We had the opportunity to break bread with a large group of clients at our Fall Seminar last week, and thanks for everyone who made it a great night at Fort Wayne Country Club. If you weren’t able to make it, and wish you had, we’ll catch you up.
Adam took the mic first and discussed how we are viewing AI and tech in general. So much money is being spent by the hyperscalers (giant data center operators like Microsoft, Amazon, Google, Meta, OpenAI, etc.) on building out AI data centers that it is actually keeping the economy afloat; the strong-enough labor market is the other reason (more on that in a bit). Demand for cloud services (not specifically AI) is still growing rapidly; plus, the hyperscalers are building out their own capacity to train their own AI models. Thus most of the new data center capacity is already spoken for.
There is an enormous disconnect, however, on how much corporate America is spending on AI services, which is growing rapidly, but a tiny fraction of what is being spent building the data centers. Surveys of businesses not seeing an immediate payoff on their investment (considering both money and time) continue to raise the question of when, not if, demand for data center capacity will wane. It might still not be for a couple years, given how this is truly a gold rush, and given their belief that AI will get continually more usable as hundreds of billions are thrown at it. It bears repeating, even though this is well-trod: AI can be a very real thing and simultaneously turn out to be a subpar investment theme. Pretty much every past boom in innovation eventually became an investment bust (internet, autos, air travel, railroads).
Adam talked up about Alphabet, d/b/a Google, as one way we continue to invest in AI. It has a base business that is “waymo” than search, and most of its businesses have yet to be monetized. It has 9 businesses with more than 1 billion users: Search, Chrome, Workspace, Android, Play Store, YouTube, Gmail, Google Maps, and Google Photos. Plus it owns Waymo (the leader in autonomous vehicles), it owns 14% of Anthropic, and it designs its own AI GPU chips. AI is a natural evolution for their businesses, both consumer and corporate, even as it potentially brings more competition in Search. The stock has taken off lately, from $150 at the low in April to $250 now. We would not be surprised if it becomes the most valuable company in the world at some point (it’s a distant 4th now). Even after that run, the stock trades at the same P/E as the S&P 500, 25x.
John completely redirected the conversation to the slow lane with his dissertation on yield. He surveyed the crowd and asked for a show of hands what kind of yield they liked, starting with 1% and ending up at 15%. This may have backfired, however, as hands continued to shoot up as yields of 7%, 8%, and eventually 15% were greeted enthusiastically, even as he showed what you get for those yields, like CCC-rated junk bonds, distressed stocks, and Argentinian sovereign debt. It is entirely possible some folks may have been conflating yield with total return (yield + price appreciation, or how much your investments go up each year).
While admitting this would have been a more apropos topic in the 2010s, when you couldn’t find yield anywhere, he then revealed the reason for the timing. Investors are now using yield as a form of speculation, which may be yet another signpost indicating how late-cycle the market might be. There is an entire cottage industry that has sprung up to take advantage of this desire to speculate on “yield”…see the screen grabs:
You can fetch yields of over 100%, even over 200%, on certain ETFs (exchange traded funds)! If you want to conduct your own due diligence, here’s a good place to start:
https://etfdb.com/compare/dividend-yield
At the top of the list are single-stock ETFs. Yes, just like it sounds, they are “income” plays on owning only a single stock. Let us state upfront: to say these are risky is like saying Warren Buffett is well to do. We looked at 2: AIYY and MSTY. MSTY has become a cult favorite, and now has $5 billion invested into the fund. The fund writes covered call options on the underlying stock MSTR, a tech company called Strategy (formerly Microstrategy) whose claim to fame is not its underlying business but that it has put basically all of its assets into cryptocurrency. When you write covered calls, you (should) own the underlying asset (MSTR in this case), and then you agree to sell MSTR at a higher price (called the strike price) some number of months in the future. For selling that option, you get to collect cash upfront that the buyer of the option pays you. If the underlying asset goes up above the strike price, you miss out on the appreciation above that price. If the underlying asset doesn’t go up, you collect that cash from the buyer and walk away with income and the underlying asset intact.
The pitch here is that you can get a 169% yield, and who knows what the stock will do because who knows what crypto will do? So just pencil in a 0 and your return, voila, is 169%! MSTY’s total return is +81% over the last year, which includes the zesty yield and a 34% drop in the price of MSTY. The underlying stock, MSTR, has returned +118%, so identifying this stock was a great idea, but you gave up 37% from owning MSTY compared to MSTR.
AIYY has the same strategy, but for the stock C3.ai. Ironically, the stock has performed poorly; despite its name, investors are viewing the cloud application software company as a net loser in an AI age. Its stock is -37% since AIYY debuted in November, 2023. AIYY has a yield of 173%. Surely AIYY couldn’t have fallen so much as to make it a loser compared to the underlying stock, though, right? Surely it did….it has lost 87%, to earn a total return of -56%. If you’re wondering the math on -87% + 173%, you have to bear in mind that that current yield is calculated on the current AIYY price of $2.83, not on the price at AIYY’s outset, which was $20. On the original cost, the yield is much lower.
Looking down the list on that website, eventually you come to some ETFs that are based on the S&P 500, which is intriguing since the index yields only 1.1% currently. XYLG yields 23%. With this, you own the S&P 500, but the fund then writes covered calls on the index. Most of that huge yield is a capital gains distribution last December of $5.25, or 18% of the fund’s NAV. If you don’t know what a capital gains distribution is, we salute you! It’s a payout of all the capital gains the fund incurred that year, and you owe taxes on it. That 18% is a massive tax hit if you own XYLG in a taxable account. Because the market went up so much last year, many options were stopped out, or matured, well into the money, which triggered realized capital gains. It is true that, in down years, the income collected from selling calls that don’t hit the strike price should mean you outperform the underlying index. But it doesn’t prevent you from losing money. To wit, in 2022, the S&P lost 18% total return. XYLG was -16% total return. Better, but not exactly “downside protection.” In the last 5 years, XYLG, even with its 4.8% ongoing dividend yield, has a total return of +81%, versus +116% for the S&P 500.
Do people who buy these ETFs honestly believe that they can magically just get the yield, and “come what may” with the underlying index or stock? We honestly believe they do. But we also think this speaks to a larger movement among investors for “protection,” with the market at an all-time high and with the general sentiment that the world is kind of bonkers.
This makes sense when we look at gold. Bear in mind that trying to divine wisdom from the price of gold is a fool’s errand, given that it can be a play on rising inflation, deflation, US dollar weakness, commodity inflation, central bank buying (or selling), or government debt concerns. Overall, its value is as a “hard asset,” untethered from the condition of our financial system. So how to explain its 35% rise this year? Coupled with the sharp rise in bitcoin, you would have to assume some level of speculation is in play, but also that its value as a hedge against a blowup in our financial system or stock market has risen sharply as well. Investors have plowed money into gold ETFs; see the column chart:
The chart on the top left highlights that gold has outperformed the S&P over the last 17 years, which is a rarity, but only if you didn’t reinvest the S&P dividends. If you did, the S&P leads, which shows that, even with a 1.1% yield, income is a really really important component of total return…because you can reinvest it. Gold, as a reminder, pays no income because it generates no cash flow…it just sits there.
We are regularly asked by clients to consider alternatives for investment, and are always happy to research them. The charts below give a window into what we consider “natural yield,” meaning that the source of the payout to you is well-understood and is sustainable. Unnatural yield, on the other hand, derives some portion of the payout from other sources, sometimes leverage (borrowing money to fund the payout) but usually from paying out principal. In other words, taking money from one of your pockets so you can put it in your other pocket, or robbing Peter to pay Paul. A whole ‘nother source of yield is credit risk, attributable to the level of riskiness of the borrower.
Bottom line, we still like safe bonds as the ultimate hedge for stocks.
The Economy
The economy keeps plowing ahead, in spite of the declining Leading Economic Indicators Index, which has always predicted past recessions, with no false positives:
The labor market has held up well, though it is turning stagnant recently. Despite rounds of layoffs we keep hearing about, jobless claims haven’t turned up. Job openings are down, but only to the pre-covid level, which was pretty high at 6.5 million. This labor market support is possible because corporate profits are still rising, at a roughly 5% rate currently. Consumer spending is buoyed by the decent labor market, but also by the “wealth effect” of rising stock prices and home prices…but only for those who own one or both. Rising government spending and the resolution of the sunsetting tax cuts this year, vis a vis the recently-passed tax bill are also providing support. Inflation is still simmering, although we will know better in a few months the true effect of tariffs.
Since the Fed cut rates the day before the seminar, it was fresh on peoples’ minds. Crazy to remember, though, that the Fed’s first rate cut this cycle (of 4 cuts now) was exactly 1 year and 1 day prior to this Fed cut. So it’s already been more than a year since the first cut. How does the market do when the Fed is cutting rates? At the risk of obviousness, it depends…a LOT…on whether a recession follows:
Two final charts, in homage to our discussion at our last seminar… First, if you stayed in the market through the March-April swoon this year, kudos! You have sidestepped the risk one takes by jumping in and out of the market: missing the 1 best day of the year, which in this case will surely end up being April 9, when the market shot up 9.5%, good for the 8th best day ever (by far the most in S&P index point terms at 474, more than double the 2nd best). If you got out April 8, and got back in even as early as April 10, you have hardly made any money this year:
Finally, the S&P 500 Equal-Weight Index continues to underperform the S&P 500 this year, and yet still continues to reign supreme over the long-term AND in this century. The performance of the Equal-Weight index (far right column) is 1.1% better annually than the regular old S&P 500. Over 55 years, that equates to a 23,504% differential.
Despite what you think or hear about how great the megacaps are, on average, over the long-term, the top of the market underperforms. We can debate the reasons for this, but the numbers don’t lie. We are always conscientious about weightings in portfolios we manage, and we fully believe that pays off in the long run.