Dear readers, our quarterly stock market commentary is a little longer than usual today. We hope you enjoy the results of this effort.
We end the first half of 2023 with a cash reserve and a stock market that has been in a strong recovery following two huge shocks. Market agents are worried about the concentration in the tech sector and in extended valuations as estimated by traditional metrics like price/earnings ratios or price/sales ratios. Our US Equity ETF portfolio is underweighting the tech sector, but it does have some exposure to it. Please remember that these positions may change at any time.
The recent fierce discussion regarding artificial intelligence (AI) applications has spurred tech sector participants to new highs. About a dozen stocks are the power behind the S&P 500 Index’s dramatic price ascension. There are some signs that the market is now broadening as bullish characteristics seem to overpower the bears and force the short sellers to cover. The worry over options expiration seems to have occurred without too much market pressure. The feared “Triple Witching” day in mid-June seems to have fallen under the spell of the market’s bullish power and magnetic optimism.
We remain underweight the banking and financial sector in the US Equity ETF portfolio. We believe that the time will come to enlarge that bank sector exposure, but that time has not yet arrived, in our view. Banks have been hammered this year. The significant bank failures in the spring of this year have made the record books. The total size of SVB, Signature and First Republic combined now exceed the total assets of the banks that failed during the Global Financial Crisis in 2007–2009. How quickly we forget that history. Washington Mutual was the largest failure and was seized by the Office of Thrift Supervision (OTS) and turned over to the FDIC. Assisted mergers resolved Wachovia, Bear Stearns, Merrill Lynch, and Countrywide. It took the Lehman meltdown to trigger the final contagion.
The Federal Reserve was fast in acting this time (in 2023) to avoid further sequential failures and resulting contagion. The Fed is not going to repeat the history of the Great Financial Crisis.
This time, the shareholders and debt holders of the troubled banks’ debt were punished, but no depositors lost money. We are waiting for the results of the “claw backs” coming for management. That may take years to resolve. The Fed avoided a much-feared banking system meltdown. What happened was an unusual and extraordinary effort by the Fed. They used a special provision of the Federal Reserve Act to avoid the contagion that might have developed and sent the US economy spiraling into crisis. The Fed structured the emergency lending to finance the FDIC as the FDIC set about to liquidate and resolve the failed banks. Remember that the Fed did this as the debt ceiling fight was developing and when it was not known how the US Treasury would be able to borrow to finance the credit line it extends to the FDIC.
We applaud the excellent commentary by Bill Nelson, Chief Economist at the Bank Policy Institute, for ferreting out the details and explaining them to his readers. With his permission, which has been given, we will forward his latest note of explanation to any reader who asks us. Note that these are Bill Nelson’s personal views. We thank him for letting us share them with our readers upon request.
For market agents, the banking crisis was the first of the two huge shocks. Stocks were punished. Clients were scared. I recall one conversation in which the client asked that we liquidate her entire portfolio (about $9 million) and sit in cash. She said, “Sleep at night is more important than anything else.” I agree with her about sleep. By the way, she is now back into a balanced portfolio structure of equities and bonds.
Let’s get to the second shock. It was the debt ceiling crisis, and it was entirely contrived by those members in the House of Representatives who chose to use their narrow margin of political power to force a perilous and costly round of brinkmanship on the American society and the stock markets and the bonds markets. We will be publishing an extensive discussion about the full cost of the debt ceiling crisis. As we said in interviews, we Americans pay the price for it before there is an actual default — even if there is ultimately no default — and we also pay after the resolution, by a permanent shift in the longer-term markets. Our estimate is that the final full cost of this politically motivated, unnecessary, fear-inducing shock is in the many tens of billions. In future writing we will disclose how we got that estimate.
Suffice it to say that the debt ceiling shock hurt stock markets and bond markets and came right on the heels of the banking system crisis. So, markets faced a “double whammy” in the second quarter of 2023.
In such circumstances sellers seek safety, and with cash equivalents yielding 4%–5 %, they are able to find an attractive alternative to owning stocks or longer-term bonds. Thus, the flight of money was from smaller and mid-sized banks to the very large banks and from bank deposits to govy money market funds which, in turn, placed billions into the repo facility backed by the Federal Reserve. Longer-term bondholders found bargains if they had the courage to buy them. At Cumberland, we were able to obtain almost 5% tax-free in certain high-grade munis that were indirectly backed by the federal government, while the very same federal government’s taxable 30-year Treasury bond was yielding under 4%. This is the same credit, with 1% more being paid tax-free to the Muni bondholder. This incongruity makes no economic sense. But it does show how distorted some of the market segments became when they face two huge sequential shocks.
Looking ahead to the rest of 2023 as the second half unfolds is like peering through a fog. The employment statistics that we write about provide a mixed picture. The recession-or-no-recession debate rages. We think one is coming but have no idea how severe or when it will arrive.
The earnings picture for the American stock market entails a mixed batch of outlooks. Remember, it takes earnings to establish longer-term values for stocks. Lastly, there is the evolution of AI, which is certainly a technological jump forward, but what it means for revenues and earnings of the companies involved is unknown. We’re bullish on the applications of AI and believe that they will be a buffer to replace shortages in the labor force with higher productivity from technology. The labor shortage is fixable if Congress were to open the immigration channel and let the people who want to work come into the country. But extreme culture war politics stands in the way. The other issues of declining population, lower life expectancy, and low birth rates are demographic headwinds. If our politicians don’t fix this immigration policy issue, they will only witness those other headwinds to worsen over time.
I’m not sanguine about the political results in our nation, given systems fractured by the political culture wars presently underway.
What about the long-term view of the stock market? Many point to stock market history as a positive force. To address that question, we are fortunate enough to have obtained permission to share this excellent research study published by DataTrek. Nick Colas and Jessica Rabe have a daily, detailed, market-focused newsletter filled with facts and data (see https://datatrekresearch.com/#home-call). They research and back up their views with citations. We subscribe, and we read their letter daily. We thank Nick and Jessica for permission to share their 20-year stock market view with our readers.
Now here’s the guest commentary, which we will use to close this quarterly report.
David R. Kotok
Chairman & Chief Investment Officer
Email | Bio
STT: Why Stocks Go Up – A DataTrek Commentary by Nick Colas and Jessica Rabe
The idea that US stocks reliably compound at 10-11 percent on a total return basis is only right over extremely long timeframes. Over a 20-year holding horizon back to 1928, nominal/real returns have been as low as 2.4/0.6 pct or as high as 17.7/13.7 pct. Even recently (1999 – 2018), 20-year returns were just 5.6/3.4 pct. Two factors drive cross-cycle returns: the cost of corporate capital and the return/growth on that capital. Over the next 20 years, US equity returns will be driven by the latter; risk-free rates are already about as low as they can go.
The 3 essential takeaways from this data are:
1: The famous adage that US large caps compound at 10-11 percent annually is rarely true:
- Yes, the long run average of trailing 20-year annual compounded returns from 1947 to 2022 is a nominal/real 10.8/7.1 percent.
- In practice, however, even 20-year returns are rarely close to those results.
- A one standard deviation band around the mean ranges from a +7/+14 percent nominal return on the upside to a +4/+7 pct real return on the downside. In real dollar terms, that is the difference between doubling your money in 11 or 18 years.
2: There have been two cycles of peak 20-year compounded annual returns since 1947:
- The first was from 1942 to 1961, at 16.7/13.3 percent nominal/real returns.
- The second was from 1980 to 1999, at 17.7/13.7 percent.
- The causes of these peak returns are fairly easy to identify. In the first case, it was the US victory in World War II and the subsequent post-war economic and demographic boom. In the second case, it was declining interest rates and the late 1990s tech bubble caused by widespread adoption of Internet 1.0.
3: The three periods of trough long-run returns have equally clear catalysts:
- The October 1929 crash and Great Depression saw 20-year nominal/real compounded returns of just 2.4/0.6 percent from 1929 to 1948.
- Two oil shocks, which together took crude prices from $1/barrel to $40/barrel from 1973 to 1980, and the recessions/inflation they created meant the S&P only compounded at 6.8/0.9 percent from 1963 to 1982.
- The combined effect of the dot com bubble bursting in 2000 and the end of the housing bubble/Financial crisis of 2008 took 20-year S&P annual returns down to 5.6/3.4 percent from 1997 to 2008.
Putting these swings into the context of fundamental drivers of stock returns, what we see at play in the chart above is the waxing and waning of two factors:
The first is the corporate cost of capital. This has two components. The first is the risk-free cost of capital, measured by long-term Treasury yields. The second is the amount investors require to own stocks over Treasuries (the equity risk premium).
The second is corporate return on capital. Every company, if it is to remain in business long enough to affect S&P 500 index returns, must generate a return on its capital in excess of its cost of capital. At the very least, that requires it having a sustainable competitive advantage. To be a truly important stock to index returns, however, it must also be able to reinvest its cash flows to grow the business over many years at returns similar to or better than the base business model.
In the simplest terms, the first peak in the chart (1942 – 1961) came from American companies earning consistently high returns on capital during the war and into the long post-war recovery. They had a strong competitive advantage, the world was rebuilding after World War II, and American demographic and economic trends gave them ample room to reinvest capital at excellent rates of return.
The second peak (1980 – 1999) was primarily a cost of capital story. Ten-year Treasury yields fell from 16 to 5 percent over that period, dramatically reducing both borrowing costs and lifting stock prices. Equity investors went from expecting +20 percent annual returns, based on the combination of Treasury yields and equity risk premium, to only needing about 10 percent to make it worth owning stocks over risk free bonds.
To our thinking, this is the correct framework with which to consider where US large cap returns will be over the next 20 years:
- The story of the next 2 decades will not be about declining cost of equity capital, as it was in the 1980s – 1990s. Ten-year Treasuries only yield 3.4 percent today. We might be able to eke out a small gain as they go back to 2 percent, most likely over the next 1-2 years. Past that, however, this piece of the equation ceases to be helpful to stock valuations.
- Long run US equity returns will therefore be driven by corporate return on capital and the ability to grow that capital base productively. If companies can do that better than the last 2 decades, then nominal returns will be better than the 9.7 percent of the last 20 years. If they cannot, then returns will be lower than the recent past.
This framework leads to 3 conclusions:
First, growth stocks are a better place to be than value stocks for long-term equity holders. Companies that can both achieve high returns on capital and deploy incremental capital aggressively and productively will see better stock returns than those which cannot.
Second, technology/Big Tech will have to lead the charge since no other sector or group of companies can generate similar returns on capital and leverage global growth opportunities as well as these businesses. Even in their current depressed state, margins for the US large cap Tech sector are +90 percent better than the S&P 500 (22.4 versus 11.5 percent). It would not surprise us if Tech/Big Tech were +50 percent of the S&P 500 in 10-20 years’ time. In fact, if this is not the case, then US equity returns will likely be quite poor over these timeframes.
Third and lastly, US stocks need fresh companies to take the lead if they are to compound at even the long run historical average. For example: in June 2000, the top 5 stocks in the S&P were: GE (4.2 pct weight), Intel (3.6 pct), Cisco (3.6 pct), Microsoft (3.4 pct) and Pfizer (2.4 pct). If those 5 names were still 17 percent of the index today, the S&P would not have compounded at 7.2 percent over the last +22 years.
The same thing will need to happen in the next 20 years in order to see at least 10-11 percent annual compounded S&P 500 returns, but it is hard to say which companies will most help create that outcome. That is why it is so important for the US to have a vibrant venture capital industry, for it – and only it – can restock the system with new and innovative companies. Also worth mentioning: the ability of US stock markets to draw international companies to list here is a competitive advantage for American investors, especially if these companies can find their way into the S&P 500.
Takeaway: The old mantra that “stocks always go up over the long term” may be historically true but that doesn’t mean we should take it for granted. There are specific reasons why US equities oscillate between paltry and generous long-run returns. The same will be true over the next 20 years.
Learn more about DataTrek Research here: https://datatrekresearch.com
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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.
