AFMC - Is 'Irrational Exuberance' Helping To Drive Equity Market Resilience?

2023-10-31 03:00:00 ET

Summary

• Are markets experiencing 'irrational exuberance?'
• Why the U.S. consumer may be at the end of their spending rope.
• Has the Fed lost its influence over the U.S. economy?

Transcript

Greg Bonnell: From geopolitical risk to drama in Washington, sticky inflation, and high interest rates - certainly a lot of uncertainty facing these markets. Joining me now with his perspective on how to approach the current investment landscape is Phil Davis, founder of philstockworld.com. Phil, always great to have you back on the program.

Phil Davis: Hi. Very nice to be here. Thanks.

Greg Bonnell: We got a lot to talk about. Luckily, we're going to be together for an entire program. I want to start with what we're seeing in the markets right now. These have been some tough days for the markets, whether it's bond yields pushing higher, uncertainty in the Middle East. How are you reading it all?

Phil Davis: Well, the geopolitical stuff, it's a big wild card. We've been at war in the Ukraine for years. So we kind of take these things in pace after a while - unfortunately, get used to anything. And I'm more concerned about where the markets are right now, which I think they're very stretched.

And the problem is the markets are priced like there's nothing going on, and there are things going on. I think that's where you run into trouble, is the optimism in the markets. It's that irrational exuberance again.

Greg Bonnell: That doesn't sound good because there's a lot going on. And these are fluid situations, particularly in the Middle East. If something happened, that could shock the markets. Could we see an outsized reaction?

Phil Davis: Well, we've seen a little bit of it recently, right? The Fed came in and said we might be a little bit tighter than you think, and it's going to be longer than you think, and then the eruption in the Middle East. And there's more inflation pushing back now than people thought they would be, which justifies the Fed continuing to tighten. It's not as rosy as a S&P at close to 30 times earnings reflects. It doesn't make any sense.

Greg Bonnell: When we talk about the 10-year treasury yield in the States, keeps making that run for 5%, gets above it, pulls back-- but it's still very high. We've got to go all the way back to, what, 2007, 2006 to find levels like this. What is the driver here? Is it really just the central banks telling us that we're probably going to be higher for longer?

Phil Davis: Well, look, the central banks are telling you this is what it takes to contain inflation. You don't want to have 10% inflation annually. We had that in the '80s. It's really painful and difficult to navigate.

The most important thing for investors to understand - amazingly, this is lost on people - is 5% interest on a bond is 5% interest on a bond. It's a technically risk-free investment, although it isn't because when the bond goes up, you lose money on that. But in theory, it's a risk-free investment compared to the market.

Now, a company that's making 20 times earnings is also returning 5%. That's what 20 times earnings reflects - a 5% rate of return on your money over time. When you're over a 20 times multiple, the stock isn't as good as the bond. And if your stock's not as good as the bond, which is, essentially, safe, then your stock better have damn good reasons for the price it's at. And people have completely lost touch with that concept.

Greg Bonnell: Let's talk about this environment. And if we're talking about higher for longer and some of the things that are happening with central banks, there are people who would have thought after a year and a half of aggressive central bank rate hikes, that the economy would have slowed demonstrably by now.

Heading into this year, there was a thought on the street that we might even be in cutting territory now because the work would have been done. The work is taking longer. It's all a long way of me asking, has the Fed lost the influence it thinks it has on the economy?

Phil Davis: I think people think the Fed has more influence than it actually does. The Fed can respond - in a flat, flat environment where nothing's happening economically, the Fed can say, OK, we're going to nudge it this way or that way. But if the economy is heading in a certain direction, the Fed can't do much about it. They're just going to get run over.

And what the Fed can't afford is to look foolish because it's the mythology of the Fed being able to influence the markets that is the Fed's biggest power. It's like the Wizard of Oz. Don't look behind the curtain because it's just a little guy pulling some levers. And if people lose faith in the Fed being able to control the economy, that's when the economy can get really out of control.

Greg Bonnell: Well, when we talk about the economy, we talk about the fact that we thought the Fed may have had more influence at this point. You keep hearing about a resilient consumer, a resilient consumer. Are the consumers really that strong, are households really that strong at this point in the cycle?

Phil Davis: No. I think that we've got over $5 trillion of consumer debt, not mortgage debt. Consumer debt is over $5 trillion. And maybe 20% of that is revolving credit at 18%, 20%, whatever the heck they're charging these days for credit cards. It's painful, and people are reaching sort of the end of their limits.

And that's why we're watching the bank earnings very closely to hear what they're saying about the consumers, and the defaults, and the late charges, and so on and so forth. It's all starting to kind of grind to a halt because consumers have really hit their limit. And now we're coming into holiday shopping season. If that doesn't improve, we've got some serious issues ahead.

Greg Bonnell: I've often thought about the consumer story and the fact that we are seeing credit card balances run up as well. And I question, with my limited understanding, whether it's resilience or it's simply just tapping every available mechanism you have to keep spending.

Phil Davis: To me, it's tapping. Look, people are getting jobs. There are more jobs, right? So we're adding couple million more consumers - a guy with a job is better than a guy without a job. So we're adding a couple million consumers a year. But that's not enough to really tilt the scales.

What's really driving consumer spending is inflation. You have to spend more. You have to go to the grocery store. Last year, it cost you $200 to go shopping. Now it costs $250 to go shopping. So yeah, consumer spending is up but not because they're happy about it, not because they're enjoying themselves. That's a problem.

Greg Bonnell: Let's talk about artificial intelligence. I know you've mentioned at times before on the show we're in the thick of earnings season. We're starting to get some of the biggest names in tech reporting earnings. What do you expect to see given the AI bump we saw earlier in the year? Earlier in the year, you said the word "AI" in your earnings release, everyone got excited. What's happening now?

Phil Davis: Well, look, long term, AI is going to be a massive success the same way that dotcom was a massive success. But just like dotcom, 9 out of 10 companies that are doing AI now are going to be gone in 10 years or 5 years. Who knows? People are throwing money at anything that says "AI."

But honestly, in the S&P 500, there's only about 11 companies that provide AI. The other 489 companies in the S&P 500, they consume AI. They're paying for AI as a service. It's an extra expense. And they have to justify that expense over time with productivity gains. Otherwise, it was a bad project, just like dotcom. People couldn't justify all the money they threw at dotcom projects back in the day.

In fact, today, Microsoft ( MSFT ) had spectacular earnings because they, very, very wisely, spent $10 billion on the first day of AI and bought OpenAI, ChatGPT people. They bought them. And because they bought them, all of ChatGPT is hosted on Microsoft's cloud.

And plus, Bing has become more popular, also hosted on Microsoft's cloud-- so cloud services Microsoft exploded. Meanwhile, Google ( GOOG ) ( GOOGL ), who rushed to the market with Bard, it's not a very good product. And they're not able to integrate it and do the things that Microsoft's doing. So Microsoft went up, and Google went down.

So not even the companies that provide the AI are necessarily all going to win. But Google, Nvidia ( NVDA ), Adobe ( ADBE ), people like that, they're going to do great eventually with the AI. But other people are just buying it. It's a service.

Greg Bonnell: There's definitely a tale of two different companies. They were just showing the audience how Microsoft performed on the back of their earnings and how Google performed -- very divergent. We had Meta ( META ), the parent company of Facebook, after the close. We got more on deck for the rest of the week. What are you watching for from some of these companies if, indeed, we should be watching for the AI angle?

Phil Davis: Well, again, I think the most important takeaway of this thing is that most companies, it's not a question of having AI. Saying "AI," just like "dotcom," doesn't mean you're going to be successful. It matters what you do with it. If you figure out something smart and you develop a system around it that creates a consumer experience that drives revenue, great.

But most people aren't doing that. Most people are just saying, I got to have AI. I don't know why. I don't know what I'm going to do with it, but everybody else seems to have it and I better move quickly. And yeah, they're probably right, but that means expense, expense, expense. And then maybe next year sometime, they figure out how to make money with it.

Greg Bonnell: It feels like the early days of the broader community getting access to the World Wide Web, as we called it back then. I can remember with my old 14.4 modem, dialing up, getting on chat forums. You're like, oh, it's sort of cool when I'm talking to someone on the other side of the world about a new album that just got released, but where's the money from it? Eventually they found how to get the money from it.

Phil Davis: Yeah, but how many people really did, right? How many people actually figured that out? It all went to a few mega tech companies that are around today.

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