The three great market uncertainties

Good day. Target’s earnings report was bad. We would like to see this as a timely confirmation of our argument in the last letter, which said the American consumer was becoming a little less playful. But Target has unique problems that are preventing us from taking a victory lap. However, we’re still wondering if the US retail holiday season is shaping up to be a disappointment. Send us your opinion: robert.armstrong@ft.com and Aiden.retier@ft.com.

Three market uncertainties

Every moment seems especially uncertain when you live it. It is always an illusion. In the shadow of several elections and a pair of wars, with central banks pivoting and stock markets on an unusually long bull run, the end of 2024 may look especially perilous. One way to remember that risk is just the water we swim in is to list and describe our uncertainties. It makes them feel manageable.

What follows are my three big questions and my guesses about their answers. I deliberately choose the word “guess.” Confidence in the answer would remove the question from the list. Another required characteristic of a question is temporal specificity. Of course I would like to know what the GDP or CPI will be in a year, but I always want to know.

This is what I lie awake at night thinking about:

Is there a level for 10-year Treasury yields that will crash stock markets? Are we going to reach it soon? To generalize broadly, stocks do not like high and increasing returns because they represent restrictive financial conditions and compete with stocks for capital flows. The recent history of the 10-year Treasury yield and the S&P 500 shows the tension:

No coverage assumption: Yes and yes. The market is pricing in a drop in rates and stocks are expensive enough that investors are looking for an excuse to reduce risk. At the same time, inflation is not advancing smoothly; President-elect Donald Trump’s political promises don’t seem likely to help with that. A crisis seems very unlikely: there is still too much global liquidity for that. But a substantial correction (something like late 2018?) seems eminently possible.

Are we in a credit cycle? And if so, what part? Corporate bond spreads over Treasury bonds are tighter than ever. In a normal world, this is consistent with late-cycle prosperity, suggesting that the next move in spreads is up and it is time to reduce risk. But are we still in post-pandemic suspended animation? Or is it really a recovery? Opinions on Wall Street vary.

Unhedged guess: No. Cycles begin and end with downturns, which “reset” markets by eliminating overleveraged players and forcing a general review of risk. This time there was no real recession because fiscal policy prevented it. Another crisis will be necessary for the economy to return to a cyclical pattern. Until that happens, history will be a poor guide to economic conditions.

Is AI a bubble? AI is going to change everything. There are a handful of companies that have the resources to invest in the technology. So maybe those companies will be the ones developing profitable AI products. And perhaps most businesses will see a productivity boost from AI automating administrative work. If that is true, there will be no bubble, so there will be no burst.

No coverage assumption: Yes. Railways and the Internet also changed everything, but their first manifestation was in bubbles that burst. The combination of the fact that AI is obviously something amazing and important, and the fact that we don’t really understand how it will work as an industry, makes it absolutely perfect bubble fuel. The AI ​​hype has plenty of room to run, and at some point there will be a reckoning. But you can’t know when, so you can’t trade it. You probably won’t even be able to get out of the way. Buckle up everyone.

Earnings

Yesterday’s Nvidia report marks the informal end of earnings season. It’s been good. S&P 500 companies (as usual) have mostly beaten revenue and earnings expectations. Despite some election jitters and high valuations, we have avoided market turbulence.

According to some number crunching by John Butters at FactSet, 75 percent of companies in the index beat earnings per share expectations, slightly below the five-year average of 77 percent. The picture is worse for revenue: 61 percent of companies outperform, compared to a five-year average of 69 percent.

To some extent, this reflects high expectations. The market is expensive in every sense. Investors want to see a lot to justify these valuations and will reward those who deliver and punish those who don’t. According to FactSet, average price gains for those beating expectations were 1.5 percent two days before the earnings release and two days after. The average price decline for companies that reported negative earnings surprises was 2.9 percent. Both figures are slightly higher than the historical average.

Target was an example of this. Yesterday it reported that its same-store sales declined 1.9 percent and its stock price fell 21 percent. By contrast, in the first quarter of this year, its comparable sales fell 4.8 percent and its stock price fell just 7 percent over a five-day period.

The Magnificent Seven tech stocks were subject to similar dynamics. Microsoft, Apple and Meta all beat earnings and revenue expectations and still saw their stocks fall. For Microsoft and Apple, the culprit was slightly disappointing future guidance. For Meta, it was a decline in user growth. The market is also looking especially closely at investment in AI. Investors remain bullish on AI, but they want a clear story about future returns and are making judgments accordingly. Meta, Apple and Microsoft announced high capital spending, but still have little revenue to show for their AI projects. Google and Amazon have stronger arguments to make and their stocks performed better.

Good news: Market returns are less dependent on Big Tech. Citi’s Scott Chronert notes that while Mag 7 stock continues to post strong numbers, the rest of the index is generating some growth. After a two-year decline in earnings growth, the other 493 companies have posted positive aggregate earnings growth over the past two quarters.

Looking ahead, expectations remain high. Investors expect S&P 500 earnings per share growth of 11.5 percent this year, 10.9 percent by 2025 and 12.6 percent in 2026. Unhedged believes the progression is unlikely to be so fluid

(Reiter)

a good read

Olivier Blanchard in Trumponomy.