March 01 2024

Noise and Bias

Rally expanding: From Mag7, to Granolas. One thing in common: superior growth and earnings. Those blue chips have led the charge, and took global markets higher.

This bubbling up rhymes with the dotcom bubble, but is nothing like it. Monetary policy was loosening both in the US and Europe back then, while rates are higher and money supply decreases now. Valuations often cited as sky-high for the Mag7 are still about half as high as valuations of the dotcom era. It is not about internet only, it is about infrastructure for industry 4.0, and pharma. Most importantly, the main performers are actually posting stunning growth, profitability and free cash flows, in stark contrast with yonder years.

There remains that some still smell a rat, and the sage of Omaha would most probably have something to say about “overvaluation”.

Then again, the right opportunities are probably still there for a keen eye to see. You might want to follow the winners. Also, some areas appear ripe for a bounce, such as dividend stocks, Utilities, Energy, and Materials. Besides, should the economy continue to perk up, Industrials would probably rally further, as per Liz Young at SoFi.

However, there are cautionary tales on not reaching too deep into the opportunity basket, where the unprofitable sort, and not-credit worthy lurk. This means that SmallCaps in general, and deeply discounted high yield are only for the brave.

There remains this deranging two-pronged disconnect though. One at home, between large caps and small caps, and one overseas between the US and the other large economies.

Real yields suggest that PE ratios are too lofty to trust, and would probably warrant a ~10% correction. Still not the end of the day though.

So what is it? To justify the strength of the US economy, Bill Gross hesitates between excessive fiscal spending or AI productivity gains.

Well, two things can be true at the same time. In fact, lavish Government spending, running a ~$2tn/yr deficit, supports key parts of the economy on an imposing 37% spending-to-GDP ratio. We are heading toward a US flavored Liz-Truss moment, as and when the newcomer president will extend the latest fiscal largesse. Some say, let’s kick the can down the November road on this one, shall we?

In parallel, it is very true that companies are putting their cash coffers at work to subsidize the transition to the AI-of-everything era. Nvidia appreciates their data center infrastructure spending very much, thank you. Actually, Nvidia has been efficiently matching new demand for data centers, thus expanding its FY24 data center sales to ~$48bn (78% of FY24 revenues) and expanding its TAM to $300bn in the foreseeable future.

Productivity gains are made at several levels. First, the sharp uptick in demand for chips has been forcing TSMC, Intel and Samsung not only to reduce the size of chips, down to 3 nanometer, to cram as many as possible, but also to augment the yield of each chip through “advanced packaging”. Transistors are stacked on top on one-another for greater efficiency. Nvidia is TSMC’s main client for this capability. Watch out for supply constraints.

Additionally, productivity will come to your office. Goldman Sachs estimates that ~25% of work can be AI-automated across all industries. This percentage tops 44% in administrative support functions.

So far, indeed, the jump in productivity growth has been greater for services. Information and business services saw the largest increase in productivity per worker from 3Q19 to 3Q23. The picture is more contrasted for manufacturing, where huge capex precedes the roll-out of AI-enabled machinery.

All good, but where does that leave us market-wise? February saw a broader market rally across large and small names in the US. Within blue chips, market breadth is narrowing. Despite a catchup, rate-sensitive small caps are laggards as investors remain lukewarm. I support a healthy and frequent rebalancing across styles, which allows profit-taking on larger names, and “relution” on smaller.

Bond are back…kind of. As February saw a rally in rates, bonds took it on the chin and are nursing negative performance YTD24. Now, it sounds more like “bonds have briefly been back”, or “will be back”. I continue to believe that on a 2-year north of 4.5% fixed income money is worth spending though. Traders would prefer long 2-year, and short 10-year even more, as the curve would likely flip back following the first rate cut. Besides, rising term premium in the light of fiscal mismanagement is not excluded either.

Lastly, I note some opportunities on the fringe of private credit. As a combination of worsening Commercial Real Estate defaults, and prudential ratios, banks are offloading assets from their balance sheet to shore up liquidity. They sell the most liquid and valuable first at a small discount for quicker sale. Worth getting on board as a private lender.

Stay safe out there !

About –

360 Advisory LLC is a Boston-based RIA managing investments