QVMM - Is It 'Groundhog Day'... Or Should We Call This Movie 'Back To The Future?'

2023-09-11 10:05:00 ET

Summary

• August CPI, due 9/13/23, becomes another focal point / the inflection point du jour.
• A look back on US rate structure gives perspective (higher for longer?).
• Still very constructive on the market with caveats on sector and valuation.

For the market, every day is Groundhog Day

Wouldn't you like to wake up just one morning and not be inundated with a barrage of headlines about potential bad times ahead for the economy due to high interest rates and inflation, the Fed's continuing battle against inflation, geopolitical upheaval and government dysfunction (government shutdowns)? Fa-geda-aboud-it! It isn't going to happen. In fact, I can't think of a time when I've ever seen a good news day. In this trying environment, perspective always helps, and that is what I attempt to give in my posts.

This week's focal point should be the CPI inflation numbers for August. Over the past year, we have seen a tremendous reduction in the CPI stats, but August 2022 is a tougher comparison. I don't claim to know what the number will be, but I do believe that I might have a feel for the potential reaction to a positive or negative surprise. Last August, CPI was reported up 1/10th of one percent (1.2% annualized rate). Heaven forbid if the number is 2/10th or 3/10th of one percent (2.4%, or 3.6% annualized). The bears/media will seize on these numbers (both of which would be above the Fed's 2% long-term inflation goal) and will trigger a raft of speculation around the Fed being more aggressive raising rates at the FOMC September 19 meeting. Rinse, wash and repeat. It's groundhog day all over again!

I can't depart this topic without a few words of counterpoint. Although unemployment has ticked up a bit, job creation has slowed and there is evidence in certain sectors of the economy that things are beginning to slow, we are not talking about financial collapse. At worst, what may lie ahead is a slowdown or mild recession. Since many have been forecasting recession or worse for months, when it arrives (if it arrives) it will have been well-priced in to the market (maybe last October). Remember, the Fed has two mandates: stable prices and robust employment. At this point, the rapidity with which they raised rates and the usual lack of immediate cause and effect response by the economy has to make them more cautious, not wanting to do serious harm by pushing rate policy too far.

Perspective: Looking back on US rate structure

For purposes of comparison, the current US Fed Funds target range is 5.25-5.5% and the yield on 10-year US Treasury note closed last Friday (9/8/23) at 4.26%. Please compare these number with this historical data on rates:

"Interest Rates (Fed Funds) in the United States averaged 5.42 percent from 1971 until 2023, reaching an all time high of 20.00 percent in March of 1980 and a record low of 0.25 percent in December of 2008."

(YCharts)

"The 10 Year Treasury rate is at 4.27%, compared to 4.30% the previous market day and 3.27% last year. This is lower than the long term average of 5.88%."

(Google Finance)

I will reiterate what I have written so many times in past: the only reason that the rates of the last 12 years have been so low is because of the financial emergency in 2008 and the pandemic. The only reason that they were kept so low during the interim period was because of fear that the economy was too weak to sustain higher rates and, subsequently, relentless jawboning on the part of the previous administration to keep those rates low. This was an abnormal rate structure that is not needed in the strong economy that exists today. So, could rates remain higher for longer? Yes, and they would still be well below their historic highs but pretty much where they have been on average historically. It does look as though we've gone "back to the future" in that respect. BTW, the 10-year note is still 160 basis points lower in yield than its historical average... what a deal for the economy!

Constructive on the market with caveats on certain sectors and valuation

"In 2000 [at the peak of the internet bubble] tech stocks were 33% of the S&P 500, but by 2003 these names occupied only 14% of the index." ( Investopedia ) Today, the "Magnificent 7" occupy by themselves almost 28% of the S&P 500 market capitalization ( Yardeni Research ). That is what I call concentration risk. To be sure, today's M7 are much better-capitalized/real companies than the majority of internet plays that were in vogue 23 years ago (i.e., there may be downside and underperformance, but not to the extreme of the Y2K experience). Nonetheless, you can see where the crowd has gone with its money, and that is never good company to keep. By way of comparison to another past market favorite group, energy in 1980 was almost a 30% weight in the S&P 500. Today, it is around 4%. Energy will never be technology, but realistically, it could become a 6% weighting over time. Assuming no change in the index, we're talking about 50% gain. Infotech has to go to a 42% weighting to provide the same result. Never say never, but it is hard to imagine tech being able to do that.

Valuation in the Mag 7 stocks is also concerning. Going back to Ed Yardeni's work, the forward P/E on the "MegaCap-8" (includes both classes of Google ( GOOG , GOOGL ) is almost 28 times (Fig. 9 here ). This skews the S&P forward multiple higher to 19.1 times. Without these 8 stocks, the forward multiple on the S&P 492 is 16.9. (15 is the long-term average for this index.)

To examine this concentration in another way, on May 15th of this year, the combined market capitalization of Microsoft ( MSFT ) and Apple ( AAPL ) was nearly $5 trillion (just two stocks out of 500). At the same time, the total market cap of the Russell 2000 index was only $2.23 trillion. This is an incredible mismatch. In June of 2023, the total market cap of the S&P was $37.16 trillion. At 28% of the index, the Infotech segment was over $10 trillion of the S&P. If just $1 trillion of tech (10%) rebalanced to the small-cap index, you could potentially be looking at a 50% upside in the R2K. This is not to mention the S&P 400 mid-cap index, which ended 2022 with a $2.2 trillion market cap. These numbers would indicate to me that there are significant opportunities away from the current market's favored few.

What's your take?

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