Global equities have rallied for more than a year in the face of skepticism from Wall Street analysts and strategists, in part thanks to “goldilocks” economic data — not too hot, not too cold. Technology stocks have performed particularly well during this time, discounting a robust future of profits related to Artificial Intelligence (AI), another economic tailwind that Wall Street has yet to embrace fully. In our view, this is classic early business cycle and bull market behavior. Every bull market climbs a “wall of worry" as equities skyrocket on the hope that the economy, earnings, and, in this case, AI will deliver on their promises. In the early phase of these cycles, many doubters usually fail to invest fully and miss the great returns – such as those of recent quarters. Today, this is evidenced by the nearly $6 trillion in money market balances that would typically be in equities - had it not been for this "wall of worry." The level of skepticism and money market balances confirm that we are still in the early stages of this cycle of economic growth, earnings, and the AI technological transformation. At this point, investors would be wise to ask themselves how far and how long stocks can continue this upward trajectory? What are the risks to this bullish case and how can we protect ourselves from a reversal of these fortunes? Let's dig in!
From 2022 to 2023, most companies worldwide shed expenses to brace for the Federal Reserve and other global central banks’ aggressive policies of raising interest rates. This, coupled with generous fiscal policy in the U.S., allowed economies to survive the rate hikes without a recession. Now that inflation is close to or, in some cases, lower than central bank targets, rate hikes are complete. At the same time, economies remain in great shape, a critical element to the strength and longevity of the new business cycle we foresee. This combination can be decisive for the new cycle, akin to an athlete who recovers quickly from an injury and is playing at 100%. Strong, stable growth combined with global central banks with an eye on lowering rates are hallmarks of early-phase strong bull markets - and this one is likely no exception.
How Long?
Our Founder, James Demmert, has written extensively in his books about the history of business and bull market cycles. In the past, the average business cycle has lasted 7-9 years, but those that included a technological transformation have been longer. This is informative and should set the tone for investors’ risk tolerance and wealth planning - assuming the bull market doesn't get derailed.
How Far?
During the 1990s tech-led bull market major stock indexes tripled! The effects of the internet fueled significant productivity and earnings growth – similar to what we envision for today's AI transformational tech shift. If we simply apply the math of the 1990s to this new AI tech-led bull market, we arrive at S&P 500 15k, Nasdaq 50k, and The Dow over 100k. While these targets may seem overly optimistic, the math is in-line with previous technology led bull markets. Of course, there are potential risks that could derail these targets which we discuss below.
Sectors: What we can learn from past cycles of transformational technology?
Drawing comparisons between today’s technological revolution and the dot-com era is apt because the internet revolutionized work, social interactions, and entertainment. AI promises a similar, if not more significant, impact. The dot-com bull market was substantial for many years. During that bull run, valuations were supportive; however, speculation resulted toward its end. Corrections should be expected as we continue to learn about which technologies work and which will not, but the long-term nature of this innovation is genuine. Current earnings reports, corporate capital expenditures, market breadth, and macroeconomic indicators have all validated our belief that we are still just in the early phases of these positive developments.
The primary beneficiaries thus far have been companies involved in the infrastructure and hardware essential for scaling AI capabilities, much like the companies that laid the foundation for the internet with fiber cables. We envision that the next phase of the cycle will likely see a boost for consumer and enterprise applications of AI, although we are not quite there yet. This current- and forward-looking perspective informs our overweight positions in technology hardware, industrials, and communications. Even utilities play an important role in portfolio construction, as power needs are enormous with AI.
Risks to the bull case
We know that even the most well-formulated plans can sometimes go awry due to unknown events that are out of our control. So, we will be closely watching the central bank interest rate policy, U.S. debt levels, potential government regulation of AI, and geopolitics, among other potential headwinds.
2024 also marks a high number of elections, reminding us of the importance of political stability. Historically, elections have limited long-term impacts on markets - a trend we expect to continue. Recall the surprise election in India this year, where Prime Minister Narendra Modi was reelected but with a new government. Despite volatility in Indian stocks and uncertainties regarding Prime Minister Modi’s new government, economic momentum and the overall bull market in India persist. A similarly uncertain yet ultimately strong market is possible when Americans hit the polls this November.
Regardless of who ends up in the white house, we believe that the US debt growth will improve through the AI supercycle of spurred profit growth. In the 1990s, we faced a similar debt crisis that became more manageable as a result of the waterfall corporate tax revenues during that supercycle.
Interest Rates and Fixed Income: Staying the course
As we approach a pivotal election year, the Federal Reserve’s stance on interest rates remains a focal point for investors. Despite speculation, we believe a rate cut before the election is unlikely. The Fed is committed to maintaining its political neutrality and will continue to be data-driven in its decision-making process. A rate cut before the election complicates this assumption. While there is a possibility of interest rate cuts in the medium term (potentially after the election), our perspective is that this will not be the primary driver of equity returns. Instead, we are placing greater emphasis on earnings growth as a more significant determinant of market performance. The focus should remain on companies demonstrating robust fundamentals and sustainable growth.
Looking ahead, we are optimistic about the return of interest rates to a more “normal” historical range. The Zero Interest Rate Policy era is behind us, and we are enthusiastic about the opportunities this new interest rate environment presents. We find significant value in long-term bonds, as we believe we are at the peak of the interest rate cycle. Locking in attractive yields now positions our clients advantageously for years to come, particularly as we expect the yield curve to normalize and un-invert.
Active Risk Management: Staying Vigilant in a Bull Market
Even in a bull market, rigorous risk management remains a cornerstone of our strategy. We continually enhance our processes, leveraging technical analysis, advanced software, and insights from our global trading partners to ensure effective stop-loss mechanisms. Recent market gains have allowed us to raise stop-loss thresholds, further safeguarding our investments and profits. You may have also noticed subtle portfolio adjustments as we have refined sector allocations to align with our investment philosophy. While we do not foresee reducing equity allocations or dramatically shifting sector exposures, we are prepared to adapt and become defensive should any factors threaten our positive outlook.
Hitachi and Mitsui
Please be aware that both Hitachi and Mitsui underwent stock splits on June 30th, 2024. A stock split increases the number of shares in a company while reducing the price per share proportionately without affecting the total value of your holdings. Schwab has updated the price of these holdings but not your share quantities, causing both companies to incorrectly show significant losses. Specifically, Hitachi has executed a 5-for-1 stock split, while Mitsui has implemented a 2-for-1 stock split. As of July 1st, Schwab posted the updated share quantities with a record date of June 30th. However, because these updates took place after the end of the quarter, they will not be properly reflected on your June Schwab statement. Rest assured, this issue should be resolved soon on Schwab’s website and mobile app, and on our client portal and quarterly statements. The transactions will be validated on your July Schwab statement. If you have further questions about these anomalous transactions, please contact your Main Street Research advisor.
Thank you for your continued trust in our firm. As we navigate these dynamic times, we remain committed to delivering value and achieving your financial goals. If you have friends or family who could benefit from our services, please do not hesitate to refer them to us.
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