Published February 16, 2024
Below are excerpts from the recent edition of JP Morgan’s Michael Cembalest’s newsletter. In his latest letter, Mr. Cembalest runs through how the rally in the shares of the Magnificent Seven is primarily earnings-driven, the performance of the doom-and-gloomers on investment returns, and lastly, a review of some of the cheapest investments on the planet and whether the tumble in Chinese shares is worth buying.
Here are Mr. Cembalest’s observations:
“Consistent with our piece last August and our 2024 Outlook, US manufacturing surveys for January improved vs December and were stronger than the regional surveys implied. Encouraging sign: a pick-up in new orders. Something to worry about: very tight labor markets and the increase in “prices paid” inflation.
Magnificent 7 stocks keep rolling
First the good news: the Mag 7 rally has been earnings-driven rather than relying on multiple expansion. Of the group’s 28% return since 2019, 21% is attributable to sales growth, 6% from margin expansion and just 1% from multiple expansion (where investors are willing to pay higher prices for the same level of earnings). This is quite different than the margin-less bubble in 2000-2001 where investors paid ever-higher prices regardless of earnings growth.
But there are challenges as well:
- Market concentration has reached its highest level since 1972. The top 10 stocks have broken away from stocks #11-#50 to an even greater degree than during the tech bubble in 2000-2001
- Large spikes in market concentration have frequently coincided with or preceded prior recessions, as shown in the chart below (recessions shown as gray bars on the chart).
- Market concentration is making life difficult for active equity managers; 2023 was one of the worst alpha years on record with only 23% of Russell 1000 large cap managers outperforming (vs 66% in 2022) These dynamics why we spent so much time on antitrust issues in the 2024 Outlook. We see that as the primary Achilles heel that could disrupt the continued domination of the largest stocks. While Tesla has run into a pricing buzzsaw and lower volumes, the rest continue to thrive.
Armageddonist update
One of my guilty pleasures: highlighting the track record of the doom-and-gloom “Armageddonists” that the media flock to for comments on the impending disasters always facing investors. I first wrote about this “Legion of Doom” in 2019. From 2011 to 2016, these pundits each proclaimed at some point that the sky was falling. We computed the returns investors would have missed out on by switching from stocks into bonds when their predictions occurred; the resulting underperformance ranged from 30% to 60% by the end of 2019. In 2020, it looked like Armageddonists got bailed out by a global pandemic. However, after markets had already collapsed in March 2020, the Armageddonists started doing Armageddony things again and predicted further calamity. As shown in the second chart, markets have almost doubled since COVID Armageddonizing took place. To be clear, investor sentiment is currently very bullish, leverage is elevated, and markets are pricing in a lot of good news. I would not be surprised to see some kind of correction later this year. If history is any guide, the Armageddonists will pick that point in time to tell you that it’s going to get a whole lot worse.
Why are these folks, with their horrendous track records, still so widely quoted? Because, as many studies have shown, most media outlets prefer to report bad news. This is in part a reflection of human behavior: bearish news appeals to human negativity bias, a topic examined by Nobel Prize winner Daniel Kahneman in his 2011 book on the brain and human survival instincts; and by political scientist Stuart Soroka who illustrated the inverse relationship between magazine sales and the positivity of a magazine’s cover; and in a 2014 experiment in which a German city newspaper lost two thirds of its readers on days when it deliberately only published positive news.
Be wary: Negativity Sells! (and hurts your investment returns).
Bottom fishing in Chinese equities
One place Armageddon is happening: China, where equity markets are crashing. Trading volumes are up, which is typically a sign of seller capitulation and a bottom; but there is nothing typical about Chinese equity markets. Like a Venus Fly Trap, MSCI raised its China weight in the EM Equity Index from 20% to 40% right before Xi’s “progressive authoritarianism” campaign began in 2021. Since then, Chinese equities have been tumbling.
For all the talk about how cheap Chinese equities have become, that’s relative to valuations they once traded at. On an absolute basis there are several markets/sectors that are just as cheap. Anyone interested in bottom-fishing should probably cast a wider net in addition to looking at China. The chart below shows the cheapest areas of the global stock market, with those on the left being the cheapest (at only 3x forward earnings estimates. Compare that to the 20x the U.S. market trades at!).
Market Update
Stocks ticked lower to begin the week as investors awaited new numbers on inflation along with a full slate of corporate earnings. Stocks were little changed Monday but fell hard Tuesday. A report on consumer inflation showed stubborn prices in some areas and was read as too hot for the Fed to cut interest rates at their March meeting. Yields popped upward to their highest level in two months as stocks tumbled. The interest-rate-sensitive small-cap stock index tumbled almost -4% while broader market indexes saw losses of -1.4%. The losses were modest when compared to a massive spike in volatility as investors had grown too complacent after a 15-week rally in share prices. But investors who have felt left out of the rally used the Tuesday drop to buy stocks. Wednesday found market recovering much of their Tuesday swoon while bitcoin 50,000 per $ for the first time since 2021 – an example of the increased risk-taking mood prevalent in markets. Prior forays above 50k for the cryptocurrency have held only briely before plummeting. Will it be different this time, now that we have bitcoin ETFs and the backing of many more financial institutions? In earnings news Wednesday, ride-hailing services Uber and Lyft surprised investors by generating profits and solid positive cash flow to send their shares sharply higher. Weaker reports in retail sales and industrial production soothed fears of higher interest rates Thursday to push stocks higher with small-cap commpanies recovering +2.5%. While the Magnificent Seven stocks have generally slowed their upward moves in recent days, the rest of the market has been picking up the slack, as it did Thursday when financial and energy shares were the star performers. Friday saw stocks ultimately off -0.5% after being higher through much of the day. A hotter report on wholesale prices kept the bond bulls at bay. Positive reports from chip equipment supplier Applied Materials and construction aggregate supplier Vulcan Materials offered further proof that economic growth is reasonably strong. A pivotal week for investors have come around to the Fed’s view that there will be no interest rate cut in March, and likely not in May either. Despite the pushing out of interest rate cuts, earnings have come in well for almost all sectors of the economy, and that has supported the stock market thusfar in 2024. However, we note again that the market has gone practically straight up – scarcely giving up any ground in a furious 16-week rally.
Stocks experienced a rare slip this week. But by week’s end, the damage was very slim. The S&P 500 (SPY) closed the week lower by only -0.34% while the small-cap Russell 2000 ETF (IWM) closed above $200 for the first time this year, higher by +1.16% on the week. Recall the index was DOWN -4% early in the week, so recovered a lot of ground. The strength in small and midcap stocks was evidence of money rotating slightly out of high-flying growth stocks. That rotation cost the Nasdaq 100 (QQQ) leaving the index lower by -1.48%.
Warm wishes and until next week.