Will AI be a winner Take All Market?

 Much has be written about the explosive growth in capital spending on AI by Google, Meta, Microsoft, and Amazon. (See: https://www.wsj.com/economy/the-ai-booms-hidden-risk-to-the-economy-731b00d6?mod=author_content_page_1_pos_1 , paywall) Those four companies are on tap to spend about $360 billion this year on building out data centers and related investments. Given the high prices of their stocks, market participants are assuming that AI investment will have a huge payoff in the future and are willing to overlook short term declines in free cash flow.

My sense is that investors are underappreciating three risks. The first is that the return on tangible capital will likely be lower than the hitherto high returns on intangible capital earned by the four companies. Second, the bidding war for talent where $100 million payouts have taken place will squeeze margins. Third, and perhaps most important, is that AI will not, at least initially, be a winner take all market. It is likely that AI will be nowhere near as profitable as winner take all Microsoft's operating systems, Google's search, and Meta's social media. 

Why? At the present time there are six highly capitalized entrants in the AI market and many smaller ventures competing for market share. The six are ChatGPT, Gemini, Anthropic, Perplexity, Meta AI, and Grok. Although ChatGPT has the current lead, this is a highly fluid market environment with deep pockets competing for market share. Thus, my guess is that investors will soon be disappointed with the returns coming from AI. The likely beneficiaries of this competition will be consumers and the highly talented employees.

The Guns of August*

One hundred and eleven years ago the guns of August opened fire signaling the start of World War I. Although far from being deadly, the July employment report reeked carnage on the stock market with the S&P 500 declining by 1.6% on Friday while the bond market sustained a massive rally with the 2-year note yields declining by 27 basis points and 10-year yields declining by 14 basis points. The markets are clearly sniffing out a recession.

 

Nonfarm payrolls increased by a meagre 73,000 jobs, but what really spooked the markets was a gigantic downward revision of 258,000 jobs for May and June. Further, all of the gain can be accounted for by healthcare and social services, hardly growth drivers. The three-month average for employment gains of 35,000 jobs is indicative of a stalled labor market. The far more volatile household survey was much worse with the average monthly decline from May to July of 287,000 jobs. My guess is that the administration’s immigration raids are now taking their toll on the job market. The labor market is experiencing simultaneous demand and supply shocks.

 

In March I called for the recession of 2025 to begin in the second quarter. (See: https://shulmaven.blogspot.com/2025/03/the-recession-of-2025.html ) That obviously didn’t pan out, but with real final domestic demand growing at only 1.2% in the second quarter and the job market stalling out, it was pretty close to a recession.

 

The day before the employment data came out, President Trump announced a panoply of tariffs on a host of countries that have failed to make a deal with him. Those tariffs and the earlier ones announced for the E.U. and Japan means that the U.S average tariff rate is now about 19%, eight times above where we started the year. Simply put, Trump called the market’s bluff on the TACO trade an eventuality we noted in June. (See: https://shulmaven.blogspot.com/2025/06/stocks-too-complacent-about-taco-trade.html )

 

As a result, with Trump’s tariffs now baked into the cake and with a stalled job market, the U.S. economy is on course for stagflation. The tariffs will keep inflation as measured by the core price indices above 3% and that will put the Fed between a rock and a hard place, especially because the unemployment rate will remain well contained, at least for now.

 

Adding insult to injury President Trump fired BLS Commissioner Erika McEntarfer because he didn’t like the revisions to the employment data. His big, beautiful economy is not as beautiful as he thought. This banana republic move will lower the market’s confidence in future data coming out for the government’s data mills, not a good thing.

 

Lastly, I have been skeptical of the stock market’s big rally off the April lows. (See: https://shulmaven.blogspot.com/2025/06/my-ucla-anderson-forecast-presentation.html ) My sense is that this skepticism will soon be justified.

*- With apologies to Barbara Tuchman

A Stock Market in Denial

Investors in the U.S. stock market are living in a state of denial. To be sure, the S&P 500 advanced nine days in row for the first time since 2004, and it has bounced 14% off the early April low, investors are wishing away the trade tsunami that is about to hit the economy. As I write this, the west coast ports are shutting down, bringing with it layoffs among dock workers and truckers. That malaise will soon spread eastward. 

Consumer confidence remains in the toilet. Thus, it is no surprise that year-over-year same store sales for McDonald’s, Chipotle, and Starbucks are down. Indeed, domestic airline travel is down, and foreign tourists are staying away from America in droves. On the business side, save for the Magnificent 7, capital spending plans are plummeting. Although the recent employment report for April was better than what I would have expected, my guess is that it will turn out to be the last good report we will see for quite some time. As a result, my March forecast calling for a recession starting in the current quarter still stands. (See: https://shulmaven.blogspot.com/2025/03/the-recession-of-2025.html ) 

Investors remain in denial that the postwar global architecture of the past 80 years is in ruins. (See: https://shulmaven.blogspot.com/2025/04/regime-change-end-of-economy-as-we-have.html ) To me this means that all of the old rules of thumb concerning the economy and the stock market are no longer valid. Simply put, we are entering a new world with unknown economic and geopolitical   consequences. In a nutshell, the world has become a much riskier place.

For those who believe that the U.S. will win the trade war with China, I have a few words of caution. According to the “Sinocism” newsletter, the domestic Chinese media are portraying the trade war as a “protracted war.” The members of the Chinese Communist Party know full well that the term “protracted war” harks back to Chairman Mao’s 1938 pamphlet calling for protracted guerilla warfare against the Japanese aggressors. That war lasted for seven years. Further, Thucydides taught us 2500 years ago that nations go to war for “honor, fear, and interest.” To China the trade war with the United States is a matter of honor.

The bottom line is that soon the denial phase of the current bear market will soon turn to anger as investors realize that the Trump tariff policy will bring with it higher prices and reduced output yielding a stagflationary recession. When that realization crystalizes, the S&P 500 will breach the April low before too long.

My Review of Donald Chew Jr.'s "The Making of Modern Corporate Finance"

An Ode to Modern Financial Theory

As a former professor of finance, I read Donald Chew’s book with great interest. His book is a history of the development of modern financial theory from its early roots in John Burr Williams’ 1938 “Theory of Investment Value” to its beginning in the late 1950’s with the works of Miller and Modigliani on capital structure and dividend irrelevance. He made a mistake in attributing Myron Gordon’s model to Williams. 

Chew writes in a very breezy style by referring to Michael Jensen as Mike and Stewart Myers as Stu. From his post as an editor of Stern Stewart’s “The Journal of Applied Corporate Finance,” he got to know most of the major players in academic finance. I too met many of the academics he discusses, and indeed I was an early adopter of Brealey and Myers textbook he highly praises in my corporate finance class during the 1982-83 academic year. I also met, on several occasions, his mentor, Joel Stern.

Chew makes the case that earnings per share don’t count, but rather it is the ability of a corporation to earn a return above the cost of capital with return measured as net operating profit after taxes. It is with this insight that Stern Stewart pioneered the concept of economic value added. (EVA) Indeed, instead of using earnings to value a corporation, value can be defined as the present value of the cash flow associated with existing assets plus the present value of future growth opportunities. Hence, Amazon for example, can trade at values divorced from current earnings.

However, he oversells his point that earning per share doesn’t count. Corporate management and analysts continue to stress earnings per share and woe to the company that misses its quarterly earning estimates.  In the short run earnings seem to count a great deal.

He also oversells private equity. To be sure private equity posted extraordinary returns in its first twenty years starting in the 1980’s. Since then, returns have eroded, and their risks have been underrated. Put simply, the industry is guilty of what Cliff Asness of AQR, calls “volatility washing.”

This book is of interest to readers who are interested in how modern financial theory evolved and it is helpful in understanding what forces drive stock prices in long run.

 

Regime Change: The End of the Economy as we have Known it

 “There are decades where nothing happens: and there are weeks where decades happen.”

                       Attributed to V. I. Lenin

In the short span of twelve weeks, Donald Trump has undone the Bretton Woods monetary order established in 1944, the GATT free trade order of 1947, and the NATO collective security order of 1949. (See: https://shulmaven.blogspot.com/2018/02/my-amazon-review-of-benn-steils-marshal.html) As a result the world is now facing a simultaneous geopolitical and economic crisis and it is no surprise,  that stocks and especially treasury bonds and the dollar have sold off. (See: https://shulmaven.blogspot.com/2025/04/a-broken-stock-market-and-broken-trust.html) Simply put, the old world order is gone, an there is nothing, as of yet, to replace it. The transition will be painful.

Those who expect that the Trump tariffs are negotiating tactic will be sorely disappointed. Trump needs the revenue to finance his tax cuts, and the Democrats only differ with Trump as to the way his policy has been conducted. They still hope to reclaim their union support by being pro-tariff and they too need the revenue to finance an ever-larger welfare state. The era of free trade, as we have known it, is over.

Three years ago, I wrote that the United States was about to enter a new 13-year economic cycle. I noted:

“My guess is that we are at the very beginning of new thirteen-year cycle with unknown consequences. I would speculate that the next thirteen years will bring with it a much higher rate of inflation than we have been used to, a multi-year bond bear market and a partial deglobalization of the economy caused by local politics, supply chain issues and geopolitical tensions. To me the big question is whether this cycle will bring with it a stagflation or a high cap-ex/high inflation economy with a cap-ex boom coming from the in-shoring production and energy transition. As they say, time will tell.” ( See: https://shulmaven.blogspot.com/2022/05/the-useconomy-is-entering-new-thirteen.html)  

Although it has taken a bit longer to play out, we are now in the midst of it and perhaps something much more. We are likely entering an eighty-year super cycle in what Neil Howe has called a “fourth turning” which will involve economics, politics, values, and the way we relate to each other in society. (See: https://shulmaven.blogspot.com/2023/09/my-review-of-neil-howes-fourth-turning.html)  This is far bigger than my 13-year cycle in that it encompasses six 13-year cycles that began in, not coincidentally 1945.

If this is close to correct, then we are now entering unchartered waters. The stock market and economic histories that we have been used to over the past 80 years may no longer be relevant in understanding the future. Instead of ever rising share prices we may now be in an era where stocks go sideways for an extended period of time. I would note that between 1924-1949 the Dow Jones Industrial Average traded in a range of between 100-200 with the significant upside exception of 1928-30 and the significant downside exception of 1931-1933. For example, in 1927 the high in the Dow was 201 and which was nearly identical to that recorded in 1949 and the 1929 high was not exceeded until 1954. The equivalent going forward would be for the S&P 500 to trade in a broad 3500-6500 trading range over the next several years.

The recent action of the bond, currency and stock market is indicative of a sea change in the markets. Instead of rallying in a time of turmoil both the treasury bonds and the U.S. Dollar have sold off. Indeed, the dollar has declined 9% since the end of February. Simply put foreigners are losing trust in the U.S. Dollar and with 18% of U.S. stocks held by foreigners the selling is only now beginning. I would say the same thing for foreign holdings of U.S. real estate.

Over the weekend the Trump Administration announced that it would reduce the Chinese tariff of 145% to 20% on smart phones, computers, and other electronic products. That action has lifted the Sword of Damocles hanging over Apple. This suggests a major relief rally for Apple and the stock market as a whole, but what multiple can you put on company and the stock market as whole whose share prices are subject to the whim of one very unstable man? I would sell the rally.  

Bond Market Carnage Bombs Trump Back to the Table

With the yield on the 10-year Treasury bond skyrocketing from 3.9% last week to 4.4% today, the Trump Administration called for a 90 day pause on the extortionate tariffs  announced last week.  Going forward there will be a minimum tariff of 10%, except for China(125%), steel, aluminum, and automobiles. The tariffs announced last week are now a ceiling and 10% is now a floor. In response the S&P 500, as of this writing (2:43 EDT) soared 8%. I would remind readers that the best single days in the stock market occur in bear markets. 

My guess is that the downturn will resume in a few days as investors realize the huge uncertainty associated with negotiating tariffs with 80 countries over the next 90 days will have a deleterious effect business and consumer investment. As a result my call for a recession starting this quarter still stands.( See: https://shulmaven.blogspot.com/2025/03/the-recession-of-2025.html ) My view is reinforced by the fact that the  backup in interest rates will drive another stake in the already weak housing market. A 7% interest rate on a 30-year fixed rate mortgage is a killer.

Lastly something very negative is going on in the bond market. Whether it is trillion dollar basis trades going south or selling by international holders losing trust in the United States, the fact remains a 4.4% 10-year Treasury bond in a weak economy signals something is very wrong. (See: https://shulmaven.blogspot.com/2025/04/a-broken-stock-market-and-broken-trust.html)

A Broken Stock Market and Broken Trust

 The headline read:

“Selling Swamps Exchange

Leading Issues Tumble

As Wall Street Assails

The New Tariff”

This is not from yesterday; it is from the front page of The New York Times dated June 17, 1930. The day before President Hoover announced he would sign the Smoot-Hawley Tariff Bill and stocks responded with an 8% decline in the Dow Jones Industrial Average. Responding to President Trump’s tariff announcement the S&P 500 declined by 9% last week, wiping out $6 trillion in market value. Simply put, just as in 1930, high tariffs are poison for the global economy. And to add insult to injury, the Trump tariffs are higher than Smoot Hawley.

My sense is that the decline in stock prices is not over. In the week leading up the October 19th,1987 20+% crash in stock prices, the S&P 500 witnessed a similar 9% decline. As we wrote last month, we believe that the recession of 2025 has now begun. ( See: https://shulmaven.blogspot.com/2025/03/the-recession-of-2025.html) In response to the tariff announcement and the wealth destruction that it caused, consumption and investment are freezing up and as a result of the DOGE cuts, government spending is heading lower. The recession is baked in the cake.

Adding to the unease is that in less than three months the Trump Administration has broken the trust in America with respect to our military alliances and our reliability as a trading partner. What has taken decades to build up has been destroyed in a few months. Further, even if Trump tries to repair the damage, his administration is staffed by D and F players who are incapable of playing on the global stage. Commerce Secretary Howard Lutnick, trade advisor Peter Navarro and Economic Council Director Kevin Hastett hardly inspire confidence. 

Although Scott Bessent is potentially a B or an A player, he was, according to Bloomberg News, not in the room when the tariff schedule was decided upon. Indeed, Secretary of State Marco Rubio has proved himself to be so much of a Trump sycophant that would be incapable of healing the breach with our allies and Secretary of Defense Pete Hegseth is clueless.

This is a far cry from the team Nixon had when he broke the dollar’s link to gold and devalued it. Nixon had Secretary of State William Rogers and Secretary of the Treasury John Connally, neither of whom were A players. In the background, however, were National Security Advisor Henry Kissinger and Under Secretary for Monetary Affairs Paul Volcker. ( See: https://shulmaven.blogspot.com/2021/07/my-amazon-review-of-jeffrey-gartens.html) During the 1987 stock market crash Ronald Reagan was guided by the expert advice of George Schultz and James Baker, both consummate A players. Thirty years later George W. Bush had the steadying hand of Secretary of the Treasury Hank Paulson during the financial crisis of 2008 and Obama benefitted from the advice of Tim Geithner his treasury secretary.

As a result. It is hard to see how we are going to get out of this mess with minimum damage. The easier way would be for Trump to take that advice of former Goldman Sachs CEO Lloyd Blankfein. He tweeted the other day:

Lloyd Blankfein

@lloydblankfein

“The switchboard at the WH must be burning up with gov’ts trying to surrender in this trade war. Why not give them a chance? Make the 10pct min tariff immediate but defer the “reciprocal” part 6 mos. Take the win! The Prez said he’d make us tired of winning…I’m there “

That would certainly give the markets some breathing space. The much harder way is for the Republicans in Congress to become so fearful of the midterm elections that they break with him on the tariff issue. To get there will require a lot of carnage in the markets. Similarly, a court action to declare Trump’s actions illegal will take time.

Finally, we have to remember that the Trump Administration needs the revenue from the tariffs to fund its tax cuts and to protect American industry.  A 10% tariff would raise $300 billion/year and a 20% tariff $600 billion/year. Tariffs aren’t going away. So, my guess is that when the markets open tomorrow, it won’t be pretty.

The Recession of 2025

This coming December the Business Cycle Dating Committee of the National Bureau of Economic Research will find that a recession began in the second quarter. Although there are clear signs that the economy is weakening, most observers believe that we are in a temporary growth slowdown. Moreover, you can’t see a recession in the most recent economic data. Therein lies the point I am trying to make. When a recession is in the data, it is too late to make a credible forecast, because the whole world would already know it. The task of a forecaster is to make a call when the data is ambiguous, not when it is clear. Of course, I along with many who called for a recession 2022 and 2023 were dead wrong.* Obviously, the forecasting community is gun shy.

My argument for a recession is based on the recent 10% decline in stock prices that will dampen consumer spending, the friction caused by the Trump tariffs that will raise prices, stall capital spending, and disrupt supply chains and government spending will decline making it pro-cyclical. It looks like we are about to relearn the very hard lessons of the 1930 Smoot-Hawley Tariff Act.  

At the start of the year the value of an expensive U.S. stock market was more that two times nominal GDP. As Keynes noted, “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

Moreover, I would suggest that the stock market decline is far from over. On March 5th I posted on LinkedIn that the high for the stock market was in. Steve Blitz of Lombard came back to me with the comment, “More critical is where is the low.” My sense is that the stock market and the recession will feed off each other that will send the S&P 500 down to the 4900-5000 level, making for a bear market-like 20% decline. We closed to today at 5600. 

Although it is hard to prove statistically my guess is that with 50% of consumption accounted for by the top 10% of income earners, the decline in stock prices will have a negative effect on consumer spending via the wealth effect. Consumption spending as a share labor income is very stable, not so for wealth.  Early signs of weakening consumption was highlighted by several airline executives mentioning a slowdown in air travel.

As far as supply chains go just think about the amount of steel and aluminum, now subject to a 25% tariff, which is used by the Ford F-150 truck and the Boeing 737 airplane. There may be domestic substitutes for steel, but not aluminum. The electric grid is troubled enough that it would be hard pressed to supply electricity to a new aluminum smelter.

Net Net. President Trump’s speculation that the transition to his “golden age” could be marked by a recession.

* I operate under the slogan "Often wrong, never in doubt."

 

We are in the Early Stages of a Bond Bear Market

Bond market cycles last a long time. For example there was a bond bull market from 1920-1946 when long term U.S. Treasury yields declined from 6% to 2.3%. Thereafter a 35 year bear market ensued to September 1981 which took the yield on 10-Year U.S. Treasury Bonds to 15.84%. This was followed by a 39 year bull market that ended in August 2020 with the 10-Year U.S. Treasury yield trading at a meager 0.56%. It seems clear to me that with the 10-Year bond closing this week at 4.76%, we have been in a bond bear market for over four years. 

Thus if history is any guide, we are only the the early stages of a bear market that could last another two decades. Of course, as in any bear market, there will be rallies along the way, the the path for yields will be decidedly upward.

The fundamentals underpinning the bear market include monumental budget deficits throughout most of the world's largest economies, unfunded pension plans, a still smoldering inflation, and, at least in the near term, the global electorate's preference for populist politics that is working to deglobalize the world economy.  Further, if you add to the mix the need for enormous expenditures to harden infrastructure for weather events and the costs associated with energy transition, all the forces are in place for higher inflation and higher yields.

As far as the stock market goes, stocks can and have risen in the early stages of a bond bear market. That certainly has happened over the last four years. However, as high interest rates begin to bite, the stock market will no longer have a bond bull market at its back to support a near record price-earnings ratio for the broad market.  

The views outlined here are consistent with an earlier blog in 2022 outlining the prevalence of 13-year cycles. (See: https://shulmaven.blogspot.com/2022/05/the-useconomy-is-entering-new-thirteen.html) Also see my recent short term outlook       (https://shulmaven.blogspot.com/2024/12/2025-revenge-of-bond-vigilantes.html)

2025: The Revenge of the Bond Vigilantes

 Before going on to our thoughts about the outlook for 2025, I would like to review what we got wrong and what we got right about 2024. ( See: https://shulmaven.blogspot.com/2023/12/2024-volatile-politics-volatile-markets.html)

• We were dead wrong about the stock market. Instead of trading in 5000-4200 range, The S&P 500 soared above 6000.

• Stocks completely ignored the geopolitical risks we outlined.

• The S&P 493 did not outperform the Mag 7. 

What we got right or close to right:

• Inflation, as measured by the core CPI, accelerated to a 3% run rate and the 10-Year Treasury closed well above 4%. (For my UCLA discussion on the economy see: https://shulmaven.blogspot.com/2024/12/my-ucla-anderson-talk-on-prospects-for.html)

• The Fed avoided a recession but did not cut rate soon enough to help Biden.

• The presidential election was close, and, at the time, we were leaning toward Trump.

• Ukraine did not set the West Siberian oilfields ablaze, but it did hit energy infrastructure deep into Russia.

• It looks like Israel has defeated Hamas, but Saudi Arabia, as of yet, is not on track to join the Abraham Accords.

Now for what 2025 will look like:

• Inflation will run at a 3% rate because of continued wage growth of above 4%, the imposition of tariffs and the beginnings of a mass deportation of undocumented/illegal immigrants.

• With continued inflation and a rising federal deficit, the yield on 10-Year Treasuries will exceed 5%. The bond vigilantes will exact their revenge.

• In this environment stocks will exhibit the volatility we though would happen this year and the S&P 500 will likely trade in a wide range of say 6400-5400, closing lower on the year.

• The House Republican Caucus which puts the “dys” in dysfunction will get is act together to renew the 2017 tax cuts with a $20,000 SALT deduction. The other elements of Trumps tax cut plans will be put in separate bills making passage unlikely.

• Two of Trump’s controversial cabinet appointees will be turned town by the Senate.

• France is fast becoming the new Greece and German dysfunction will only increase.

• Israel will attack Iran’s nuclear infrastructure which will bring with it unknowable consequences.

As they say in Las Vegas, read’em and weep, but remember I am often wrong and never in doubt.

My UCLA Anderson talk on Prospects for the Financial Markets 2025

The link below presents my talk at the UCLA Anderson Forecast discussing the outlook for the financial markets in 2025. The link opens with my talk, but you can scroll to the beginning to view the entire forecast program.

https://www.youtube.com/live/rbpRv5pt5OE?feature=shared&t=3075

The Fed's "Coup de Whisky" to the Stock Market

 Last week’s 50 basis point cut in the federal funds rate to 4.875% served up a “coup de whisky” to the stock market. Those words were spoken in July 1927 by Benjamin Strong, President of the New York Fed to Charles Rist, the Deputy Director of the Bank of France at secret central bank meeting on Long Island.* Much like today the U.S. economy was humming along, but Britain was rapidly losing gold. To take the pressure off the British Pound, Strong and several other regional banks cut the discount rate from 4% to 3.5%.

 

In response an already strong stock market was off to the races and would double over the next two years. That move put the roar in the roaring twenties. Although today’s circumstances are far different, but not so different; the economy is at roughly full employment, real GDP has likely grown at a 3% clip over the past six months, and inflation remains moderately above the Fed’s 2% target. Nevertheless, just like 1927 stocks roared in response to new highs.

 

The Fed’s move and it signals of further cuts of 100-150 basis points over the next nine months, is a bright green light for the stock market as investors now believe that the risk of recession is off the table and faster growth will ratify the very optimistic profits estimates for next year. I don’t think that we will repeat the late 1920’s blow-off but further new highs in stock prices appear likely.

 

Interestingly the yield on longer maturities increased. Why? On the margin the 50bp cut will increase both growth and inflation. The lower short-term interest rates will support corporate borrowing and auto finance. Housing, on the other hand, won’t be helped all that much because mortgage rates responding to higher long rates actually increased. That will force house buyers into variable rate paper.

 

The real risk in the Fed’s move is that inflation will not be as quiescent as it now believes. Simply put, the rate-cutting cycle that the market is banking on might be cut short.

* For a full discussion of this event see Ahamed, Liaquat, "The Lords of Finance" (New York: The Penguin Press, 2009) pp. 290-304

2024: Volatile Politics, Volatile Markets and the Fed Joins CREEP

Shulmaven did not cover itself in glory in 2023. (See: Shulmaven: 2023: Another Year of Living Dangerously ) We got much of it wrong:

* The economy did not enter a recession.

*Stocks did not trade in a broad range of 4200-3300 and instead approached its all-time high of 4800.

*Bitcoin didn't collapse to below $10,000 and and instead more than doubled to over $40,000.

*Trump was not a spent force and he now seems cruising towards nomination.

* The market has yet to recognize we have entered a new 13-year cycle.

We got a few things right:

*The Fed remained on the warpath for much of the year and wage gains remained solid.

*10-Year Treasury yields stayed above 4% for much of the year. Coincidentally  the yield ended where it stated at 3.9%

* Ukraine struck deep into Russia with missiles and sabotage as global tensions remained high.

Now, in the spirit of being often wrong and never in doubt here are my views for 2024:

* With the S&P 500 trading just below its all-time high and the VIX index at 12, I believe 2024 will be year of high volatility coming from volatile international and domestic politics. Think 1968.

* The stock market appears to be ignoring the warning of former Secretary of Defense and CIA Director Robert Gates where he noted in the November/December issue of Foreign Affairs "The United States now confronts graver threats to its security than it has in decades, perhaps ever."

* In retaliation for attacks on Ukraine's power plants, Ukraine will set ablaze several of Russia's prize West Siberian oilfields.

* Israel will defeat Hamas sufficiently to declare a victory and by yearend Saudi Arabia will be on track to join the Abraham Accords. (See: Shulmaven: Hamas Aggression Must be Punished)

*Domestically all of the signs point to a Trump victory for the Republican nomination and his victory in November, hardly a confidence building eventuality. Nevertheless, I am not yet predicting a Trump victory; I think it is a 50/50 call as of today.

* The Fed will do whatever it takes to avoid a recession in 2024. Their recent pivot is a step in that direction.  Objectively the Fed will join the Committee to Re-Elect the President. (CREEP, the name of Nixon's campaign in 1972.) As a pillar of the establishment and fearful of its independence, the Fed will effectively be all-in for Biden. Thus the Fed will plant the seeds for a very problematic 2025.

* Core CPI will likely run at a 2-2.5% rate in the first half, but accelerate to a 3% run rate by yearend. As a result the yield on the 10-Year Treasury will once again be north of 4%. In keeping with my view that we are in a new 13-year economic cycle, wage growth will remain solid.

* In this environment the S&P 500 should trade in a broad range of 5000-4200, approaching both ends more than once during the year, with the VIX exceeding 30 at least once during the year. Consistent with the past month, the S&P 493 will outperform the Magnificent Seven.

Stock Market Correction or Bear Market?

 I certainly haven't covered myself with glory this year. My recession call in May, just ahead of a 5% GDP quarter is damning. (Shulmaven: Has the Recession Arrived?) Nevertheless with the S&P 500 now down a touch over 10% from its July 31st high, a correction has been signaled. Perhaps more troubling, notwithstanding the fact that the index is still up 7% on the year, the equal weighted index is down 6%, meaning more stocks are down than up. Just as in the early 1970's nifty fifty market, the leadership has been extraordinarily narrow. Indeed with the onset of a middle-east war we have yet again another parallel to the 1970's. (Shulmaven: Roaring 20's or That 70's Show)

To me my biggest concern is that the S&P 500 is still down 14% from its 4797 all-time high set on January 3, 2022. It can be argued, that just like in the 1970's, we are now in a structural bear market that began almost two years ago. If that is the case, the rally this year could be characterized as one of the biggest head fakes of all time. It remains to early to make that call, and a big tell will be whether or not the broader stock market rallies next month with the abatement of mutual fund tax selling.

My Amazon Review of Victor Haghani's and James White's "The Missing Billionaires: A Guide to Better Financial Decisions"

Utility vs. Wealth Maximization

 

Victor Haghani and James White of ElmWealth have written an important, but too academic book, about investing for retirement. Trust me, this not Burton Malkiel’s “A Random Walk Down Wall Street.” In the interest of full disclosure, I worked with Haghani at Salomon Brothers in the late 1980’s and early 1990’s, before he went on to Long Term Capital Management (LTCM). After initial success in 1995, the firm failed spectacularly in 1998. From that Haghani personally learned the importance of sizing of investments. Simply put, he was over-invested in his firm.

 

This is a book more about how much to invest rather than what to invest in. Sizing is critical and the author’s missing billionaires were way over invested in a single asset, and they maintained unsustainable lifestyles. They utilize the concept of the “Merton Share” where the size of an investment is positively related to expected return and negatively related to risk aversion and the square of expected volatility.

 

The goal is to maximize utility, not wealth. Here I will give an example of my own. An investor has an opportunity to invest $9,000 in an investment that has a 1% chance of a return of $1,000,000 and a 99% chance of a total loss. The expected return is a positive $1,000. A pure wealth maximizer might just take the bet, while a utility maximizer would abstain.

 

In order to make their math work Haghani and White assume that individuals operate under “constant relative risk aversion.” For the lay reader this is a nonstarter, and the book is loaded with references to the finance literature. Further, at least in my case, I don’t think it is valid. When I retired, I was determined to have a fortress balance sheet, which saved me more than a little bit of anxiety during the 2008 financial crisis. Once passed, as my wealth increased, I began increasing my risk levels, but retaining a core fortress balance sheet.

 

The authors take the Jane Austin view that a critical measure of wealth is the income derived from it. Hence, they conceptually like annuities, if only they could be structured in a transparent and low fee way. In today’s financial marketplace that is a tall order. My problem with annuities is that they cause confusion between the return on capital with the return of capital.

 

If you follow Haghani’s and White’s advice you would today be cautious about the prospect for long-term returns from today’s stock market. At this writing the earnings yield of the Case-Shiller price-earnings ratio is 3.39% while the five-year TIPS yield is 2.35%. A real equity risk premium of a meagre 1.04% has historically led to very poor future returns.

 

There is much more in this book, but my guess is that the lay reader would find it a difficult go. On the other hand, a reader with financial training will gain much insight.

For the full amazon URL see: Utility vs. Wealth Maximization (amazon.com)

My Review* of Scott Patterson's "Chaos Kings: How Wall Street Traders...................."

 Tail Riders

 Wall Street Journal reporter Scott Patterson has written a book celebrating the exploits of hedge funders Nassim Taleb of black swan fame, and Mark Spitznagel whose successful bets on high impact low probability events made them a fortune. Their strategy is simple and requires a great deal of patience and a high tolerance for pain in that they are continuously long deep out-of-the money put options on the major stock market indices. Most of the time the options expire worthless, but when disaster strikes their value explodes and those monster gains overwhelm the small ongoing losses. In essence Taleb and Spitznagel take positions on the left tail of the probability distribution for stock market returns.

 Although they don’t know when a catastrophe on the order of the 2008 financial crisis or the 2020 Covid collapse would occur, when it does happen, they are positioned for it. Their sales pitch is that they are selling portfolio insurance for a modest premium and that they allow for much higher equity exposures than otherwise would be prudent. Their model is 97% equities and a 3% position in their fund.

 When I was a partner in a hedge fund over two decades ago, we made a similar bet on catastrophe by buying out of the money call options on Eurodollar futures. It was a bet that interest rates would fall. When Long Term Capital Management failed in September 1998 the price of the options increased tenfold.

 Just to note, I previously reviewed Spitznagel’s “The Dao of Capital” and Taleb’s “Skin in the Game.”(See:  Shulmaven: My Amazon Review of Mark Spitznagel's, "The Dao of Capital: Austrian Investing in a Distorted World" and  Shulmaven: My Amazon Review of Nassim Nicholas Taleb's "Skin in the Game: Hidden Asymmetries in Daily Life"  )   Patterson is a skilled writer so he tells their stories better than they can. However, I would quibble with Patterson in that he wanders off into tangents that are really extraneous to the book’s main points.

* Amazon has yet to post this review. Amazon just posted this AM with  

 Tail Riders (amazon.com)

My Amazon Review of Benjamin Graham's and Jason Zweig's (Ed) "The Intelligent Investor (Rev. Ed.)"

 Margin of Safety

 I just finished rereading “The Intelligent Investor,” a book a I read many years ago and much of its investment insights are still very valid for today. I would note that I was weaned on Benjamin Graham’s “Security Analysis, Principles and Techniques” as an undergraduate at Baruch College. I guess you can say that Graham’s ideas are in my blood. Indeed, just as Graham probed the Standard and Poor’s stock guide, so too did I for many years. Today we have computerized databases.

 The most critical ideas that are useful today include:

·       * A stock certificate is more than a piece of paper; it represents an

      ownership interest in a business.

·      *  Investments should only be undertaken with a quantifiable margin of safety.

·     *   “Mr. Market” who on occasion is manic-depressive allows you to express a view on a stock or a bond every day.

·     *   Despite all of your efforts at security analysis the stock market is loosely efficient making it very difficult to outperform a broad index. Investment success flows from a few very special situations.

·      *  Investors can be characterized as defensive or enterprising, but even for the enterprising investor Graham’s rules are designed to minimize losses through diversification and heeding to margin of safety requirements.

 

As the classic value investor, much of Graham’s work is focused on tangible book value. That metric worked well though the middle of the 20^th Century, but that kept Graham and his acolytes away from growth companies who were powered by intangible capital. Thus, it was hard for Graham to get comfortable with owning many of the growth stocks of his era, but his discipline kept him away from the craziness of the bubbles that occurred in 1961 and in the late 1960’s.  Jason Zweig, the editor of this version discusses at the length the extremes of the late 1990’s dot.com bubble.

 

Graham was fond of public utility shares in the early 1970’s because they traded a low price/earnings and price/book ratios. Unfortunately, he did not foresee the debacle that cost over-runs in nuclear power brought on to this sector. Zweig points this out. Also, Graham really didn’t associate the rise in interest rates in the late 1960’s with the rise in inflation. He characterized common stocks as inflation hedges, which in the long run they are, but that is not necessarily true in the short run as rising inflation propels interest rates higher and price/earnings ratios lower.

 

Then there is a short discussion on Graham’s investment in Government Employees Insurance Co. (GEICO). There his partnership broke his diversification rule by investing 25% of its capital in it for 50% of the company. However, its valuation in terms of earnings and tangible equity was very low. It was his best investment and Warren Buffett, his best-known student, followed him into GEICO and as a result Berkshire Hathaway now owns the entire company.

 

Although the book’s examples are dated, the investing rules outlined here are timeless.

For the full Amazon URL see: Margin of Safety (amazon.com)

Random Thoughts on the Economy and the Stock Market - No. 5

 *-Contrary to what we have been thinking the stock markets as measured by the S&P 500 surged to  its highest level of the year and is just a touch off its August high. The stock market responded to strong employment growth in May and the signals coming out of the Federal Reserve that there will be the first pause in their rate hiking policy that began over a year ago. Further the White House and the Congress agreed to deal over the debt ceiling that postpones that issue well past the 2024 election. For that proviso alone Biden won the debt ceiling stand-off.

*- Obviously the May employment data indicates that my call for the recession starting that month was way off the mark. (See: Shulmaven: Has the Recession Arrived?) Nevertheless, with household employment down by 310,000, compared to a 339,000 increase in nonfarm payrolls, and the the unemployment rate rising to 3.7% all is far from perfect in the labor market.

*-  Little noticed last week was updated guidance from Equity Residential, the owner of 80,000 upscale apartment units,  which indicated that same store rents were up 6% from a year ago. This is hardly the news that the Fed has been looking for. Rents increasing anywhere near that level will make it impossible for the Fed to achieve its 2% inflation target.

*- Treasury bill and bond issuance is about to surge as the government reverses its special measures to avoid breaching the debt ceiling. This action will drain reserves from the system and put upward pressure on interest rates.

*- Net, Net. I would be a seller of the rally.

There is Something Rotten in REITland

REIT stocks aren't working and they haven't been working for years. The performance of the shares since 2016 have been just plain ugly. Some of this is due to the fact that  underlying real estate values have declined in the office and mall spaces.  The technological disruptions caused by e-commerce and work from home have certainly exacted a toll on those markets. So if you add leverage into the mix, it makes for a precipitous decline in valuations. On the flip side, the industrial sector became a huge beneficiary of e-commerce with values up 75%. However, apartment values, according to Green Street Advisors, are up by about 10% since 2016 and strip retail values are essentially unchanged, while the share prices in those two sectors are down over the eight year period.

As many of you know I have a long history in real estate and REITs going back to the 1970's when I penned my Ph.D. dissertation on REITs. Although I have long since left sell-side research and my stint at running the Real Estate Securities program and the University of Wisconsin, I still have more than a passing interest in the space. Presented below is the performance of what I perceived to be quality large cap names while I was a practicing analyst. I also include the performance of the newer tech related REITs in the data center and cell tower markets who have done far better than the more traditional REITs. (See Table 1) I would also note how well the storage stocks and the Sunbelt oriented apartment stocks have done compared to those REITs focused on the over-owned coastal markets.

Table 1. The Performance of Selected REITs, 2016 High - April 13, 2023

Sector/REIT                 2016 High         Apr. 13, 2023        % Change

Office         

Boston Properties            144                       52                      -64%                      

Highwood Prop.                53                       23                      -57

Kilroy Realty                    77                        30                      -61

SL Green                        128                        23                      -82

Vornado                           90*                       15                      -83

*-Adjusted to the JBG Smith spin-off.

Apartment        

AvalonBay                      192                       170                     -11

Camden Property             91                        104                    +14

Equity Residential            82                         60                     -27          

Essex Property                240                       211                     -12

Mid-America                  110                       147                      +34

UDR                                 39                         40                       + 3

Strip- Retail    

Federal Realty                 171                         97                     -43

Kimco Realty                    32                         19                     -41

Regency Centers               85                         60                     -29

Mall      

Macerich                           96                         10                     -90

Simon Property               229                        109                    -52

Industrial    

Prologis                             55                        122                  +122

Hotel   

Host Hotels                        20                         16                    -20

Storage     

Extra Space                      95                         159                    +67

Public Storage                278                         305                    +10

Healthcare   

Ventas                              77                           44                     -43

Welltower                        80                           75                      - 6

Tech Related       

American Tower            113                         211                     +87

Digital Realty                 113                          92                      -19

Equinix                          391                         709                     +81

Given this rather poor performance of real estate in the public markets, it is puzzling to see that major institutions have just thrown a record $30 billion at the new Blackstone Real Estate Fund. For whatever reason, investors seem to prefer their real estate in a private wrapper rather than a public one. Perhaps some of that money will find its way into taking private several of the REITs mentioned here that are selling well below analyst estimates of net asset value. I recently spoke to someone very knowledgeable in this regard, and he noted that despite the price declines, the stocks are not cheap enough to entice a deal. But should interest rates drop as the markets now anticipate, that situation could very well change.

To me there is one lesson to be learned here. Investors have to be more cognizant what REIT managements are doing with respect to capital allocation, leverage and executive compensation. It seems that there has been quite a bit of leakage between the underlying performance of the real estate and the returns earned by REIT shareholders.

Random Thoughts on the Economy and the Stock Market - No. 4

*-The failure of the Silicon Valley Bank last week represents the first bank run of the 21st Century with deposits cascading out with a few clicks on a smart phone being egged on by social media. The Fed and the FDIC came to the rescue by insuring deposits over the $250k limit. This granting of super-deposit insurance was by my reckoning, a mistake. Instead, the FDIC should enforced small haircuts on deposits in excess of $250k. My take would be to offer 95% to those depositors who wanted their money immediately and issue for those who could wait, a one year zero coupon note priced at 95. This would still be a far better deal than one that would have been typical in a bank failure.

*- This episode represents a complete failure of the bank regulatory apparatus in that Silicon Valley's 86% deposit growth in a year represented an unmistakable yellow flag. Further, the bank invested those deposits in long duration assets which should have been viewed as a per se violation of safe and sound banking practice. That would have triggered either the closing of the bank or the firing of its officers. I can't wait to hear the testimony of the regulators from the FDIC, the San Francisco Fed and the State of California testifying before Congress.

* - Despite what Senator Elizabeth Warren said, the Silicon Valley Bank would have passed the stress test that it was exempted from. Why? As usual the Fed was fighting the last war by gearing their stress test to asset quality. Silicon's assets, by and large, were not subject to credit risk; instead they were subject to gigantic interest rate risk that the Fed to ignored. Chalk that up the Fed's zero interest rate policy that finally ended in early 2022.

*- As fears of a generalized run on the banking system catalyzed borrowings at the Fed's discount window surged to record $153 billion, up from $5 billion the prior week. An additional $143 billion was to guarantee the deposits of the three banks that recently failed and $12 billion was allocated to the Fed's new, and dubious, term lending facility.

* - The Fed's Open Market Committee meets this week and only 10 days ago market participants were anticipating a 50bp increase in the Fed Funds rate. Now the debate is whether the Fed will do 25 bps or nothing. There are good arguments on both sides, but my guess is that the Fed will copy the ECB and do a 25 bps increase and signal at least a temporary pause.

* - Unfortunately there will be another shoe to drop. The value of office real estate has plummeted and those losses have yet to be recognized on the balance sheets of banks, CMBS', private equity, and pension funds. Along with bank stocks cratering last week, the shares of the office REIT's collapsed. See below for the price declines of a sample of office REIT's over the past year which are down 55%-71%.

           REIT                                52- Week High         Current Price        % change

BXP (Boston Properties)                   133                           51                       -62%

Cousins Properties                               42                           19                       -55%

Douglas Emmett                                  35                           11                       -69%

Kilroy Realty                                       79                           29                       -63%

SL Green                                             84                            24                       -71%

Vornado Realty                                    47                           14                       -70%

* - As a result my guess is that the path of least resistance for stocks is lower with a retest of the October lows likely.