Trademark Financial Market Update – November 1, 2023
Interest Rate Environment Update
It seems to me that the world is now in a new interest rate paradigm. The 10-year Treasury Note’s yield struck 5% several days ago, and while it is probably oversold at present (when yields go up when bond prices go down) nonetheless, the yield is back in the range it occupied for most of the 1990s and 2000s. This has prompted investors to “de-rate” most of the stock market or in other words, to lower the range of the multiple of earnings that they are willing to pay. Remember, financial wonks use interest rates as a key input when they project the present value of future expected company earnings. When interest rates rise, the present value of those future earning decreases.
During the post-GFC world in which interest rates were suppressed, investors re-rated stocks because their cost of capital was going to be lower than normal for the foreseeable future. Additionally, the lower interest rate environment supported higher valuations as the present value of future expected company earnings increased. No industry was a greater beneficiary of this than technology, where future growth is significantly more valuable to most firms than current earnings and assets. That said, all companies benefitted, to some extent.
P/E multiples expanded from the 15-17 times range of the afore-mentioned era to 19 times earnings, and even higher at times in the late 2010s ending in 2021. That year, inflation broke out. The Federal Reserve was late to react because it was slow to grasp that the forces that had reinforced the dominant deflation narrative had been broken by the massive government response to the Covid Crisis and by geo-political changes. At that time, it became evident that China wasn’t going to be exporting deflation, and there would no longer be a “peace dividend”.
The U.S. economy as a whole did not threaten collapse when the Fed pushed rates above 3%, as it did in late 2018. To the surprise of most, 4% didn’t bring the economy down, nor did 4.5%, 5%, or even today’s 5.5% (so it would seem). Businesses that were very profitable during the low interest rate period are far less profitable, or even not viable, in today’s new rate environment. Their stock prices are beginning to reflect that new reality. Industries like telecommunications and banks were not able to tolerate 4% rates. Others (real estate, utilities, consumer staples) broke between 4% and 5% because they adapted their (slower-growing) business models toward greater leverage when rates were low. Even higher growth industries like biotechnology eventually broke, as 5% rates meant that losses could not be financed indefinitely.
The interesting thing is that if one compares non-technology stock performance in the U.S. to non-technology stock performance elsewhere in the world, it is very similar. The U.S. won the performance sweepstakes over the past 13 years because its technology sector is far broader and deeper than anyone else’s. That said, even technology doesn’t develop as fast when financing is more expensive and harder to obtain. We believe the de-rating process is largely complete for value stocks, small cap stocks, and foreign stocks as their multiples now appear reasonable to dirt cheap (international small caps). That said, if a tech stock de-rating drags down markets, those cheap sub-sectors may get even cheaper.
The industry that has suffered the greatest de-rating has been health care, which in past cycles has benefitted from being somewhat recession resistant. More than that, health care has been a secular play on aging. Within the health care sector, the medical product & services subgroup has been destroyed. There is a view that GLP-1 drugs like Ozempic are going to make the population less obese and as a result we will have much less need for things like artificial knees and heart valve replacements. Evidently, we are all going to age gracefully now. I would very much like to take the “under” on that. At some point, this is going to be a great area to invest in.
I believe that it is going to be very difficult to get inflation under 3% without putting the economy into a contraction that will be extremely politically difficult. Fiscal policy has remained expansionary enough to offset a lot of the monetary tightness the Fed has tried to implement. This is a big reason why the economy has avoided recession, and yet most people believe the economy is in fair to poor condition today. It follows that if inflation doesn’t really get below 3%, long bonds won’t get below 4%. Even 4% assumes well-contained inflation and prudent fiscal policy; I think it is reasonable to assume we aren’t going to see the latter anytime soon. This puts the Treasury Note long-term yield into the range of 4.25%-5.00% with a 25 basis point “overshooting” allowance on either side. Short rates should eventually come down nearer to the rate of inflation, so optimism about the yield curve normalizing makes sense, which I believe will make 2-5 year bonds the most attractive over the next year.
Stock Market Update
When the S&P 500 broke through support last week near 4200, it increased the odds of a new bear market beginning. That said, it would be unusual for this to play out in the November-December period. This is typically a strong time of the year, and you would have to go back to 2018, 2008, or 2000 to find pronounced weakness at this time of year. I had expected support to hold above 4200 and the S&P 500 to eventually challenge all-time highs (4800) in the first half of 2024. I am now very skeptical that this will happen. I believe the best case now is probably the end of July highs near 4600, because the market will have to expend more energy just getting back to the right side of the 200-day moving average. Falling to 4000 or less is not out of the question.
 Most of the money you make from a stock investment comes from the stock or its industry or its market being re-rated (adjusted upward to reflect better conditions than were previously assumed). De-rating is the opposite of re-rating.
 Best case, rates tend to average 1% over inflation. When inflation is uncontained and/or a country is running unsustainable fiscal or monetary policy, investors demand a higher “margin of safety”.
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