YWR: The Market Gods will hate me for this...
YWR: The Market Gods will hate me for this...
Disclosure: These are personal views, not investment recommendations to buy or sell a security. For investment advice definitely seek professional help!
The Market Gods are going to fry me for this…
but..oh well…
Last week the S&P 500 got a long overdue rattle with the VIX spiking to 40.
And we all want to know if this is the start of a bigger drawdown?
Is the long overdue recession finally happening?
Did the BOJ’s 15bp rate increase kick just off a liquidity vacuum where 1000’s of Mrs. Watanabe’s repatriate their money to the Japan and the S&P 500 crashes further?
Is this the start of a 1987 crash?
The YWR view is No.
Project Zimbabwe is still intact.
The risk to equity markets is that we go much higher.
We are not going to have a recession and the Fed does not need to make emergency cut rates.
If the Fed does panic, fine. Project Zimbabwe just happens faster.
To be clear. I’m not trying to call it perfectly.
Yes, the S&P can sell off another 10%, or end the year flat, etc, but the big trend is higher.
The YWR’s are trying to add exposure rather than sell.
And now to really seal my fate…
I think US Equity volatility could remain structurally lower in the future.
Why do I say this?
Outline
Earnings Health check
Project Zimbabwe
Where are the risks?
Earnings as a Service
This is not 1999
The Africanisation of US Elections
Public Service Announcement on E-Bikes
Earnings Health Check
If the economy is about to enter a recession, nobody sees it. Earnings estimates for 2024 and 2025 are solid.
In the chart below forward 12 month EPS is trending steadily upwards. Maybe price got a little ahead of itself and needs to catch down to earnings, but there is nothing sinister in this chart.
In fact it’s just kind of amazing how steadily earnings are growing. Something we will get back to later.
But just because analysts and company managements don’t see a recession doesn’t mean the floor isn’t about to drop out. They never see anything until it is too late.
How do we know the trend can continue to the upside?
Project Zimbabwe
The YWR view has been that inflation will remain high in the years ahead and while the news will be terrible, the stock market will soar to unimaginable heights.
We call this Project Zimbabwe and we wrote about it in January 2023.
We also wrote about paradox of bad news and strong markets in Bad is Good.
As a reminder of the Project Zimbabwe dynamics below is a chart of the net profit for Delta Breweries in log scale. Delta sold roughly 1.5 mn litres of beer each year in Zimbabwe during this period from 2015-2022. While volumes didn’t change, profits grew exponentially. Because of inflation.
To be clear, the US will be a much milder version of Project Zimbabwe, but the dynamics are the same.
Share prices will rise higher than expected and YWR is trying to get as much exposure as possible to equities and London real estate.
Where are the Risks?
It’s under appreciated how much of the economy is the US government. When government spending is 36 and 44% of GDP, and growing, how do you have a big recession?
Go through the main GDP components (Consumption, Investment, Government, Net Exports) and try to model a recession.
Investment is rising driven by the Mega Trends of electrification, energy transition and reindustrialization. There is a backlog of $1.4 trillion in projects with not enough people to complete them.
As for the consumer, yes interest rates are higher, but after years of deleveraging post the GFC, consumers are in good shape. They also have record real estate and stock market wealth.
And let’s not forget 40% of consumption expenditure is from the very top quintile of consumers. There are frequently news articles about how the consumer is suffering, but sadly, most consumers are mathematically irrelevant.
I’m also becoming less interested in the unemployment rate. The surprise of the late 2020’s could be that unemployment rises to 10%, while the S&P 500 continues to make new highs.
US public companies are in good health too. Interest coverage is near multi-year highs. The Federal Reserve did a big study to try and find hidden financial risks, but it was a nothing burger.
And then back to government spending.
The CBO’s projections for government spending grow steadily through 2034.
It seems terrible for the government to be spending so much, but if you are the global risk free security and can fund the spending, it makes everything quite stable. The US government never lays anyone off and always spends more each year. It’s great!
This leaves the US$ as a potential risk. A big $ devaluation which causes a rapid rise in US government funding costs and the Federal Funds rate.
I don’t see it.
Yes, the $ will be weak against gold, BTC and equities, but relatively to the main fiat currencies (EUR/GPB/JPY) I don’t see any shock moves. Gradual weakness is possible, but all countries are in the same boat.
In summary, I don’t see the economic crash risks.
The US government will spend more every year, which backstops the economy. That spending flows into the general economy causing inflation and economic ‘growth’. The ‘risk’ is to the upside.
Earnings as a Service
I mentioned earlier the amazingly steady trend in S&P 500 earnings.
This isn’t by accident.
US companies are getting better.
US companies are delivering steady EPS growth though a combination of better business models, and cost management and share buybacks.
This is a hard one to quantify, but once you look for it you will see it.
Companies have been shifting their business away from selling products to selling recurring services. This makes the revenues much more stable.
Here are some examples.
Do you remember when Windows used to come as a box of software when you bought a computer? It’s hard to remember because Microsoft has totally moved away from that and now you are locked into Windows365 as an annual service fee automatically deducted from your account. And who is going to cancel Microsoft 365?
Services have grown from 25% of Microsoft revenues in 2016 to 79% in 2024.
Yes, if there is a recession MSFT might not grow as much, but they’ve take a lot of the potential volatility out of their earnings. It’s a structurally better business now.
Apple is doing the same thing. Product sales have stalled, but they are growing the services line which is now 22% of revenues.
You see it in Morgan Stanley too. Today’s revenue mix has less reliance on volatile business lines like trading and investment banking (37%) and more exposure to recurring business lines like asset management and net interest income.
Asset Management and Net Interest income have grown from 30% of revenues to 50%. The modern Morgan Stanley is structurally less volatile than it used to be. It’s a better business.
Yes, I’ve cherry picked 3 examples, but I think if you look for more examples you will see the same thing. It reflects a business culture shift. Nobody wants to make products anymore, or if you do, it’s to sell a backend service (the razor blade model).
To get a high valuation in this day and age you need to be a platform company with network effects, or have recurring subscription revenues. Company CEO’s get the message and have been slowly transforming their companies to have higher recurring revenues with better earnings visibility.
The other way companies manage their earnings volatility is with sophisticated financial modelling and share buybacks.
The modern CFO is a financial conductor. She defers revenues (keep some dry powder), shifts the timing of expenses, and manages down the share count to orchestrate a steadily growing EPS.
Share buybacks are likely to hit an all time high of $1 trillion in 2025. This is reduces both earnings and stock price volatility.
The net effect of better business models, financial engineering and share buybacks is that S&P 500 earnings are becoming structurally less volatile.
This is layered on top of a US economy, which is also becoming structurally less volatile as the government becomes a bigger share of the economy.
Which is why maybe the super low VIX readings we are seeing are not a sign of complacency and an impending disaster, but actually the result of less volatile corporate earnings.
Maybe the S&P 500 is the new risk-free asset.
This is not 1999
It’s a common comparison to say Nvidia is the new CSCO and all this AI spending will be useful in the long-run, but suffer a near-term crash, like in 1999.
But really, valuations are not crazy. The Mag 7 are global technology monopolies with very little/to no competition, massive free cash flows, and their competitive strength is about to get even stronger.
Think about Amazon, Microsoft and Google. Corporate America World shifted their entire business to the cloud. It’s an incredible dependency if you think about it, and it’s going to get even worse. With AI, companies will be reliant on Amazon, Google and Microsoft for everything, including how their firm thinks.
It’s a lock-in, the likes of which has never been seen before in history of business. And no regulator is stopping it.
Companies will effectively become operating shells. Yes, they will have a brand and a product and a business, but the value of the business will be extracted by Mag7 companies which run the technological operating systems, advertising, data storage, software an AI behind the scenes.
The AI parasite benefits the NASDAQ, the S&P 500 and US earnings, which is why earnings estimates are rock solid, growing and increasingly detached from the economy.
The full Coatue chart pack is in Killer Charts
The Africanisation of US Elections.
A word on the election.
How can we be positive with such a big event on the horizon?
It’s likely the US election will be a train wreck with disputes, Supreme Court cases and election fraud investigations.
No side will be happy and there could be riots and protests.
But I think the surprise will be that the S&P 500 will be resilient regardless. It might even go up.
My African friends, who are experts on this, tell me that after 3 weeks of protesting everyone will mumble, grumble, go back to work and life will carry on.
In Africa election disputes are normal and expected. Yes, you can go out on the street and protest, but you know it won’t change anything. Sadly, you eventually you go back to managing what you can manage, which is your job, your business and your family.
The surprise will be not that the election is a mess, but that the market is either resilient or goes up (Bad is Good).
Public Service Announcement on E-Bikes
YWR has changed its policy and now officially endorses E-bikes.
I previously considered e-bikes as cheating. My view was (and kind of still is) if you aren’t in good enough shape to get to the top of the hill, and need a battery to get you there, then you don’t deserve the tasty downhills.
But we can’t fight progress, and there are benefits. E-bikes mean we can expand our rides further and we don’t kill all our energy points on long grinding uphills.
In the end E-bikes are like powder skis. You should have them in your quiver.
And they are fun.
Have a good weekend!
Erik
Erik. It's not the market gods that will smite you down, you want to worry about the lads over at Zerohedge!! ;). Well-argued as ever!
Interesting. The high-inflation 1970s were pretty bearish for equities and they saw PE ratios drop, with quite a lot of volatility; the S&P500 lost 60% of its value even in nominal terms between the 1968 peak and the 1982 trough. Likewise the highly inflationary late 1940s were very bad for the stock market. Clearly the Zimbabwe effect is a thing, it was seen in Weimar Germany too, but I wonder why it didn't work in the 1940s and 1970s. In both periods, the oil price went sharply higher.