US Strategy Weekly: Not Normal Times

A Government Shut Down Looms

In normal times, investors would be worried about the possibility of a government shutdown by the end of this week, but these are not normal times. Two months ago, Congress agreed to $1.59 trillion in discretionary spending for the fiscal year that began on October 1. Nonetheless, in-fighting by House Republicans is making it difficult for House Speaker Mike Johnson to pass funding bills. As a result, the first batch of government funding, for agencies that oversee agriculture and transportation, will run out this Friday at midnight. Funding for other agencies including the Pentagon and the State Department will expire on March 8. The main issues appear to be that Republicans want to see spending cuts and policy positions that address migration along the Mexican border. President Joe Biden is arguing for funding for Ukraine. It seems reasonable that both sides could find a mutual solution to these issues; but then again, nothing is reasonable or logical in Washington DC, particularly during an election year.

In addition, the market is also shrugging off a report from Moody’s Analytics stating that the banking sector faces $441 billion of CRE loans maturing this year and Moody’s forecasts the share of troubled loans will increase. The Department of Justice has launched an antitrust investigation into UnitedHealth Group (UNH – $513.42). Russia has ordered a six-month ban on gasoline exports as of March 1 and the Organization of the Petroleum Exporting Countries, led by Russia, agreed to extend voluntary cuts totaling about 2.2 million barrels per day into the first half of this year.

Bubbles are Not Bull Markets

These are not normal times for equity investors for a number of reasons. The most important of these is the possibility that equities are in the early stage of a stock market bubble. Last week’s response to Nvidia Corp.’s (NVDA – $787.01) fourth-quarter earnings report increased the odds that equities are indeed forming a bubble. We were asked if this means we are now bullish, which is not an easy question to answer. Although we expect stock market indices will move higher, perhaps substantially higher, this is different from being truly bullish, in our view. To us, being bullish means stocks represent good value and have excellent long-term potential. A bubble is quite the opposite. It means stocks have disconnected from fundamentals and are driven purely by sentiment, liquidity, momentum, and leverage. To us, this kind of stock market is like a boat at sea without a rudder.

In terms of fundamentals, the trailing four-quarter operating SPX PE multiple is now 24 times and well above all long- and short-term averages. The 12-month forward PE multiple is 21.7 times and when added to inflation of 3.1% sums to 24.8, well above the top of the normal range of 23.8. By all measures, the equity market is at valuations seen only during the 1997-2000 bubble, the financial crisis of 2008, or the post-COVID-19 earnings slump. See page 8.

Bubbles are usually fueled by a theme that supports the concept that “it is different this time” and therefore fundamentals no longer matter. The current bubble’s theme is generative AI. In our opinion, AI is less transformative than the Nifty Fifty stocks were in the early 1970s era that preceded the January 1973 peak. Beginning in the late 1960s, Baby Boomers began to enter the workforce and were the source of a massive wave of consumption of new products like cameras from Polaroid Corp. (delisted), film from Eastman Kodak Co. (KODK – $3.53), drinks from Coca Cola Co. (KO – $60.34) and burgers from McDonald’s (MCD – $293.76). These consumer stocks did represent the growth segment of the stock market, but they eventually rose to unsustainable prices.

Some strategists have said the current market is nothing like the dot-com bubble that led to the January 2000 peak, because today’s AI stocks have earnings and the dot-com stocks of the late 1990 era did not. It is true that companies like Global Crossing inflated their reported earnings figures and ended up being acquired by Level 3 Communications, and then CenturyLink Communications, LLC in 2017, and is now part of Lumen Technologies (LUMN – $1.54). But the dot-com bubble also included Amazon.com (AMZN – $173.54), Microsoft Corp. (MSFT – $407.48), eBay Inc. (EBAY – $44.39), and Cisco Systems (CSCO – $48.31). These stocks clearly had earnings. In fact, the current environment is very similar to the dot-com era and perhaps one could say this might be the second act of the dot-com bubble!

We have written about the three strategies one can employ during a bubble: 1.) jump on the bandwagon and follow the momentum stocks. For many money managers who are measured against the S&P 500’s performance, this is the only possibility. However, one has to remain diligent about monitoring the market for weaknesses that may suggest the bubble is about to burst. 2.) own a blended portfolio of stocks with good long-term potential and add ETFs that mirror the indices. 3.) own a portfolio based on good fundamentals and simply wait out the bubble. One’s strategy is an individual choice.

Election Year Seasonality

This is an election year and stock performance in an election year ranks third in the four-year election cycle. In short, it is in the middle of the pack. In an election year, the fourth quarter usually provides the best performance in the Dow Jones Industrial Average. The second and fourth quarters are the strongest in the S&P 500 index, and the second quarter has the best record in the Nasdaq Composite index. In general, the best performance tends to come in the last three months of the year. See page 5.

But what we find most interesting about election year performances is that monthly performance is different based upon whether an incumbent president wins or loses. Normal seasonality suggests that April, November, and December are the best-performing months of the year. But analyzing election years since 1944, we find that incumbent wins are preceded by strength in June, March, and December, in that order of magnitude. Incumbent losses are preceded by the best equity performance materializing in November, April, and May, which is closer to normal seasonality. (Note that the weakness seen in March 2020 correctly indicated a Trump loss.) See pages 5 and 6. However, the rally seen in February to date is not typical of a normal or an election year. So far 2024 is far from typical!

Confidence After what seemed like an improvement in confidence in January, The Conference Board confidence indices took a negative turn in February. Moreover, the January indices were revised substantially lower. The Conference Board expectations index dipped back below 80, the threshold typically associated with recession. Across age demographics, consumers younger than 35 and older than 54 saw the greatest deterioration in confidence and many respondents indicated jobs were harder to find. This was an interesting shift from earlier. The University of Michigan sentiment data will be released Friday. See page 7. The most important economic release of the week will be the PCE price deflator on February 29. The December data showed the PCE deflator unchanged at 2.6% YOY and core down 0.3% to 2.9% YOY. The market is hoping (expecting?) that inflation will continue to moderate.

Gail Dudack

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