By: Herbert Diamant
When we think about the stock market, we look for ways to invest in companies that have growing businesses that will reward us with higher earnings and stock prices. We have only a passing interest in the next quarter, as our focus is longer term, over the next five to ten years. This strategy has proven effective over the decades by using fundamental analysis to identify opportunities.
What keeps us awake at night is a market that at times feels like a casino, where speculators chase the same stocks. In such a market, decisions are being made mainly for the thrill of playing and to avoid the fear of missing out. We avoid such behavior, in favor of investing in long-term growth companies at reasonable prices.
As part of our fundamental analysis, we first examine the Federal Reserve’s monetary policy. They are under enormous political pressure from the White House to cut interest rates. While there has always been an informal discussion and attempts at gentle persuasion, it is precedent setting to attempt to fire Federal Reserve Board members and replace them with presidential “yes men”. The worldwide perception is that this loss of independence means the credibility of monetary decisions… simply disappears. To illustrate, the latest inflation measures showed that prices for goods and services were increasing at a year-on-year rate of nearly 3%, above the Fed’s target of 2%. Their response was to lower interest rates.
Lower interest rates can stimulate the economy, increasing already elevated inflationary pressures. When added to the uncertainty about the impact of tariffs on price inflation, we could enter a period of stagflation, a stagnant economy with inflation. The Federal Reserve will then have to materially increase interest rates, the opposite of what it is doing today.
A second component of analysis is our government fiscal policy, which is chaotic and changing. Manic policy swings materially increase business uncertainty and impact long term decision making. Businesses are dealing with tariff announcements ranging from 10% to 100%, with loopholes and exemptions in some industries. Although many companies stocked up on goods in anticipation of higher prices, now they are gradually increasing their end prices for finished goods to offset this tax. This suggests price inflation from tariffs will be felt in the next year.
After we identify good companies to invest in, the third component is whether this is a buying opportunity. There have been times when the markets remained attractively valued and we could confidently buy all these stocks to complete a portfolio. This is not one of those times. Despite the headline news of indexes hitting new highs, most stocks are fully or overvalued. Nearly every technical study we see points not only to high valuations, but setups for a correction. Also, we have developed a great feel for market conditions, which only comes after decades of watching markets full-time. As portfolio managers, our gut instincts unanimously agree not to chase this fully valued market. Looking past the headlines, we are seeing quality stocks decline as much as 25% on news of a quarterly earnings miss. These moves should not be occurring during a strong market.
Then there is Artificial Intelligence, or AI. Less than three years ago I listened to Nvidia’s CEO give a rather technical keynote address describing how his chips would change his company. At that time, their business was focused on video game graphic chips. Some analysts thought he was making a risky company bet on these new chips. His vision prevailed and he remains a great promoter of his company. Yet they continue to face significant exposure to the geopolitical risks of Taiwan, where most of their chips are made. As important, this company depends on just 4 customers (Microsoft, Meta, Amazon, and Alphabet) for over 40% of its AI products, and a reduction in any one of their orders would materially impact sales. This may explain the explosion of circular financing” deals to diversify sales, where a vendor like Nvidia essentially gives money to their customers to buy their chips.
With this fully valued stock market across most industries, how can stock indexes relentlessly move higher? AI exuberance is driving the market, and the index calculations now depend on Nvidia’s share price moving higher. Year to date, over 20% of the S&P 500 Index return is from this one stock. The difficulty in determining whether this stock is overvalued is that once a security moves to all-time high territory, there is no chart resistance or overhead supply. Without knowing where prior resistance is in this stock price, one way a market technician formulates a reasonable upside projection is to look at the percentage decline during the last major market downturn in 2022. Since this company did not sell AI chips at that time, this analysis is meaningless. This leaves both this stock…and the market indexes … dependent on continued positive news flows from this CEO.
One area where AI will harm the economy is that AI makes companies believe they can do more with fewer people. The impact of displaced workers, especially from the higher spending, white collar labor force, will become a significant drag on our economy. With consumer spending accounting for approximately 70% of GDP, a drop in confidence among unemployed workers will lead to lower spending. This will impact both GDP and companies’ sales growth.
At times, making sense of all these cross currents feels like we are playing a strategic game of three-dimensional chess with impatient speculators. During these periods, a combination of cash and high-quality stocks is prudent, as we continue to protect principal and maintain cash on hand to buy when securities can be purchased at compelling prices.
If you have any questions about portfolio advice and management, give us a call or email us at info@portfolioadvisor.com.
