My Short-term and Longer-term Thoughts

Stock markets typically see gradual increases, but lately, they've been skyrocketing. American stocks have surged by 21% since the end of October and are currently about 5% higher than their peak in January 2022. On February 22nd, Europe's equities hit a new record for the first time in two years. India has been experiencing a prolonged economic boom fueled by optimism. Even Japanese stocks, long associated with stagnation, have finally surpassed their 1989 levels after decades of decline. It's been an exceptional run. Since 2010, the S&P 500 index of American stocks has delivered an annual real return of 11%.

These remarkable gains are even more notable considering the challenges markets have faced. The era of easy money has given way to two years of interest rate hikes, and bond investors are currently betting against imminent rate cuts. A trade war between the U.S. and China persists, alongside ongoing conflicts in Ukraine, the Middle East, and parts of Africa. Governments worldwide are increasingly turning away from free markets and globalization in favor of industrial policies and protectionism. Despite these headwinds, the market rally persists, prompting the question: what could possibly derail it?

One conclusion might suggest a looming bubble, especially in the U.S. On Wall Street, valuations—measured by profit multiples—are currently at 80% of their late-1990s dot-com bubble levels and 90% of their 2021 highs, before interest rates began to rise. However, earnings continue to exceed expectations, so maybe profit multiples as less concerning.  Similar extremes can be observed in other indicators such as market concentration and value spreads. The proportion of the top 10% of American firms' value relative to the entire market hasn't been this high since the Depression in the 1930s. And then there's Bitcoin, trading around $60,000 again, near its 2021 peak.  One thing for certain is we are living in unprecedented times where advancements in technology may be changing the course of history in front of our eyes.

Yet, there are rational arguments supporting market exuberance. As central banks worldwide tighten monetary policy at an unprecedented rate, many analysts warned of recessions and declining corporate profits. However, the economy has defied expectations. Strong corporate results are being reported across various sectors, including retail giants like Walmart and Japanese automakers like Toyota.

Optimism about artificial intelligence (AI) is also boosting investor confidence. This optimism was recently fueled by Nvidia's earnings report on February 22nd, as the company dominates the critical market for AI training chips. Nvidia's profits have soared, driven by its position in AI-related technologies. However, caution is advised. While the enthusiasm for AI is justified, it's wise not to rush into investments. The future of AI and its commercial applications remains uncertain, and competition in the sector could limit profits, even for market leaders like Nvidia.

Furthermore, expectations for economy-wide productivity growth, driven by AI and other technological advancements, may be overly optimistic. While the transformative potential of AI is undeniable, realizing its benefits may take time, and identifying profitable investment opportunities in this evolving landscape is challenging.

In the shorter term, in the next year, the expectations still look good.  A few items will contribute to short-term growth.  We have yet to see interest rate cuts, which will come at some point this year.  This will help to boost the earnings side of the P/E equation, as well as help consumer’s confidence and their wallets.  A second item, it is an election year in the US and elections are almost always good for the stock market.  A third item is the tailwind from the current AI boom.  It probably won’t last forever, but the hype will continue for a while yet.

Looking ahead in the longer term, sustaining current market valuations will be difficult. The era of rapid profit growth fueled by low borrowing costs and taxes may be coming to an end. Under realistic assumptions, achieving modest equity returns in the coming decade will require substantial profit growth from American firms, a feat unlikely to be easily accomplished.

One thing that is for sure, the market goes up and the market goes down, but over the long term the trajectory is always upward.  Trust the process and importantly, trust the human spirit to always move forward.