TRENDS IN EQUITY MARKETS
Artificial Intelligence
Looking back at the AI craze, the lingering question is whether it got overhyped. But it’s hard to look more magnificent than the “Magnificent Seven” stock price performance in 2023.
It seems as though everyone excited about AI also got excited about NVIDIA’s business results, which could be one of world’s greatest growth stories we have ever seen. But the expectations bar has been raised, and it will be tougher and tougher for NVIDIA to deliver in the coming periods. With that firm priced for years of success, take the example of its compatriot, Taiwan Semiconductor. Without a company like this, there is no NVIDIA, because NVIDIA designs the chips to be fabricated by the likes of Taiwan Semiconductor. Compare the valuation of the two companies, and it is like looking at night and day, possibly due to the perception of geopolitical risk around Taiwan.
Those two are just a couple of firms among hundreds, but this illustrates how pockets of the AI trend look more expensive while others may still be more fairly valued or even inexpensive. By and large, it’s early innings. ChatGPT’s splash was only a year ago, and in the grand scheme of historical tech adoption, a single year is nothing.
Value vs. Growth
Though the lack of a corporate dividend policy need not mean a company is unprofitable, it does often correspond to the company showing up in a growth stock universe. Data from Dartmouth’s Ken French shows that over the last 20 years, the companies that paid no dividend outperformed the quintile that paid the highest dividends by the largest amount on record. We are looking at the merits of a mean reversion thesis that plays out over the longer run.
Figure 2: Top Quintile of Stocks by Dividend Yield Minus Stocks Paying No Dividends
CHART TAKEAWAY: Over the last two decades, companies who did not pay a dividend outperformed high dividend payers by a record-setting margin. Should outperformance mean revert, stock market screens for dividend payers may prove fortuitous.
Sources: Kenneth French Data Library, CRSP database. Data 7/31/1927-7/31/2023, with August and September 2023 sourced from WisdomTree PATH using the Russell 3000. The axis commences in 1947 because it is 20-year rolling data. Stocks separated into top quintile minus bottom quintile.
The issue for these mean reversion concepts is that a similar performance gap has opened up between large and small caps over the last 10, 15, 20 years, essentially since S&P 500-style firms emerged from the dot-com rubble in late 2002 and into 2003. The problem as we head into 2024 is that many small- and mid-cap companies are unprofitable firms that are further punished by higher borrowing costs and rising costs of capital.
In short, value is out of favor relative to growth, and small caps are out of favor relative to large caps, and definitely relative to mega caps. The bold among us should recognize opportunity in small-cap value for the double whammy mean reversion, should that play out. And the December FOMC meeting definitely was a catalyst in this direction that we think can play out throughout 2024 with lower risk of a recession and deeper policy mistakes.
In general, a focus on quality stock selection can help drive a smoother ride within equity markets, and we think the core of portfolios should remain centered on large-cap quality stocks.
International Ideas
Our favorite international idea, Japanese equities, also has a quality factor play but with a 2024 catalyst: explicit action by the Tokyo Stock Exchange to increase quality metrics across corporate Japan. Companies are taking action—engaging in higher cash dividends and buybacks, reducing cross-shareholdings and even conducting some more mergers and acquisitions. And it could be that the forthcoming change in aggregate countrywide return on equity (ROE) and other quality metrics are what catalyzes new money to come into Japan.
Short Term vs. Long Term
With short-term Treasuries hovering above 5%, there is a high hurdle for anyone looking to consider equity engagement. It’s an opportunity cost of doing anything in equities because the money markets’ lack of volatility is also part of the calculus.
Our long-run view, however, is that stocks are real assets; earnings and dividends tend to grow over time. The 5% hurdle rate may not be there forever, especially if the Fed does, in fact, take rates down in 2024. We think the 10-Year Treasury Inflation-Protected Securities (TIPS) yield is really the most appropriate bond metric to check when gauging equity risk premia. There, you’re again below 2% as we enter 2024.
That means the S&P 500 has at least a 300 bps equity premium over TIPS today. Excluding Tech, U.S. value stocks are trading for 14 to 15 times earnings, which is more like a 7% equity earnings yield and a 5% equity premium to TIPS. Small caps are baking in a recession, which is what we infer from 8%–9% earnings yields in that asset class. That is where the opportunity lies. There is no iron law that says portfolios must be top-heavy in the Magnificent Seven because of high exposure to S&P 500 proxies.
Going down the cap spectrum could open valuation doors. Nevertheless, it’s easier said than done. The 5% yield on cash is a real issue for stocks right now; post December FOMC meeting, it has less chance of being the market’s anvil in 2024, too. For the last few months, we believed the primary risk for equities was a Fed too stubborn to bring rates down. We think the Fed recognizes that inflation risks are subsiding and bringing more optimistic confidence for 2024.
A focus on quality stock selection can help drive a smoother ride.
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