By all appearances, the US stock market rally is healthy and gathering momentum, drawing increasing amounts of money from investors (more money is pouring into funds) while cash held in funds is also falling rapidly (see Chart 1). The closely watched Standard & Poor’s 500 index has just clinched its 31st record close so far this year while the Nasdaq Composite Index, too, has been hitting consecutive fresh all-time highs.
The FOMO (fear of missing out) trade is back, as recession fears have been all but banished. Indeed, speculative elements are evident, including rising interest in meme stocks. The equity market is now driven by greed with the fear gauge, the CBOE Volatility Index (VIX), falling sharply in the past two months and hovering near five-year lows (see Chart 2).
The obvious question for investors would be whether to chase this rally. The honest answer is: We do not know how much further stocks could run from here on. What we do know is that valuations are on the historically high side and this rally is being driven by just a handful of stocks, primarily Nvidia, compounded by the growing presence of passive exchange-traded funds (ETFs) that simply mirror the underlying index. The 10 largest stocks currently account for a massive one-third of the total market capitalisation of S&P 500 stocks. High valuations can persist, and have persisted from a historical perspective, for longer than they should, before the necessary correction occurs. Clearly, the stock market is not the economy — but the two cannot be disconnected over the longer term. And herein lies our worry.
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Consumer spending is weakening
The US economy recorded far more robust growth than expected in 2023, with real gross domestic product (GDP) at 2.5%, surpassing the average annual growth rate of 2.2% recorded from 2010 to 2019. The primary driver was private consumption, which contributed 1.5 percentage points to overall growth. In 2023, private consumption surged 2.2%, but momentum slowed in 1Q2024, with growth decelerating to 2%. This weakness persisted into April, as real personal consumption expenditures declined 0.1%. Is this a sign that the growth in personal consumption is downshifting, and therefore bodes ill for the overall economy?
The strong consumption growth post-pandemic was driven by several factors. First, there has been a change in consumer behaviour. The pandemic’s uncertainty and disruptions triggered a YOLO (you only live once) spending spree. Fearing an unpredictable future, people embraced a “seize the day” mentality, prioritising experiences and enjoyment over long-term saving. And that spending spree was enabled by excess savings accumulated during the pandemic, boosted by several rounds of massive government financial support. This pile of excess savings had, however, been depleting steadily since August 2021 and was fully exhausted in March 2024, according to a study by the Federal Reserve Bank of San Francisco (see Chart 3). In other words, the exceptional spending spree is likely over.
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Case in point: We are seeing increasing delinquency rates for credit card loans. The percentage of credit card loans in serious delinquency — defined as more than 90 days past due — has been rising since 3Q2022, reaching 10.7% in 1Q2024, a level not seen since 2Q2012 (see Chart 4). This, combined with commercial banks’ diminished lending capacity due to the Fed’s ongoing quantitative tightening, will lead to slower growth in consumer credit — and consumption going forward.
Yes, recent positive real wage growth, thanks to strong economic growth and a tight job market, has allowed consumers to finally catch up with the price surge during the pandemic. Real wages are now slightly higher than they were in 2019. But real wages for US workers are still lagging far behind where they would have been, if the pandemic had not happened (see Chart 5).
This is why almost all surveys show consumer dissatisfaction over the state of the US economy, despite the strong headline GDP growth and low unemployment rate. Consumers, especially those in the lower-income groups — who are not benefiting from the positive wealth effect from rising home and equity prices — are being forced to cut back, without the boost from now-depleted excess savings. Case in point: Companies such as McDonald’s, Starbucks, Amazon.com, Mondelz International, PepsiCo and Nestlé are reporting weaker demand and consumer downtrading.
Consumer demand could weaken further as wage growth slows, owing to the easing of job market tightness. The number of job openings has been steadily declining, falling 33.8% from the peak of 12.2 million in March 2022. The number of job openings per unemployed person — an indicator of job market tightness — has shrunk from 2.03 in March 2022 to 1.24 in April 2024. Meanwhile, the quit rate is also falling — typically, changing jobs gives wages a bigger boost (see Chart 6).
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On the other hand, living costs are likely to remain elevated, with sticky inflation. We have written extensively about the effects of deglobalisation and rising protectionism and trade barriers on the prices of goods. Growing geopolitical tensions, such as the Russia-Ukraine war and Israel-Palestine conflict, are also disrupting international trade and leading to higher logistics costs. For instance, the Red Sea crisis forces shipping companies to reroute, adding thousands of miles to journeys and significantly increasing transit times, fuel consumption and shipping insurance costs.
Sticky inflation, as we know, is causing the Fed to keep interest rates higher for longer, which inevitably will lead to weaker consumer demand, consumption and economic growth. Recession risks may have abated, for now, but concerns could yet re-emerge over the coming months.
Conclusion
The depletion of excess savings from the pandemic years, deceleration in consumer credit expansion and potentially slower wage growth, coupled with persistent inflationary pressures, will lead to a slowdown in consumption. Given that consumption accounts for two-thirds of the US economy and is the primary engine for growth, a downturn in consumer spending would have significant repercussions on the broader economy and, ultimately, corporate earnings and sustainability of the current equities rally.
So far, investors have been taking negative economic news — higher unemployment, slower consumer demand and economic growth — as good news for the stock market. This is because weak economic data is seen to bolster the case for the Fed to start cutting interest rates, avoid recession and, over time, lead to a new cycle of economic expansion.
Our fear, however, is that at some point, bad news will become just that: bad news for both the economy and stock market. There is very little room for error, given prevailing high valuations — S&P 500 stocks are currently trading at an average forward price-earnings multiple of 22.2 times, which is one standard deviation higher than its 30-year average (see Chart 7). It would be increasingly harder to justify further gains. In short, the downside risks are substantially higher than upside gains.
When everyone is crowding onto one side of the trade, it is usually time to start making contrarian bets. We are thus shifting our focus towards more defensive stocks for our portfolio. Alternatively, shorter-duration bonds could also offer better risk-reward at this juncture. Having said that, we see one bright spot in the US market: the housing sector. We will elaborate on this next week.
Box Article: Nvidia: can a company outgrow its discount rate?
Is Nvidia’s stock still cheap or too expensive after its eye-watering rally? We guess it depends on whom you ask. Nvidia’s surge to become the world’s most valuable public-listed company (beating out both Microsoft and Apple) within a few short years is an amazing feat by most yardsticks (see Chart 1).
Artificial intelligence (AI) — specifically, generative AI — is widely seen as a driver for the next industrial revolution that will fundamentally change the world. And Nvidia is the poster child for the AI boom, being the dominant supplier of the chips (graphic processing units) required to power data centres and AI applications. For some, such as The Motley Fool, “traditional valuation metrics and historical precedents, in turn, may not wholly apply to groundbreaking companies like Nvidia”.
We have no doubt that generative AI will have a profound impact across businesses, productivity, the economy and society. But it does not change the fact that there is only ever one reason to invest in a company — for its future cash flows. In other words, no matter how lofty the hype, there is an intrinsic valuation for every company — that is equivalent to the sum of its discounted future cash flows. It matters not how this valuation is derived, using the DCF methodology or some of the other more popular shortforms, such as the PE valuation metric.
The massive rally in Nvidia’s share price is predicated on its exceptionally strong growth — currently, the market projects that its profit will increase to US$85 billion by 2026, from just under US$10 billion in 2022 (see Chart 2). Let us assume that this forecast is realistic and the earnings of about US$4 per share is achievable and sustainable. Using a discount rate of 4.5%, which is the prevailing yield on 30-year US Treasury, the intrinsic value for Nvidia is roughly US$90. (Bearing in mind that a 4.5% discount rate itself is an unrealistic assumption. It is too low, as it assumes Nvidia’s future cash flows are as certain as those of US treasuries.) Its current share price is US$140, or more than 50% higher. In other words, Nvidia shares have already fully priced in the current cycle of growth, and more.
We have previously explained how all businesses go through the S-curve life cycle, from infancy (low growth) to expansion (rapid growth) to maturity (low growth). Some S-curves will be steeper than others, that is, their products have stronger rates of growth — for instance, owing to a major innovation that drives rapid adoption and demand across multiple market segments (market size). This is the Nvidia story. It saw robust demand for its chips between 2016 and 2022, driven by cryptocurrency mining (the first S-curve) and even stronger demand from the generative AI boom (second S-curve) (see Chart 3).
But every innovation and product, no matter how transformative, has limits — at the top of the S-curve, growth tapers off or drops. This could be due to several reasons, such as increased competition, market saturation, technological disruption, regulatory changes and changing consumer preferences.
Based on its current share price, the market is effectively telling us that not only will Nvidia dominate the current demand cycle for AI chips, but it will also find and dominate the next S-curve, or new cycle of earnings growth.
It is also probable, however, that Nvidia will be replaced by another company — for instance, with an even better AI chip or architecture to perform the same AI tasks or one that is better positioned to capture the next innovation that requires chips. In this case, its current projected earnings will not be sustainable, but fall quickly thereafter.
Mathematically, if a company can continue to grow in perpetuity at a rate that exceeds its discount rate, its value would be infinity. Are there companies in that world that can achieve this?
Obviously, no one knows how the future will play out. One can only weigh the current risk-reward proposition. We think the risk is high. “This time is not the same” is a popular narrative that has been proven wrong too many times before.
— End of Box Article —
The Malaysian Portfolio fell 1.8% for the week ended June 19, succumbing to profit-taking and underperforming the benchmark FBM KLCI, which was down 0.6%. The top losers were Insas (-4.4%), KSL Holdings (-3.9%) and IOI Properties Group (-3.7%). Last week’s losses pared total portfolio returns to 215.5% since inception. Nevertheless, this portfolio is outperforming the benchmark index, which is down 12.6%, by a long, long way.
The Absolute Returns Portfolio ended unchanged for the week. The notable gainers were Tencent Holdings (+4.9%), Vanguard S&P 500 ETF (+1.3%) and Microsoft (+1.2%) while Itochu (-2.7%), Swire Properties (-2.5%) and Airbus (-1.8%) were the biggest losers. Total portfolio returns since inception stand at 2.8%.
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.
