Thank you to all our wonderful clients who regaled us with their presence at our winter seminar lunch on 12/10/24. We have hosted this gathering in December every year going back a long time, and it’s always one of our favorite days of the year. The mood is festive, the ballroom at the FWCC is beautiful, and we love to engage with so many clients at once.
Dave began the presentation by talking about the Fed (big surprise there). He showed a chart which pairs the Fed Funds rate (blue) with inflation:
As you can see, the Fed started raising rates more than a year after inflation took off. That’s bad enough but remember that the Fed Funds rate was 0% for that full year when inflation was taking off. For that sin, Dave gave the Fed a stern rebuke. Inflation began its descent in 2022, but only in recent months did the Fed begin cutting rates.
The Fed has a well-deserved reputation for being behind the curve, as they say, and this might have something to do with its 2-8 record in killing inflation and not killing the economy. You would think with this massive increase in inflation, massive increase in rates, and the severity of the yield curve inversion for 30 months now, we would have slightly lower-than-normal odds in averting recession. Remember that normal odds are 20% (2-8). And yet here we are, now with the soft landing as the consensus prediction.
Adam updated the crowd on a core holding that has suddenly shot the lights out, perhaps one of the most surprising: Walmart. This formerly dormant stock is +83% in 2024. Remember when it was a top-10 largest stock (by market cap) on the 1999 list? It’s back! WMT has passed both Lilly and JPMorgan to land in the #10 spot, with a $762 billion market cap.
Walmart stock, last 20 years
The bull case on Walmart has been that it has threaded the needle on bringing in a lot of new customers in the last couple years, seeking refuge from inflation, particularly in the upper-middle income class. Meanwhile, its massive investment in online is now paying off, as it gains traction on Amazon and moves into new adjacent businesses like subscription revenues and advertising on its marketplace. Plus it has an enormous treasure trove of data that can be “mined.”
Still, the stock is now crazy expensive, trading at 38 times earnings. Kroger, meanwhile, is trading at 13 times earnings. How much difference is there between the two companies? First look at how much stronger Kroger’s earnings have grown in the last 10 years, and yet its P/E has shrunk:
Kroger sold for a higher P/E ratio than Walmart in 2014, 19x vs. 17x. True, Walmart has become an Amazon Jr, but Kroger is no slouch, with a significant digital business. It has consistently held onto its covid earnings gold rush. You may have a less-than-positive vibe on Kroger if the idea of food inflation is irksome, but if so, you should also indict Walmart, since 60% of its sales are groceries (it’s 80% for Kroger). Plus, Kroger is ahead in terms of private label penetration, and likewise has a treasure trove of data. Both are great companies and both are doing well, but we must question what sort of signal the market is sending.
Adam’s next slide is fascinating. Apologies if you need to get the readers out or squint to see it:
First, look at the chart on the left. This is especially for those of you who are hard partisans. Since Eisenhower was inaugurated in 1953, if you put in $1,000 into the S&P 500, reinvested the dividends, and had it “in the market” only when a Republican was in the White House, you would have $27,400 today. If you did that with only Democrat administrations, waiting until 1961 when JFK was inaugurated, you would have performed quite a bit better, with $61,800.
But if you just “bought and held” through both Republican and Democrat administrations, reinvesting the dividends, the right chart is for you. You would have a bit more: $1,690,000.
The importance here is, of course, having your money working in the stock market all the time, not just half the time. But also of importance is reinvesting those dividends. Adam showed a table comparing your return if you spent those dividends. You would have $228,210 today, not $1,690,000.
John then shifted gears to attest that we routinely get asked “what’s the market going to do in _____ [time period]?” We can easily avoid answering that question because who the heck knows? Not Wall Street’s best and brightest, who one year ago predicted that by the end of 2024, the S&P 500 would be at 4,867. That would have been a 2% gain for the year. Rather, it’s 6,074 today. The highest prediction was 5,200. As Bob Uecker would say, “juuuuust a bit outside.”
But posing the question “what’s the expected return on stocks?” That one we can’t dodge since its answer provides the rationale for why we invest your money into stocks in the first place. Frankly, you have plenty of options before you even hand your funds over for us to invest. Other options, with their expected returns:
The long-term (as in 98 years) average annual total return on stocks is +10%. Earnings have grown 6-7% annually, and the dividend has thrown in roughly 3% annually. Pretty good basis for saying the expected return is +10%, eh? The U.S. just has to keep doing what we’ve been doing for the last 100 years.
But what if our market had gone exactly nowhere in the last 17 years? Lest you scoff at this unlikely notion, this is exactly what has happened in the entire rest of the developed world since 2007 (and truth be told, it also happened here, from 1965-82):
That blue line is the price line, indexed back to 0 on 12/31/07, for EAFE, which represents the entire developed world outside the U.S. Think Europe, Japan, Australia, NZ, Canada. If you think you’ve seen this before, you’re right. It was on the cover page of our October newsletter. If you’re an investor who happens to live in France, and you’re asked what is the expected return on your home market, would you go with longer-term data, or would you be more bearish given this latest data? I wouldn’t blame you if you did…we’re not so sure about the French economy either. Here’s the complete data set, showing that French stocks have returned +5% annually since 2007, and +5.3% since 1999. That’s not much more than their bonds yield.
Now flip that around. Does it make sense that American investors might be more bullish than usual, given 15 years of bliss? Hard to blame them. The U.S. is kicking posteriors and taking names. And our earnings are outgrowing the EAFE bloc, though not by a ton:
Earnings Growth
The result is that U.S. stocks (like Walmart) have become way more expensive than the rest of the world:
That 11.1 P/E premium of U.S. over EAFE has typically been 0-5 until the last 5 years. The message here is that investors do tend to overweight recent returns and extrapolate them into the future. We are reminded of the Fortune survey of investors in 1999 that showed they expected a return of +13% annually over the next 10 years, and young investors expected a +23% annual return. Total return over the next 10 years ended up at -0.9%. At some point, valuations do matter.
The love for U.S. stocks has stemmed in large part from the large position that megacap tech stocks have grabbed. This is a well-covered subject, of course, but we wanted to show some enlightening data. The narrative we are fed is that the megacap techs are the best companies in the world, growing the fastest, dominant in their industries, indomitable moats, no debt, cash hoards… All true. It stands to reason that, at all points in the past, the stocks with the largest market caps were also the world-beaters, dominating their industries, growing fast, indomitable moats, as well. Again, true.
Then why would the S&P 500 Equal-Weight Index outperform the cap-weighted index over any long time period? The Equal-Weight Index has the same 500 companies as the S&P 500, but all with the same 0.2% weight, rebalanced daily. In this index, BorgWarner is as important as Apple. If that index outperforms the regular S&P 500, that means that megacaps underperform over time. How could this be? Two simple answers: the world-beating dominance diminishes AND valuation shrinks. Of course, this doesn’t happen as soon as companies are recognized and rewarded as world-beaters; it takes years. But it does happen eventually.
Here’s the data:
You can see that EW (Equal-Weight Index) has underperformed (red numbers on the right side) in the 2020s by 2.9% annually. In the 2nd half of the 2010s, it also underperformed, by 1.9% annually. Similarly, in the 1990s, it underperformed by 3.1% annually. But the payback in the 2000s was severe, as the EW outperformed by 6.1% annually, which continued into the first half of the 2010s. Since the end of 1999, i.e. in this century, EW has outperformed by 2.5%. Even including the 1990s, EW has outperformed in the last 35 years by 1% annually.
This is encouraging to us because we tend not to put huge weightings for individual stocks into our client portfolios. Positions can become big in taxable accounts if there is a low cost basis, yes, but we always try to acknowledge to the client that this is a risk. We also try to run against the grain, being fearful when the masses are greedy and greedy when the masses are fearful. This does work to boost performance in the long-term.
We highlighted the Health Care sector as one ripe for possible good news at some point. Believe it or not, it has outperformed all sectors since the beginning of the century. Sure, this includes the dot.com hangover to start the century (which helped all sectors at the expense of tech), but it also includes recent underperformance, as in the last 9 years. These are the 25-year total returns:
On an annualized basis, this works out to +8.7% for health care, versus +7.2% for tech. But the sector has gone nowhere in the last 2 years:
Finally, we reminded the crowd that the index of Leading Indicators, the LEI, has dropped in 30 straight months:
This is important because a drop of this magnitude (frankly, it typically takes a drop less than half this magnitude) has always led to a recession. Maybe this time is different. The election has brought out the animal spirits in the market, and also for small business owners, and perhaps AI is as huge for productivity as the internet was in the 1990s (which we doubt). We shall see!
We hope you have a wonderful Christmas and a happy start to the new year!