Given the popularity of our weekly Market in Pictures, we thought it made sense to pick out a few and go into more detail with our PMs. In this edition, Dave and John Luke will spend a few minutes on each of the following:
- Rate Expectations
- Market Concentration by Country
- Asset-Light Business Models
Hope you enjoy, and please send a note to [email protected] if there’s a particular chart/topic you’d like to see covered next month. Time to swing it around!
For those who prefer to read, the transcript:
Derek
Happy March. We’re on the 4th, Monday, the 4th of March. It’s been quite a market, February added on to what was going on in January, December, November, maybe to the surprise of some, maybe not to others. We’ll see what the crew thinks here. I have my usual Dave Wagner, Equity Analyst and Portfolio Manager, John Luke Tyner, Fixed Income and Derivatives Expert and Portfolio Manager as well. We’re going to talk through some of our charts from the past month. Maybe add a little context to them. First thing the opinions expressed during this call are those of the Aptus Capital Advisors Investment Committee and are subject to change without notice. This material is not financial advice or an offer to sell any product. Forward-looking statements are not guaranteed. Aptus reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. More information about Aptus’ investment advisory services can be found in its Form ADV Part 2, which is available upon request. So load us up, Dave, what do you got there for charts? Oh, yeah.
David
Yeah, we’ll start off the first one, we’ll kick it off to John Luke, our rate and fixed income expert.
Derek
This is a regular posting, JL has shared this at least monthly if not every other week since we’ve been on Fed Watch. And it’s great for understanding where the market is versus what the Fed… I mean really the Fed has told us all along exactly what they’re going to do and they haven’t deviated a whole lot, but the market’s been all over the place, so typically behind. So JL, if you want to walk us through, there’s a few lines here and some context would probably help.
John Luke
Yeah, so the yellow line there is the rate cut expectations that the market was pricing in at the beginning of the year. And obviously it was pretty aggressive cuts, six or seven cuts depending on the day for the year. And just to go back to the last projections that the Fed came out with in December, they said three cuts for 2024. The red line is market pricing as of the end of February. And the blue line is what the Fed has communicated. And so you can actually see the market’s pricing in a little bit fewer cuts at least earlier in the year than what the Fed’s projecting. And obviously the Fed’s data will update here moving forward with just more meetings. But the general consensus is that the strong economic data, the strength of the fiscal backdrop, the strength of the employment and the jobs market in general that has continued to flow through to the economy, has pushed back cuts.
So we’re going to get less cuts in 2024 more than likely than what the market was thinking at the beginning of the year. And even that could continue to get pushed back if the data remains resilient. I think one of the things that Dave and I have talked a lot about is you saw rates really drive markets and valuations and the sentiment that was flowing through to equity markets. But what you’ve seen is that’s actually curtailed a bit the last month or so, where now even with less cuts and longer dated out or pushed out cuts are not impacting equity markets. They’ve been extremely resilient and I think Dave’s got a couple of thoughts on that. But just earnings have remained pretty strong. And so it seems like we’re actually trading on fundamentals instead of the macro, which I think in general is probably pretty positive.
David
John Luke, I got a question for you, but I’m going to phrase it with this phrase first and then a question for you. It’s one we haven’t talked about yet. And I think on a lot of our one-pagers that we put out on a monthly basis, we’ve talked about this notion of market rate equilibrium and that’s basically, what we’re seeing now for the first time in quite some time. That’s when the market expectations of where the Federal funds rate should be at the end of the year is equal to that of the SEP projections by the Fed. And one of the comments that I’ve continued to say, John Luke, is that I believe that we will continue to see interest rate volatility until we finally come to some type of equilibrium between the market expectations and the Fed expectations. As of this past month we’re finally there. Do you think John Luke, JL that even if we’re at equilibrium right now, that we may see a lower rate volatility or the continuation of increased rate volatility now that we’re at equilibrium?
John Luke
Yeah, I think it’s a great point. It goes also hand in hand with our commentary that the data was just going to be slower in terms of coming in and being less weak than what the market was hoping for to realize those cuts. It’s a good thought process, but I think that the volatility is still going to be more elevated than maybe it historically has, but hopefully not as volatile as it has been the last two years. So I know that’s not really the straightforward answer that you were looking for, but I do think that if we wake up to a non-form payroll negative number, then this projection probably changes pretty quickly. So I do think that data will continue to move it around.
David
I think that’s a great point, because that’s the point where I spent a lot of time this morning just thinking in the shower, now that we add our at equilibrium, do I really think that that interest rate volatility is going to go away? And my first inclination in the gut is saying no, but that’s going in exact contradictory of what I’ve been saying over the last two months.
John Luke
Yeah. Well, and to take it back to the portfolio level, when you get the volatility of inflation and the stickiness. And you get the lack of correlation benefit from bonds in your portfolio, that impacts a number of things, which we could spend 30 minutes just talking about that. But I think the general story there is if bonds don’t really hedge your equity exposure during an inflationary period, that you can expect a lot more volatility from that part of your portfolio, then maybe what we’re used to seeing the last 10, 15, 20 years.
Derek
If I’m correct on this, it seems like the Fed has been pretty darn consistent both on the way up and how long it’s going to take before they cut, which is what you’ve been saying all along, JL. I mean probably to your liking, they’ve been a little more hawkish for a little bit longer than anyone really thought they were going to be.
John Luke
Yeah, well I think Powell got a little jumpy in December at the Fed meeting with opening up the doorway for rate cuts getting ahead of themselves. He’s walked that back significantly along with most of the other Fed governors. So it just proves how powerful his voice is to the market and he can obviously move things around by what he says and he’s got to be very careful in how he communicates it. But it’s nice to see it back in track. One of the things that’s been funny is when things have gotten back on track, they haven’t stayed there for very long, so it’s just opening up the door for what’s next to drive it one way or the other.
Do we get more inflation and more data that makes the Fed say, “Hey, less cuts in 24?” Which I think is a real possibility and most people aren’t pricing that in. Or do you actually get the data that they’re looking for that gives them the doorway to cutting? And I don’t really have a clear view on it. But I just think that it’s likely that we get seven, eight great cuts this year. I think you probably get a couple, but I wouldn’t bet the farm on getting a bunch.
David
Well, old Jerome Powell could not contradict the US Treasury secretary, Janet Yellen, who decided to jump him in line one day before that December meeting, John Luke, over what she was saying.
John Luke
Yeah, well they’re best friends.
David
One thing I’ve been saying here, John Luke and I go back and forth and it could have two different meanings. We’ve always continued to see headlines stating that the last mile of inflation tends to be the longest. I don’t know if I fully agree with that. I think the last mile of bringing inflation back down into a more palatable level just in the heart of it, tends to be the longest. And people just don’t remain patient waiting for it to get back to that absolute 2% year-over-year threshold that the set is pontificated as the Mendoza Line over longer periods of time.
Derek
This is a fun one here. All anybody’s talked about for the past 12, 18 months is the concentration in the MAG7 and MAGA and some of the other names that it’s been, and now maybe it’s a little shortened now. But this is interesting when you compare the US, which obviously the US is of a different size than all of these countries. But it’s not really that out of the ordinary for a country to have dominance at the top. So maybe you can walk us through this one a little bit.
David
Yeah, this chart’s basically just showing the percentage of an indice per country’s weight of the top 10 holdings. We know that concentration risk in returns and concentration risk in regards to weight within a benchmark has been a hot topic, not just in the past two years, it’s been for quite some time. What I wish we actually did with this slide, John Luke, would’ve been a fun game, would be us trying to guess the largest individual holding for each one of these countries, whether it be Taiwan at Taiwan Semi, which I would assume be correct.
John Luke
Yeah, but no one sticks out there. Can you name one of the top three holdings in the iShares Ireland index?
David
No, no.
John Luke
Ryanair is one of them, the airline company.
David
I should have definitely got that. Which one’s Samsung JL?
John Luke
Samsung, South Korea.
David
South Korea, there you go. That would’ve been a fun game to do. But this is really just a chart we wanted to bring to attention, because I know all the concentration risk of return and waiting really just comes in the domestic US country of the S&P 500, when a lot of folks have their investments internationally in the MSDI EAFE and the MSCI emerging market index, which actually has a substantial larger concentration risk from a weightings perspective. So we really just thought this was an interesting chart.
John Luke
Yeah, yeah. Maybe.
David
So to catch you up just on time, this chart, it’s on our dashboard and one of our top three for the month, and I think it’s one of the most influential. It’s why I skipped the last presentation slide to go a little quick. Because I want to spend some time here and it’s one of the most interesting charts that I’ve come across and something I’ve been wanting to create for a very long time. Because many of the people on this listening to this call have heard me speak on the profit margin for the S&P 500 going back 40 years back to 1980, I think it was around nine or 10%. And fast-forward to what it is now here in 2024, closer to 18, 19%, on how that can really dictate the overall valuation for a stock or for a benchmark itself.
Because if I were to silo out and say, “Hey, in a vacuum, would you rather own or would you yield a higher valuation of stock A that has a profit margin of 8%? Or stock B that has a profit margin of 16, 17%?” I think everyone on this call would choose the latter that should yield a higher valuation for a stock. But that definitely should coincide with an overall index as a whole. And what this chart shows is basically just breaking out the S&P 500 constituents into four different categories, innovation, consumer, manufacturing and financial REITs. And if you’re really break it into more simplistically speaking, let’s focus on asset light versus more asset heavy industries or sectors. And if you go back to 1980, the aggregate asset light sectors was less than 15%. Fast-forward that to today about 50% or greater than 50% of the industries and companies creating the constituents within the S&P 500 are considered asset light.
And between that and the technology that has created more economies of scale, the S&P 500 has yielded a higher profit margin. In return, it should yield a higher valuation. And one kickback I get for a lot of my thoughts, or at least our asset allocations overall weighting to more stocks, less bonds, especially in this current interest rate regime, is that, “Hey, you know what? The S&P 500 US market, they’re really expensive. So we think that we want to pull the lever of owning more fixed income.” Which anyone on this call has heard us talk ad nauseum that we want to own more stocks less bond. And we’re not too worried about valuation of the S&P 500 right now. In fact, it may be merited given the change in the constituents that embodied the entire index as a whole, that it should yield a higher valuation.
So I really don’t like the statistic when people come to me and say, “Hey, Dave, the S&P 500’s trading at 20 and a half times forward earnings, that places it in the 98 percentile versus its history.” Well, we know that the US economy, not just from 1980, but way before 1980, has very much changed its shape on how it looks. And that comparing to Dave’s valuation to valuations in 1960, 1980 probably don’t make a whole lot of sense. And I think this is one of the first few charts that I’ve come across that really shows and illustrates that point.
John Luke
Yeah, I think I got a one-off question for you, Dave. So if you think about the amount of fiscal that’s been coming through with the infrastructure spend and the build back and all that stuff, do you think that that could influence some of these numbers where you actually start to reshore? Because the point on the valuation piece is we’ll go look at Europe or go look at Asia or Mexico or whatever for their valuation, and you can see where it’s moved, right? The economies of scale is just us shipping off a lot of the manufacturing process to cheaper labor. So it will be interesting to see how that moves moving forward if we bring jobs back to the US and manufacturing capabilities.
David
Well, it’s that and just how the other countries, where their focuses are, they tend to be more manufacturing or tend to be more service oriented on the financial side, like the United Kingdom. Everyone continues to state that they want some type of international exposure because the valuation is so cheap. And everyone here has probably heard me say multiple times, historically speaking, the international MSCI EAFE index tends to trade an 8% discount to the S&P 500. It’s closer to a 30% now. But that aspect of the conversation tends to be their only thesis on owning international, when we know that for some type of mean reversion and valuation, you need some type of catalyst and there isn’t a substantial catalyst. Much to your point, John Luke, the reshoring that we’re having here in the United States, the economy scale, the technological background that we have for growth here in the United States. Maybe there’s been some type of re-rating for the US S&P 500 to yield such a substantial premium over international markets. Or maybe, just maybe that valuation argument for international really isn’t there.
John Luke
Yeah. Where’s your growth coming from? And it’s coming from the US.
David
It’s probably going to continue to come from the US.
Derek
I’d also be curious because every CEO and every major activist investor is pushing towards an asset like model for anything that they own. Are there sectors where you’ve seen, sorry for the curve ball question, but it seems like even in manufacturing there have been the use of technology that can help create asset lighter, maybe not to technology levels, but are you seeing it inside of industries, whether it be energy or manufacturing or any of these, where there are a couple examples of companies or countries that have actually pulled this off and changed their business model?
David
Yeah, it’s a great question. And I think there’s probably four industries that come to my mind that have done this. And they’ve received a substantial re-rating in their valuation. One was airliners, two has been restaurants, three has been semiconductors, and the fourth would be exploration and production companies. So oil and gas, E&Ps.
John Luke
Home builders too.
David
Home builders, yes, John Luke, thank you. Home builders that’s a fifth one that have definitely moved to this asset light model and you should see their valuation almost double to where it was relative to a few years ago. And I think a lot of people have said that they don’t want to invest in these areas because of their valuation is so stretched. Well, a lot of people don’t understand that they’ve really changed their businesses on the underlying fundamentals where they should yield that higher valuation. And I know that restaurants and airliners are probably more of a polarizing industry than semiconductors, E&Ps and home builders right now, but really since those industries changed their model back in the 1980s, they’ve substantially outperformed the S&P 500, which is probably warranted given that move.
Derek
Like Tony Gwynn, I threw you a curve ball. I knew you were going to hit it, it doesn’t matter I’m not going to get anything past you.
David
Exactly.
Derek
I just think it’s an interesting concept and I know you do a lot of work on individual equity research and our sleeves and the active components of our fund. So just curious how this… Because it’s obviously still going on and probably more of it, so cool. All right, well, we’re going to get to a wrap. I mean, there was a chart that we put up last week that we didn’t put in here, but S&P’s up 16 out of 18 weeks, been 50 some years since that’s happened. Thoughts? Comments? How does that impact your thinking and the way we think about allocations?
David
I’ll let John Luke hit on the allocation set. Obviously this is the right tail event since the October 27th bottom of the market, which almost very much coincided with the same timeframe from the peak of the US tenure treasury, the S&P 500 is up about 27% I think, obviously hit an all-time high 15 different times. But let’s think, how often does this happen? Because obviously this is right tail events, how often does it happen? We always talk about the magnitude is more important than the frequency. Well, if you go back to 1950, the year to date return for the S&P 500s of 7% higher.
This is only the 13th best year starts at the S&P 500 since 1950. So we think that it’s such an outlier period, especially on year-to-date performance in 2024. But out of 74 instances, this is only the 13th highest. So this actually shows to me that these periods of exuberance or right tail events happen actually a lot more than we think, not just on the right tail that I’m talking about now, but also the left tail. So there’s more kurtosis in the tails. But JL hit that on the asset allocation side.
John Luke
Yeah. Well, I think one comment and then dive in. It’s hard to get real bearish when you’ve got fiscal policy running at the levels that it is right now. I mean, you think about your stock piece, that’s your real return driver to the allocations. Bonds obviously can’t grow. And it just goes back to the structure of the allocation where you’ve got to inject more equities in our belief in order to generate those compounded returns that we’re looking for. I think that it’s likely that inflation probably stays elevated, and if inflation’s at three ish percent, that’s like the gold mine for equity performance. Because companies have the ability to increase sales and then hoard some of that margin in the middle.
And so as we back into what’s left for this year, think about it, you got an election, you’ve got a number of positive catalysts that were riding high, like don’t fight the trend and those things. It’s unlikely in my opinion that the government’s going to allow any type of recessionary debacle going into the election. The incumbent party never wins during a recession. And so that’s definitely upped their sleeves. So when it comes to the portfolios, it just really matters that the allocation mix is right. We’ve got the hedges and things in place to be able to smooth that ride out if anything were to come. But when you get a three or four month swing like we’ve had it, it sure feels good to have an overweight to equities and to see the ability to capture that right tail.
Derek
Awesome. Well, I appreciate you guys making some time for this. And I think we’ve had a lot of good feedback. And we always do invite questions, invite different ideas, different suggestions for things that we could talk about. But these are a couple that have been, I think most discussed around here, so I appreciate you coming on and giving us a little extra context.
John Luke
Thanks, fellas.
Derek
Have a good one.
John Luke
All right.
Disclosures
Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security.
The opinions expressed are those of the Aptus Capital Advisors Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward-looking statements cannot be guaranteed.
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