflect their weaker earnings. We suspect this trading pattern could continue and the rally is not ready to broaden out just yet.
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Aside from the excitement created by generative AI, investors may also be piling into mega caps as a market defensive measure — these companies have strong balance sheets (some sitting on net cash), steady operating cash flow, strong market franchise/positioning and stocks that are highly liquid. It is a flight to quality, amid heightened uncertainties over the regional banking crisis, US debt ceiling and possibly, recession.
As a result of the outperformance, the mega-cap valuations too have risen sharply and are currently priced at well above their five-year historical average price-earnings ratios (PERs), except for Tesla (see Table 1). This has led some to the conclusion that there is now a bubble in AI-related stocks. For sure, the risk-reward proposition has tilted towards the former and it is possible that future returns will be lower than those of the past decade. The gap between earnings-dividend yields for stocks and cash-fixed income investments has narrowed significantly — in other words, stocks are no longer the TINA (“there is no alternative”) investment. But are the stocks “overvalued”?
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Generative AI-driven productivity gains will transmit quickly through economy
We think the productivity gains from generative AI are real and will be significant across a broad swath of the economy — similar to the huge positive economic impact from the internet, as its usage became increasingly prevalent in line with rising broadband access in the past two decades.
In other words, we foresee a new S-curve for companies — a new driver for growth and productivity gains — and this one will transmit far quicker from concept to productivity gains (profits) throughout the economy, given the already prevalent broadband access for the majority of the world’s population.
Plus, unlike the years post-global financial crisis (GFC) when the financial sector and many corporates had weakened balance sheets, this time, their financials are relatively healthy. Spending on capital expenditure should not be a big issue. As such, the higher-than-average PERs may, in fact, reflect “realistic” expectations of higher earnings growth due to AI-related productivity gains.
More downside for majority of stocks
Over the nearer term, however, we think there is room for the broader corporate earnings to fall further, as the economy weakens, whether or not it will fall into recession. And with it quite possibly more downside for the majority of stocks.
Corporate earnings have continued to hold up fairly well, given the circumstances, underpinned by strong consumer spending. Many companies have been able to not only pass on higher input costs, but also expand their margins — with price increases more than offsetting volume sales decline. This has minimised broader layoffs, save for within the tech sector — the number of vacancies continue to outstrip the number of unemployed workers, by a ratio of 1.6 — and, in turn, support consumption. In addition to a robust labour market, consumers are still drawing down on excess savings from generous pandemic handouts.
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According to a recent economic letter published on the Federal Reserve Bank of San Francisco’s website, there remains about US$500 billion of the US$2.1 trillion pandemic excess savings (at its peak in August 2021) — though, of course, the distribution of this aggregate across the different income households will not be equal. Low-income households may well have burnt through most of their excess savings.
Guidance from management portends more challenging times ahead. Warren Buffett, whose company Berkshire Hathaway owns diverse businesses, has warned of slowing sales and inventory buildup in recent months. He expects lower earnings for the company this year. Retailers including Walmart, Target, Home Depot, Lowe’s, Foot Locker and Dollar Tree have all pointed to consumer downtrading (buying cheaper brand names for the same goods) as inflation bites. Consumers are also diverting spending from big-ticket and discretionary items to necessities and groceries. In short, consumers remain optimistic but cautious.
Inflation and interest rates to stay elevated
During the early days of the pandemic, “excess” inflation was mainly due to shortage of goods — when consumers diverted their normal spending on services to goods amid massive supply disruptions — made worse by Russia’s invasion of Ukraine, which drove up commodity (energy and food) prices. This supply bottleneck is largely resolved, with economies having reopened.
According to a recent paper authored by Ben Bernanke (former US Federal Reserve chair) and Olivier Blanchard (former chief economist at the International Monetary Fund), “What Caused the US Pandemic-Era Inflation?”, the biggest driver of inflation in the US has now shifted to an overheated labour market (see Chart 2). This is problematic.
On the one hand, the tight labour market and wage growth are supporting consumption, especially for services such as travel, entertainment and restaurants. On the other hand, because of this robust consumer spending, companies have been largely able to raise selling prices, protecting and even raising their margins and profitability — contributing to more inflation.
Wage inflation is also very sticky — companies will discount their products to pare inventory but few would cut wages, except as the last resort. Furthermore, the current trend of deglobalisation, onshoring and friend-shoring will drive up costs — inflation — at least in the shorter term. We have written about this in our previous articles.
What all these mean is that inflation will quite likely stay elevated. Case in point: The latest report from the US Commerce Department showed that the personal consumption expenditures (PCE) price index accelerated in April, up 0.4% month on month, from 0.1% in March. The core PCE, which the Fed monitors closely for its inflation target, is stubbornly high, up 4.7% year on year, from 4.6% in the previous month.
If inflation remains higher for longer, interest rates will also stay elevated for some time. In fact, the odds of another rate hike at the upcoming June 13 and 14 Federal Open Market Committee (FOMC) meeting have been rising in recent weeks, from earlier expectations of a pause.
Positively, recession could be mild
The US economy has shown remarkable resilience thus far, despite the steep interest rate hikes over the past year. The question is: Is this resilience sustainable — especially when excess savings run out, probably sometime before end-2023? And inflation — and interest rates — remain elevated.
The economy is still running too hot and needs to cool off. Unemployment may rise somewhat from today’s historic lows. That said, a rapidly ageing population could keep the unemployment rate fairly moderate. Credit conditions are tightening and higher-for-longer borrowing costs will eventually hurt consumption.
On balance, we suspect the recovery period from recession (if it happens) is likely to be shorter than post-GFC. Households have repaired their balances in the ensuing years — household debt-to-GDP is below 80%, from more than 100% in 2007 — and debt servicing as a percentage of disposable income too is far lower now.
The risk for stocks is that the market is expecting a 75-basis-point cut in interest rates before the end of this year. As we stated in our article on May 1, they are predicting not even a soft landing, but a “no landing” by the Fed, in reining in inflation and excess liquidity. We are highly doubtful of this immaculate disinflation scenario. And stocks may suffer another sell-off as it becomes clearer that inflation is not going to fall as quickly as they expect. And if the Fed does cut interest rates by the expected quantum, it will be because something very bad has happened to the economy — in which case, stocks are not likely to do well either.
Conclusion
To summarise:
(i) The US equity market is currently being driven, predominantly, by seven large AI-related tech stocks. We believe the potential for generative AI is huge and realistically achievable;
(ii) But we also believe the worst is not over and prevailing valuations for the overall market are excessive;
(iii) Inflation will stay higher for longer; and
(iv) Global economies are remarkably more resilient than we thought.
How should one invest based on the above conclusions? We will share our views in the coming weeks.
The Global Portfolio fell 2.6% for the week ended May 30. While Star Media Group (+4.8%) recouped some lost ground to close higher for the week, China-based stocks continued their sell-off. The biggest losers were LONGi Green Energy Technology Co (-11.1%), Meituan (-10.8%) and BYD Co (-5.4%). Last week’s losses pared total portfolio returns since inception to 17.6%, trailing the MSCI World Net Return Index’s 47.5% returns over the same period.
The Malaysian Portfolio fared better, up 2.2% last week, thanks to gains from KUB Malaysia (+5.4%) and Star Media Group (+5.0%). Total portfolio returns now stand at 153.8% since inception. This portfolio is outperforming the benchmark FBM KLCI, which is down 23.7%, by a long, long way.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
