Happy November! I’m pleased to turn the calendar over as October was a terrible, horrible, no good, very bad month! COVID ran through our house in October, a tree fell on our fence in the sports court in our backyard, my dog died, markets dropped, and I can’t even complain because the situation in the Middle East is so terrible it makes any other bad news feel like comparing your stubbed toe to someone else’s terminal illness. October was rough.
Markets had already pulled back in September, coming off an excellent start to the year. Investors were digesting the financial data, signaling the likelihood we will hit a recession at the end of this year or early next.
I was at our annual conference in October, listening to an economist give his forecast for the year. In some ways, being an economist is an easy job, as I am reasonably confident it was the same forecast from the previous year. Higher rates are squeezing consumer disposable income and corporate profits, heading toward recession. However, it is not expected to be a deep recession as the economy isn’t broken; it just needs some excesses squeezed out. The hard part of being an economist is that you do have to be pretty tough-skinned in that most of your job revolves around you explaining why your predictions from the year before didn’t happen.
The end of 2022 brought us Chat GPT and the advent of generative AI. Generative AI is a game changer. The technology to learn from big data and generate new and original content, chat responses, designs, and to create has widespread application across all sorts of businesses.
I read “The Coming Wave” last month. The author, Mustafa Suleyman, founded Deep Mind, the company behind Google’s version of Chat GPT. It is worth reading because it details the potential and opportunities of generative AI and the challenges of trying to contain and control the powerful technology. Both exciting and somewhat frightening at the same time!
The beginning of this year was great for markets in that businesses that might otherwise have hunkered down and saved their pennies in expectation of a recession spent big on generative AI.
Businesses are happy to spend money on something they can see has a tangible impact on their bottom line right away. The “low-hanging fruit” of the technology is productivity boosts from savings in client services, fraud prevention, and selective advertising. Businesses could see an immediate payoff, and so they spent.
What was deceptive about the first six months of the year is that the markets looked fine, but it was a very narrow rally.
The leaders in generative AI, dubbed “the magnificent 7” (Microsoft, Nvidia, Google, Apple, Amazon, Meta, and Tesla) all had rocket-fueled starts to the year and drove the US market higher. These stocks account for about 30% of the US market (S&P 500). At the beginning of October, the cumulative return of these seven stocks was 90% for the year. Considering the US market was only up about 12% at the time, that should indicate how poorly most other sectors and companies have been performing. If you just used an equal weighting in those seven stocks rather than a market cap weighting (where larger companies make up a larger percentage of the index), the US market return is “0”. (1)
Clean energy, materials, telecoms, long-term bonds, and financials are all down for the year. The Canadian market is only up 2% relative to the 12% of its US counterpart. We don’t have an equivalent to the Magnificent 7 in the TSX.
The good news is that I like the tech sector and am overweight in that area, so the year-over-year returns look great. The bad news is that the growth is so concentrated that it makes for a much bumpier ride, and when the tech sector cooled off a bit at the end of summer, we felt it more than usual. Without the supercharged returns from tech, it exposed the other sectors’ lack of growth and profitability.
Higher interest rates are weighing on disposable spending, and worries about an upcoming recession have caused a pullback in the market. Against this backdrop came the Hamas attack on Israel.
Watching the situation in the Middle East unfold leaves a pit in everyone’s stomach, including markets. “Vicarious trauma” is a real thing as images of mangled bodies, bloodied children carried from the rubble, and people distraught at the loss of loved ones are streamed endlessly through social media. It has been a heavy emotional toll, which can’t help but spill over to markets. Israel and Palestine are non-important financially to the global market. Still, it is one more spark in the world with the potential to escalate into something significant, and it is impossible to weigh the humanitarian and emotional costs of the conflict.
Bruce Lee once said, “Do not pray for an easy life, pray for the strength to endure a difficult one”. Philosophically, I agree with the mindset that growth comes from stress, but I don’t think it can be universally applied.
I don’t feel like I gained anything by being sick for a couple of weeks aside from an appreciation for my health or that I am going to grow as an individual by having to pull a tree off my backyard court and repair its walls. Nor is there any good that comes from war in the Middle East. But financially, at least, the sentiment is highly relevant.
Being resilient when markets churn is one of the most important characteristics of being a successful investor. Time in the market is more important than timing the market, and money managers add their value to portfolios when markets fall. Maintaining the conviction to keep good businesses discounted because of short-term headlines and adding companies that are improperly valued when things are rough are critical to sound money management.
A recency bias causes us to place greater importance on the most recent event rather than a more logical interpretation of all data.
Kristy and I were just out for dinner with friends, and they were asking if we had traveled anywhere recently. My wife unhesitantly answered “no”. I think everyone in Vancouver feels the same way in November when the days are shorter, and the continued rain and grey hits everyone up with a bit of the very appropriately named “SAD’. It feels like you haven’t seen the sun in years.
I was a bit surprised, though, at her answer, as we were in Mexico for a couple of weeks in spring break, we took the family to Disneyland in the summer, we spent three weeks in Europe, and it is less than a year ago that I was in Qatar for the World Cup. I’m pretty sure that any unbiased poll of our travel in the year would consider it to be robust, and I had to get Kristy to pull up her phone with the screen saver picture of the family in Disneyland to remind her that we have not exactly spent the entire year with our noses to the grindstone!
As I go through client reviews for the year, there is a lot of concern over what is happening with markets because the last quarter has been terrible. That is true, but overall, the year-over-year numbers are pretty good. Recency bias will make us believe that a declining stock market will continue to fall. A more objective look at the facts will suggest that markets are amid a normal pullback after a pretty good start to the year. Recessions are normal parts of the economic cycle, and geopolitical unrest and wars are unfortunate realities of the world.
Amidst the backdrop of uncertainty and unrest, there is opportunity. When we can make calm, logical decisions in an emotionally charged environment, we set ourselves up for longer-term success. We can’t live in Disneyland, and we will not wake up every day to a tree down in our backyard. We must make choices on our investments, weighing out all the data.
Generative AI is not a short-term trend. It is a transformative technology that is only in its infancy. We are going through the first wave of adaptation, but we are at an inflection point whereby the growth in tech will accelerate again overall. Recessions are a necessary part of the economic cycle.
There is inflation and excess in the economy left over from supply and demand imbalances and an overly stimulative monetary policy. The economic legacy of COVID was that there was too much easy money circulated that was chasing a shortage of products and services. That excess needs to be squeezed out of the economy.
It was harder for me to invest in the summer, when markets were bullish, than now.
Technology valuations were frothy as they got a little ahead of themselves, the rest of the market was unprofitable, and interest rates were still rising. Difficult decisions on where to put new money when you don’t believe you are getting a deal on what you are buying. It is easier now. Valuations across most sectors are cheap, higher rates now mean that savers are finally being rewarded in fixed-income solutions for the first time in over a decade, and the tech market is back trading at what we consider fair prices considering the promise in that sector. Challenging market conditions lay the groundwork for future gains.
Take a breath. The sun will eventually appear again in Vancouver, and markets will rebound and grow. I don’t know how to bring peace to the Middle East, but I do know what to do with portfolios, and sometimes, for the sake of your mental and financial health, all you can do is focus on what is in your control.
I am looking forward to connecting with you as we move through client reviews this quarter. Please let us know if you have questions or want to get together to go over your accounts.
Stay safe, stay disciplined, stay positive.
Jeremy
- Ermey, Ryan. October 6, 2023. “The 7 largest stocks in the S&P 500 have returned 92% on average this year – but ‘it’s not terrible healthy’ for markets” [online]. Available from: https://www.cnbc.com/2023/10/06/magnificent-seven-returned-92-percent-this-year-but-its-risky-for-markets.html
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