Is Too Much Money Too Much?

1ST QUARTER SUMMARY

The economy remained stronger than most anticipated, investors felt confident, and most securities prices rose. Employment is strong and when people have jobs, they spend money. Consumer spending accounts for 67.7% of the US economy1 and has been the case for the last 15 years. One must go back to 1978 before it dipped below 60%. As the consumer goes, so does the economy.

The S&P500 index was up 10.6% for the quarter and 28.9% for the trailing 12-month period.2 Index returns are weighted to the largest companies and continue to be dominated by just a handful, notably Microsoft, Apple, and Nvidia. The return for the equal-weight S&P500 index was about half, coming in at 14.9%.3 Put in context, historically we should be very happy with a full year’s return north of 10%.

The S&P Aggregate Bond index was -.56% for the quarter and +2.2% for the trailing year.4 The “bond market” as measured by the I-Shares Core Aggregate ETF, cumulatively lost 9.2% over the last three years.5

For the last few years, we have held relatively “high” money fund balances or very short-term treasuries, yielding around 5%.6 The decision to keep “high” money market balances has proven to be better than intermediate bonds.

Interestingly, as strongly as the tech stocks performed in the first quarter, the best-performing sector for the quarter was energy (+13.5%) following a dismal 2023 (-6.3%). This rebound in energy reinforces what we have learned: Companies that generate growing free cash flow, pay down debt, buy back stock, and increase dividends reward shareholders. Generally, we have opted for the larger more diversified energy companies to somewhat mitigate their inherent volatility.

The following chart illustrates that the energy sector still appears to be very attractively valued with relatively high dividend yields and lower price-to-earnings ratios.

We will not be overweight to energy forever. However, since the pandemic, attractive valuations and rising cash flows in the energy sector offer, in our opinion, some of the most compelling risk/reward valuations available.

Without reliable, affordable energy, the world cannot prosper and as of early April, energy continues to do well.

CURRENT VALUATIONS, NEAR-TERM OUTLOOK

As we have maintained, the first driver of asset prices is liquidity, then growth, then value. Regardless of how compelling a company’s growth prospects or valuations are, if liquidity shrinks, asset prices fall. When liquidity increases prices tend to rise. This is where we are today.

By most historical measures, valuations are high. Corporate earnings have risen from Covid lows, and growth in earnings, currently projected at 12%, is being extrapolated.7 On top of that, expected further cuts in short-term interest rates have kept stock prices high. Recognizing pendulums swing to extremes, we avoid chasing the media darlings. Patience and consistency will be rewarded.

To put things in perspective, since 1928 the average annual return of the Dow Jones Industrial Average is 9.9%, and the SP500 has been 10.26% since 1957.8 Avoiding buying shares of popular stocks after they have gone up is difficult. Investing in index funds, without knowing the composition or valuation, can be dangerous. The chart following shows how expensive the top 2% of the SP500 index is today, even compared to the top 10%.

The takeaway from the chart above is that buying index funds or ETFs heavy in mega-cap tech giants today comes with risk.9 However, human behavior drives emotional reactions, and investors usually buy after stock market run-ups and sell after market corrections. Dalbar studies have repeatedly shown the average investor earns about 60-70% of popular index returns.10 We are reminded of the adage, “Once wealthy, the first priority is to stay wealthy.” No one wants to have to get rich twice.

INSIDER SELLING

Corporate insiders are always selling stock. However, the timing of when they accelerate their sales is interesting. We are currently seeing a high ratio of selling to buying in tech companies. You will notice tech insiders sold the most right before large selloffs. This pattern doesn’t always lead to corrections, but these sellers are among the most knowledgeable about their company’s prospects relative to their stock price.

TRENDS

Artificial Intelligence (AI) has dominated the headlines and the manufacturer of the fastest processing chips, Nvidia, was the runaway winner (stock price up 520% in the last 15 months). Semiconductor manufacturer’s stock prices have been notoriously cyclical and historically sold at a discount to the market. Today they are selling at two to three times the valuation of tech peers. One might ask, ‘ How long can this continue?’

Outside of Nvidia, it is unclear who the real AI winners will be. When the internet was built in the 1990s, the real winners were the “second layer” companies, like Amazon, Google, Meta (Facebook), and Uber. Most of the infrastructure companies went bankrupt or, if they survived, woefully underperformed.

With AI, one thing that is clear is the enormous amount of power required to run these supercomputers. It will not come from renewable energy projects in that most renewable energy projects have proven to be financial disappointments.11 The cleanest, most energy-efficient source is nuclear. However, the Nuclear Regulatory Commission has made it nearly impossible to approve new nuclear reactors in the last 40 years.12

This brings us full circle to the one sure beneficiary of the AI trend – energy providers. They should include natural gas producers and the distribution systems that get the gas from producers to users. We believe AI will become, like the Internet, part of everyday life. Therefore, we want to own companies that sell the “picks and shovels” to the modern-day gold rush participants. Nothing happens without energy.

INFLATION

The Bureau of Labor Statistics continues to redefine and reposition the official published numbers. After inflation peaked in June of 2022, we posited it would be easy to reduce inflation from 9% to 5%, and how hard it would be to go from 5% to below 3%. Despite the media coverage and Fed press releases, the published Consumer Price Index (CPI) has not dipped below 3% for the last two years.13

The current Federal Reserve chairman insisted on being “data dependent” prior to the 2022 mid-term elections. Once CPI hit 9% that June, the same “data dependent” Chairman immediately predicted it would be “transitory”. His politically motivated flip-flop going from “data dependent” to “forecasting” was obvious. Today, with a strong economy, full employment, and 3%+ inflation, the Fed is forecasting they may need to cut rates to prevent a slowing of the economy. If they do, inflation is sure to ramp up.

You will recall we anticipated this in our 1stQ23 communication. In December of 2022, the San Francisco Federal Reserve released a study suggesting rate cuts that came “too late” could hurt the economy for a decade.14 It is hard to imagine this was not highly orchestrated to give Powell plausibility to backtrack on his politically expedient “data dependency” stance. Without a recession, inflation should be “higher for longer.”

NATIONAL DEBT WARNING SIGNALS

Bloomberg recently released a study that indicated an 88% chance that the US Federal debt is “unsustainable”.15 The data is based upon a release from the Congressional Budget Office (CBO) which actually understates the problem. First, the CBO assumes no increase in debt service cost (currently 2.86%) when current reinvestment rates are ~2% percentage points higher.16 The second sleight of hand is the pivot to the nomenclature of “publicly owned” debt from “total” debt. The total Federal debt is more than 125% of GDP, not just the 97% owned by the public.17 As annual deficits compound and total debt increases, it slows the growth of GDP and normally hurts the currency.

There has been precious little said about the compounding debt problem recently because no politician or central banker wants to have to deal with it. Therefore, for the next couple of years, owners of assets, and those who spend less than they earn and invest in equities, should be OK. However, people who don’t own real estate nor save in stocks may be in for a tough slog.

FEDERAL RESERVE – INTEREST RATES WANING INFLUENCE

The Federal Reserve stated mandate has been to achieve full employment and keep inflation steady. However, its unspoken real priority is to maintain the integrity of the sovereign debt. That means if the US dollar starts to fall too fast, the Fed will do whatever is needed to stem the tide. Falling currencies are usually the byproduct of too much government debt caused by overspending.

This reminder was reinforced by the British government bond (gilts) crisis in September of 2022. The budget austerity caused the gilts and the British pound to crash.18 The Bank of England intervened, 10 Downing Street immediately reversed its policy, and the Prime Minister was ousted due to a lack of understanding of basic economic cause and effect.

The Fed’s primary tool to slow or stimulate the economy has been the Fed Funds rate. This rate, plus a spread(2-5%), has been the base banks use to charge customers to borrow. In years past, as rates rose, borrowers curtailed their investments in productivity-enhancing equipment and technology. Less so going forward.

Increasingly, productivity enhancement is a much smaller factor. Refinancing existing debt, at any interest rate, has become the only consideration. As the world has accumulated more than $313T in debt, the interest rate does not affect their decision.19 Borrows must refinance maturing debt regardless of interest rates. There literally is no end in sight and the inevitable effect of mounting debt is rather grim.2021

The role of the Federal Reserve has changed as Congress relies on it to save the economy from their fiscal mismanagement. If we continue to monetize our fiscal deficits, inflation will be the least, worst option.

MEA CULPA

Over the last few years, lower tech and bonds exposure, along with higher energy and money market exposure, has served investors very well. However, this is a good place to acknowledge a few unforced errors. In addition to having just two of the “Magnificent Seven”, last year when tax loss harvesting, I sold Mickey Mouse’s parent company and missed buying it back. I have long espoused the enduring value of their theme parks and the recurring revenue from the movie library. When it moved up, I failed to rebuy at the higher price.

Fortunately, when we sold the Baltimore-based asset manager to realize a tax loss, we swapped into the largest asset manager based in New York. The newer position has done quite well, and we rebought the Baltimore firm, and that too has been appreciated.

TYING IT ALL TOGETHER

Our approach to managing wealth has been to create diversified sources of rising income with the goal of exceeding inflation, after taxes and fees. We do this by owning financially strong companies that generate attractive returns on invested capital and have loyal customers. Further, we seek managements that have productively reinvested free cash flow or increased dividends.

We believe the overriding theme for the next decade will be the consequences of compounding debt:

There is no political appetite to increase taxes enough to balance the budget, let alone pay down the debt.

If short-term interest rates stay above GDP, it is a function of time before our national debt compounds to an unpayable amount.

The most likely outcome, in our opinion, is that interest rates will be lowered, inflation targets will be reset to 3%ish, monetary debasement ensues, and consumer inflation picks up.

If too much money becomes too much, having some cash on hand makes sense to us. Income-producing assets, like rental real estate in geographies experiencing population growth may do very well. Additionally, we feel some of the beneficiaries of these secular trends will be “toll takers” on essential services, asset management companies, securities exchanges, and data providers. Companies with strong financials, modest cap-ex requirements and loyal customers should do just fine.

STAY OPTIMISTIC

Let’s remember, as challenging as immediate forecasts might be, investing in capitalism and the United States, has been the best course over the last 250 years. Being a little contrarian, investing in quality for the long-term, and having patience through inevitable economic dips is the remedy for most financial disruptions.

We feel good about our positioning and hope you find comfort in it as well.

1 https://fred.stlouisfed.org/series/DPCERE1Q156NBEA

2 https://www.forbes.com/sites/rrapier/2024/04/01/the-best-performing-energy-stocks-of-q1-2024/?sh=4d3fc6b11f74

3 https://www.google.com/search?q=equal+weighted+SP500+stock&oq=equal+weighted+SP500+stock&gs_lcrp=EgZjaHJvbWUyBggAEEUYOTIHCAEQIRigATIHCAIQIRigATIHCAMQIRigATIHCAQQIRigATIHCAUQIRigAdIBCjE0MDg5ajFqMTWoAgiwAgE&sourceid=chrome&ie=UTF-8

4 https://www.spglobal.com/spdji/en/indices/fixed-income/sp-us-aggregate-bond-index/#overview

5 https://www.ishares.com/us/products/239458/ishares-core-total-us-bond-market-etf?cid=ppc:ish_us:ish_us_br_core_product_exact:google:brand_prod:ei&gad_source=1&gclid=CjwKCAjw_LOwBhBFEiwAmSEQARRSMoIYdUeNB_GYawYv4oDdXrF_pMGa7noUTvd4prRCx9Y6OaYx6hoCQC8QAvD_BwE&gclsrc=aw.ds

6 https://www.spglobal.com/spdji/en/indices/fixed-income/sp-us-aggregate-bond-index/#overview

7 https://www.reuters.com/business/finance/bofa-lifts-2024-sp-500-profit-forecast-ai-enters-virtuous-cycle-2024-03-12/

8 https://www.investopedia.com/ask/answers/042415/what-average-annual-return-sp-500.asp

9 https://www.invesco.com/qqq-etf/en/home.html

10 https://www.cnbc.com/2024/03/07/why-bailing-on-the-stock-market-is-likely-a-losers-game-cfp-says.html

11 https://www.iea.org/commentaries/financial-headwinds-for-renewables-investors-what-s-the-way-forward

12 https://grist.org/energy/first-us-nuclear-reactor-40-years-online-georgia/

13 https://www.bls.gov/charts/consumer-price-index/consumer-price-index-by-category-line-chart.htm

14 https://efaidnbmnnnibpcajpcglclefindmkaj/https://www.federalreserve.gov/econres/feds/files/2022085pap.pdf

15 https://www.bloomberg.com/news/articles/2024-04-01/us-government-debt-risk-a-million-simulations-show-danger-ahead

16 https://www.imf.org/external/datamapper/prim_exp@FPP/USA/FRA/JPN/GBR/SWE/ESP/ITA/ZAF/IND

17 https://www.ceicdata.com/en/indicator/united-states/government-debt–of-nominal-gdp#:~:text=United%20States%20Government%20Debt%3A%20%25%20of%20GDP,-1969%20%2D%202023%20%7C%20Quarterly&text=United%20States%20Government%20debt%20accounted,Mar%201969%20to%20Dec%202023

18 https://www.bloomberg.com/news/articles/2022-12-09/the-pound-went-on-a-wild-ride-close-to-dollar-parity-in-2022

19 https://www.reuters.com/business/global-debt-hits-new-record-high-313-trillion-iif-2024-02-21/

20 https://unctad.org/publication/world-of-debt

21 https://econofact.org/why-is-the-u-s-debt-expected-to-keep-growing