Happy February! Hope everyone is off to a good start to the year. Our family spent a week at Sun Peaks over the New Year, where we disconnected from life for a bit and did nothing but ski, eat, and play. I started the year refreshed and eager to see what the first quarter would bring us. My daughter, Maddie, not as much. She just finished her teaching certification in December and is officially employed as a teacher on call in the Langley and Coquitlam school districts. She is available as a substitute teacher, and with the teacher shortage right now, she is fielding dozens of calls each day from schools looking for help. She took her first official working day “off” as it was her birthday. She worked a couple of days and then took another day off, insisting she shouldn’t have to work “Mondays” and her two-day work week previously had left her exhausted. It is a bit of a trap when you start each day with a phone call asking if you “want” to work today! It’s pretty empowering to say “no thanks, not today”! She’s found her groove now, but it took a few weeks.
The start of a new year hits everyone differently. Trump’s taking office in January gave hope to many people and businesses that this year would bring about positive change. It also has caused mass anxiety and nervousness around the world as a lot of people are worrying over exactly what a second term with Trump in charge is going to look like. One month into office hasn’t brought much clarity with the only thing that I have any confidence in forecasting is that these next few years are going to be chaotic!
Markets are coming off a great year. We hit 57 record highs in 2024, which means that, on average, the market set a new high every four trading days. Most of that is due to tech, specifically the optimism surrounding Gen AI. Valuations are really high in these markets. All “Magnificent 7” stocks (Nvidia, Microsoft, Amazon, Google, Tesla, Apple, Meta) are expensive, with valuations now near record highs.
The rationalization for those record-high valuations for the Mag 7 is that they legitimately make a ton of money. The free cash flow coming out of these companies is at an all-time high. The top ten biggest businesses in the US are averaging over 25% free cash flow right now – also at a record high. Effectively, that means that after they have paid for all of their operating expenses and capital expenditures, they have billions of dollars left over that they don’t know what to do with! I’m not saying the valuations are justified, but you can certainly see how they got so high. The Mag 7 core business is killing it, and they have been reinvesting that cash back into Gen AI, making it harder and harder for other companies to break into their inner circle. This is on top of using the pocket change that they dig out of the couch at company headquarters to buy any company that either catches their interest or might become competition for them. There is an expectation that markets will broaden out, but many of the more promising companies are already owned or bought out by these market leaders. YouTube, Instagram, Waymo, LinkedIn, Fitbit, Twitch, WhatsApp, and the list goes on, are all companies owned by the Mag 7 that expand their considerable reach. It’s hard to compete with that much free cash flow.
Markets today generally reflect investor’s expectations of where stocks will be over the next year. Stock prices are forward-looking and based on anticipated earnings, economic conditions, geopolitics, interest rates, and company performance. The reason that market forecasting is less reliable than a weather forecast is that predictions are being made based on incomplete data. They are educated guesses of how the wind will blow on multiple inflection points that can potentially move markets.
Currently, the market is very “optimistically” priced based on the following assumptions:
- Gen AI is only midway through its buildout, and as adaptation becomes more widespread, more jobs will be created than displaced.
- Inflation is under control
- The US economy is going to continue to recover, and spending will broaden out beyond just tech as interest rates drop
- Trump is going to have a progressive impact on the US economy. Deregulation and his pro-business policies will have a more positive impact than the damaging effect tariffs could have.
- The geopolitical environment doesn’t worsen. The Middle East conflict doesn’t need to be “solved,” but it doesn’t escalate. The same goes for Russia/Ukraine.
These assumptions are all more likely than not, but I don’t have a high conviction for any of them. Even less faith that they all collectively fall in the right direction. There is also more vulnerability in markets when prices are high, as there is more nervousness and less tolerance for deviation from expectations when investors feel they haven’t gotten a deal on a stock. All sounds pretty pessimistic, but it is also the same feeling as the beginning of last year, and it is tough to quantify the impact of Gen AI.
Trump’s first month in office has proven that any projections for his second term as president are going to be pure guesswork. It is sort of like watching the sequel to a chaotic blockbuster, where the movie studio tries to engage viewers’ interest by having the same main character careen through even wilder plot twists, bigger explosions, and crazier sidekicks than the original.
We already had the first hiccough in expectations with the launch of DeepSeek. DeepSeek is a Chinese startup company that has introduced an AI model that rivals ChatGPT but at a fraction of the development cost. They claim to have built the model using old Nvidia chips and only spent $5M in training the new platform. Nobody believes that, but what is true is that the learning model is a lot more cost-efficient and has the potential to democratize AI access and reshape the competitive landscape. It is also a clear signal that the US is not the only player in the AI arms race.
Our dog, Kobi, just turned one. In my mind, this was the age where she would have settled down a bit. I walk her, mostly off-leash, through the woods around our place every day for an hour. I had the same routine for our previous dogs: add some playtime in our backyard, and that was enough for a calm canine. Kobi has much more energy than our last couple of dogs and still goes through a “gremlin” fit every night with this routine. The trouble is that I don’t want to walk her again! Especially at night, which necessitates her to be on a leash, which takes a lot more time to tire her out. It was a real problem for us at night when Kobi entered chaos mode! Then we discovered that treadmilling your dog is a thing. It’s awesome! Now, my wife and I will work out at night while we put the dog on the treadmill. It forces us to be more consistent with our fitness and is great for settling the dog!
The market is still digesting the impact of the DeepSeek news. If we don’t need expensive chips and billions to develop working AI models, it could be bad news for Silicon Valley and crack the “big tech “market dominance. It’s not necessarily all bad news, as a lower barrier to entry promotes more competition, lowers costs to consumers, and is suitable for new businesses and innovation in AI applications.
Many analysts I follow expect the new model to be a transformative force in the AI industry, but not one that is immediately poised to supplant Nvidia and big tech soon. There may be some short-term pain in the stock price of big tech companies, but one of the significant benefits of all that free cash is their ability to adapt to changing markets quickly. Misallocation of resources and bad bets that would wreck smaller companies are rounding errors for Mega cap stocks. If they need to pivot on their current AI development strategy, they will. I think of it similarly to Kobi. Walking the dog outside is the better choice overall, but if you don’t have the capacity to live your life at the whim of your puppy, the treadmill is a pretty efficient cheat. It doesn’t replace an outdoor walk, but it has its place. That is my first impression, but I am definitely reserving the right to change my mind! I will be watching this space closely over the coming year.
I opened a new account recently for a new, younger client. She emailed this week asking if all the current political and market instability meant we should adjust our portfolio strategy. This is a very understandable question, given the wall of worry that is forming around the state of the world right now. My answer was that the market is always volatile, no matter what financial headlines make the news.
It is worse when everything feels stable and markets get hit with something completely unexpected! Market prices are predicated on unknowable data that is constantly changing. Will a Trump presidency bring about a market correction? Probably. This is not necessarily because of Trump’s policies (although maybe!), but because statistically, there has never been a president who hasn’t experienced at least a 10% drop in the market. The majority have gone through at least a 20% or more downturn.
The good news is that there is a tangible, practical, walkable path to navigating markets. Diversify and stay invested. If you are in the accumulation or growth phase of investing, remain invested and keep investing regularly. In the decumulation phase of your investment journey, diversify and safeguard enough income so you don’t have to sell stocks in a downturn, but stay invested. Discipline is the key to many things in life, but it is especially relevant in finances!
Discipline is the ability to act towards your goals, even when motivation fades. There is little more demotivation as an investor than watching hard-earned investment dollars drop in value. Learn to embrace these moments of hardship as growth opportunities. It is hard to remember when we are coming off such an excellent year for portfolio gains, but it is so important to imprint in our minds that we want consistency over intensity, progress over perfection, and fundamentals over fads. Volatility was our friend these last few years, but that won’t always be the case. The goal is a properly balanced portfolio and investment discipline that looks through headlines.
The US market has gone up 83% of the time year over year over the last 40 years. Business owners have grown their wealth faster than business workers. Owning good businesses over the long term will create wealth more consistently than any other investment. You can own real estate, too, but a middle-class home today is still a middle-class home in 25 years. A middle-class-sized portfolio today will significantly jump your financial weight class in 25 years! Staying invested will cause you some heartache when we inevitably go through market corrections and crashes, but it is also the key to long-term financial health.
Stay safe, stay positive, stay disciplined!
Jeremy
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