Special Edition: A Tale of Two Markets
I dislike being a skeptic, sometimes its nice when the cards fall your way. Sometimes you're right on the outcome, but your reasoning was wrong. Meaning you are as good as a coin flip.
My experience with markets has molded me into a bear and a skeptic. Always on the watch for black swans and black flags. I feel a constant pull to retreat to this base state, it is comfortable, it feels warm standing against the current. If you had taken this position throughout the last 3 years you performed worse than horrible when compared to the indices. We are up 46% on SPY from the day before the crash, 120% if you got in at the crash lows. We won’t even talk about some of the Mag 7 returns which speak for over 50% of these returns.
I am taken back to Dickens and A Tale of Two Cities, a book my father gave me.
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way—in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only.” - Charles Dickens, 1859
I am torn, it may well be the best markets we have ever experienced, or it may be a set up for one of the worst. Which way do the cards fall? Can one be active without subscribing to any particular set of beliefs? What can we examine which gives us confidence in the outcome? In this Special Edition of the MF Macro blog I will present The Best of Markets, and The Worst of Markets. Trying to understand the tale of the tape from both sides, and maybe at the end you find yourself wiser. I know I might only be more confused.
Start with the good, end with the bad. Note: both views below are biased and designed draw out an emotional response or sense of disbelief from the reader.
It was the best of markets:
The Setup:
It was the age of wisdom, it was the epoch of belief, we have everything before us, it was an age of resilience. The future consists of AI agents which will replace many (at the very least entry level) white collar workers. Energy prices are low, and the US has strengthened its oil production with exports at all time highs.
Unemployment is at historic lows, and only improving as rates increase. What a resilient economy we have! Wages are solid and consumer spending continues to surprise.
Rates are at historic highs for recent history, most market participants may have never experienced rates like this. In 2020, the average lifespan of a company on the S&P was just over 21 years. 21 years ago the 10 year was at 4%, it has been lower ever since. This doesn’t really impact companies though, their credit is solid. High Yield spreads are ~350bp - the lowest in 24 months. These companies will be absolutely fine refinancing at higher rates in the coming year. Resilient!
SPY has rallied, double its average annual returns in the last 3 months. NVDA is up 30% YTD and now has a market cap of 1.5T, the 4th largest company in the world. There remains a huge amount of dry powder on the sidelines and in money market funds, this will come rushing back into equites and push us to 5000 on the S&P before we know it. Being out of the market now is a fools errand, the setup is clear and the market only goes up.
The Story:
AI AI AI: To achieve this on a global scale there is only one thing that stands in the way, Computational Power, and a whole fuck-ton of it. “The computing power required for AI is doubling every 100 days and is projected to increase by more than a million times over the next 5 years.” - Intelligent Computing. A TrendForce report pointed out that if the processing power of the Nvidia A100 graphics card is used, running ChatGPT alone will require 30,000 Nvidia GPUs, at $10,000 each that’s $300million to get things running smoothly. But this is only the beginning, and it is only one AI model. There are now dozens of these across various orgs, and the computing power needed for each new application grows by the second.
Energy: From a power use perspective there is also a need to massively grow our output, these A100s require ~400watts, or 12mWs for the whole system. This is enough energy to power ~5000 homes for a year. The energy draw of these systems will only grow. This is great news! America and its allies have little energy security issues and we can continue to grow our energy infrastructure with ever increasing fiscal stimulus and renewable energy credits. The issues in the Middle East are only temporary, our enemies still fear our military might and we have strong leadership to clamp down on any threats.
The economy: The recession occurred in Q1 & Q2 of 2022, we had two quarters of negative GDP growth and have been in a bull market since! Q4 of 2023 saw 4.9% GDP growth after all. The federal deficit increased by 23% (to $1.7T) in 2023 compared to 2022. There is a ~0.45 correlation between fiscal spending and GDP growth. It is an election year (2024) so the bull market is a lock - “Government current expenditures deviate significantly from their normal levels during election years, leading to an increase in the overall fiscal deficit of about 1.3 percentage points of GDP.” - IMF. Don’t forget that inflation is moving in the line with expectations and markets are pricing in a large amount of cutting this year.
The Finale:
Markets just continue to rip. Election year elation and fiscal fortitude keep sentiment high, the AI/Everything Tech rally blows the index through new ATHs each month. Bears are quietly buried and the market starts to forget more than I could ever know. As inflation plummets so do rates and the Fed pats themselves on the back, “Mission Accomplished” Powell will say. Maybe AI prominence is just that deflationary..
It was the worst of markets:
The Setup:
It was the worst of times, it was the age of foolishness, it was the epoch of incredulity, it was the winter of despair. The future consists of AI agents running everything (there are no tech jobs left), the Tesla bots work in all factories (there are no labor jobs left), war and pestilence continue to rise across nations and states, the fight for energy and water security is a key conversation on the Street. We have printed our way into our own demise, there is no more debt to leverage on our GDP or tax receipts. (This is pretty fucking gloomy, and now you see why I dislike being a skeptic). Before we get to this apocalyptic epoch there are more rational stages.
Markets have ripped because fiscal spending has become stretched, the praised GDP growth is just a factor of increased government (G) spending. GDP = C + I + G + NX. The AI/Tech Everything rally is simply ludicrous, Soros reflexivity is a good explanation. “Reflexivity is a theory that positive feedback loops between expectations and economic fundamentals can cause price trends that substantially and persistently deviate from equilibrium prices”. We are in a state of persistent deviations from equilibrium. NVDA is trading at >80 PE, the earnings growth it must experience to come in line with historic comps is extraordinary. A further 50% growth in its price will make it the largest company in history, this isn’t out of bounds when you consider +30% in 24 days of 2024.
Political and Geopolitical tensions are on the rise. War in Europe, skirmishes in Africa and South America. Demographic changes and a violent backlash against it. The American electorate expects a Biden vs Trump Round 2, what happens when accusations of cheating break out? Or when riots erupt once again in the streets? State vs State, brother vs brother. (We only have to wait a few months to see) A Trump victory would escalate internal US tensions beyond belief, a senile Biden would open the doors for external actors to continue their wars with little expectation of American force. I really do think that Trump will be much better long term for America’s economic outlook.
The Story:
AI AI AI: It may change the world. But it is not the future of the human race. (the anit-humanists would hope so) Much of the AI you hear about today was machine learning only 3 years ago. AI has been used to trade markets since the GFC, and it has been used in data applications for just as long. The marketing of AI, which began largely with ChatGPT has improved dramatically. ChatGPT allowed the common man to utilise and partake in the AI revolution. I do believe it will be a part of our daily lives in only a couple of years. However, it is not the last tech development and the firms leading do not have irreproachable moats. The valuations that are in this space are astronomical, and the possibility to replace large volumes of workers should make the market shudder.
Energy: The United States, and the Globe (sorry flat earthers) have an energy crisis on the horizon. Any form of security is temporary. Without government stimulus we are unable to make the economics of renewables work. We are moving faster than we can afford. Europe is much further along than we are and are facing an extended energy crisis due to a prioritization of renewables and green agendas. At some point there will be a reversion to the energy mean and hydrocarbons will rule once more. (Nuclear needs to be revisited, the Chinese are on that front) When this occurs there will be a super cycle as this form of energy has largely been underfunded comparably over the last decade. Energy has been, and will be, used as a weapon in the foreseeable future.
The Economy: I see the economy broken into tranches. There is, of course, the ubermensch elite, and the uber poor. In between there is a stratification which are experiencing the broad market changes very differently. I will call them the Lululemon’s, and Walmart peoples of this nation. (There are many more in between) The Lululemon’s are the white collar tech workers, their addiction to TikTok and Instagram keeps them consuming, and their $100K+/year advertising or project management jobs keep them funded. This bracket of the economy is growing, those that should be Walmart’s are convinced that a good life requires the consumption of (add popular brand name here). However, these upstarts cannot afford this life, so credit card debt continues to increase, and frighteningly buy now pay later is up orders of magnitude as these individuals look to fund the unearned extravagance. The Walmart’s are starting to hurt, “From 2018 to 2022, the all-food Consumer Price Index (CPI) rose by a total of 20.4 percent” - USDA. Housing & Transportation are up 15% and 25% respectively. Average and Median wages are up ~20% during the same period, over the last 30 years average wages are +170% vs Median wages at +70%. (broadening out in wages) The Walmart’s are a median wage type of folk. They had little disposable income to begin with. Those with the benefit to work at an esteemed public company have experienced a huge wealth effect in their stock ownerships, the Walmart’s are not so lucky.
This economy has been resilient because sentiment has relied on massive equity gains. People are locked into houses which they couldn’t sell if they wanted to, and they have no desire to move. The market is frozen yet price decreases occur with every new house on the market. When it thaws will there be a rush to sell, cratering prices, or will the new work from home and AirBnB future continue to drive prices higher.
The Finale:
I really do not have a lot to say here, I feel like I have already told the story. When the reflexivity of the market turns the race to the bottom may be quick. There is a top waiting to blow off in AI, only time will tell. The S&P can not simply continue to run up credit with the state of the economy. There will need to be some sort of correction to bring multiples within historic averages. This is where I really don’t like to write more, I don’t like being the pessimist. Although something simply doesn’t feel right to me.
This was an attempt by me to write something a bit different. Hope you enjoyed it, it absolutely helped to blow off a bit of steam. We will be back to our normal scheduled programing with market commentary soon.
Luke Fisher