Market Data for the Quarter Ending June 30, 2024:

  • S&P 500 Stock Total Return: +4.38%
  • S&P 500 Equal Weight Index Total Return: -2.62%
  • Ten-year Treasury Note Yield: 4.34%, up 0.14%
  • Gold: $2,331 per ounce, up 4.2%
  • Oil: $83 per barrel, unchanged

Stocks continued to rally in the second quarter of 2024, with gains increasingly concentrated in the largest dozen or so technology stocks benefiting from the hysteria surrounding artificial intelligence (“AI”). The remainder of the S&P 500 produced a net loss for the quarter. (Note: the “equal weight” index quoted above represents the return of the average stock in the index, not the market value-weighted return of the S&P 500.) Given the runaway freight train quality of massive technology stocks, macroeconomic factors such as economic growth, inflation, and interest rates, faded into the background. This can be seen in the muted changes for bond yields and commodities during the quarter.

As we have described in previous letters, the stock market has increasingly taken on the character of a massive momentum trade driven by excess liquidity in the financial system, relentless double and even triple returns in tech stocks, and breathless descriptions of the near-limitless riches yet to come from the AI “revolution.”  Missing in all of this is any consideration of what stocks are actually worth.  Investors such as us, who attempt to put a price on stocks by deliberately weighing cash flows, interest rates, and risk, have been buried in the wake of the explosive and ongoing rally in tech stocks.

Taken to its logical extreme, this liquidity, momentum, and narrative-driven market dynamic where nobody cares what anything is worth is a recipe for disaster.  However, as ridiculous as it is, we do not see its underlying mechanics changing for at least the remainder of the year, if not well beyond it.  It all starts with the amount of money the Federal Reserve maintains in the financial system.  As is well known, the US government runs massive fiscal deficits (it spends more than it collects in taxes).  In order keep these deficits from “crowding out” borrowing by the private sector (corporations and individuals), the Federal Reserve maintains more money in the financial system than the economy needs to operate.  This monetary excess intended to support government borrowing has had the side effect of putting a relentless bid into the stock market, such that investors view “risk” not as LOSING money, but rather NOT MAKING enough of it!  Given that the basis of fundamental investing is grounded in deliberately weighing the risk of loss versus potential reward, the current “gains, gains, gains” mentality has made value conscious fundamental investing a losing proposition.

The fatal flaw of this phenomenon is that without a constant supply of liquidity, it will go into a state of collapse because market prices have become a matter of momentum and happy talk.  Ultimately, the driver of stock market returns is increasing intrinsic values of cash generation discounted by interest rates and risk, not dollars chasing lines that go up.  We saw this play out in 2022.  With inflation reaching nine percent, the Federal Reserve was forced to temporarily reduce market liquidity, and the supposedly unstoppable tech stocks of today suffered substantial losses.  To wit, shares in Nvidia were down over FIFTY percent in 2022 after returning 125% in 2021.  As the old saying goes, “Easy come; easy go.” Investors today have clearly forgotten that saying.

The primary risk to the current market mania is a return of price inflation to over 4%, which we believe would illicit a response from the Federal Reserve in terms of withdrawing liquidity, as was the case in 2022.  Price inflation is currently running in the neighborhood of 3%, with Federal reserve officials expecting it to trend lower over time.  This being the case, we do not expect an end to the current market festivities for the remainder of 2024 and well into 2025.  Over the longer-term, however, it is inevitable that today’s mania will hit a brick wall and saddle investors with substantial losses that could take them many years to recover, as is typically the case with speculative bubbles.  While it may be cold comfort for you today, your portfolios would at least hold and possibly increase in value when the constraints of physical reality triumphantly (and devastatingly) return to the American stock market.

Beyond the inflationary risk cited above, we cannot ignore the possibility of political disruption following this year’s Presidential election on Tuesday, November 5.  Former President Donald Trump has not accepted his loss in the 2020 election and has not committed to accepting the results from this November’s (unless, presumably, he wins fair and square).  This being the case, if he were to lose and not accept the result, it is entirely possible that the government would be thrown into crisis to include outright physical violence in the nation’s capital and beyond.  As our expertise is not handicapping the outcomes of elections, we will leave it to others to provide such analysis.  However, given the history of the 2020 election and the January 6 sacking of the Capitol by Trump supporters, we cannot ignore this as a clear and present danger to America’s financial markets.

For the remainder of 2024, we see the stock market, as represented by the S&P 500 stock index, trading in a range of 5000 to 6000.  It finished the second quarter at 5460.  While the macroeconomic backdrop is conducive to continued gains for stocks, measures of investor optimism are at historically extreme levels of euphoria.  This is an inherently fragile condition, so episodes of heighted volatility cannot be ruled out despite the factors working in the market’s favor.

Before closing, we would like to make one final point regarding the hysteria surrounding artificial intelligence, particularly of the “generative” variety that is principally behind the current mania.  If anybody boasts to you about how much money they are making from their AI-related investments, ask them to explain how generative AI works.  Chances are, they won’t be able to.  Well, if somebody doesn’t know how a new technology works, they probably don’t know what it can do, and if they don’t know what it can do, they almost certainly don’t know how much money it will make.  If this sort of ignorance is the secret to durable extraordinary investment success, the person who could explain it would win the Nobel Prize in Economics because it violates nearly everything that is taught about investing in business schools throughout the world.

As always, we appreciate your business and the confidence you have placed in us. Please do not hesitate to contact us with any questions you may have regarding your investments.