more thoughts on the market

There are a number of reasons for thinking that next year will be a testing one for the US stock market:

–the market bottomed in early October 2022, so we’re in year three of an up market. History says that’s pretty long in the tooth

–the most important related issue, I think, is the aging of the workforce in OECD countries, coupled with general resistance to allowing in younger workers from outside. This is a classic shoot-yourself-in-the-foot move–growing the workforce is one of the two keys to economic growth (productivity gains, i.e. better machines, better education, is the other). Also, whether they realize it or not, newcomers would be tacitly accepting the burden of paying for the Social Security plans of aging locals. Brexit probably marks the pinnacle of this kind of economic stupidity–at least I hope so.

As a practical matter, the lack of more workers puts a lid at something like 1% annually on how fast the developed world can grow–meaning it’s much easier than it used to be for wealthy countries to tip into recession. This is second economic reason for caution.

Yes, the US is the young man of the group made up of the US, Europe, Japan/China. Still, being the best at using a walker isn’t the pinnacle of achievement.

–stocks aren’t cheap, as this long-term PE chart suggests. This isn’t the whole story, however, since PE is also a function of the price of the closest investment substitute, that is, Treasury bonds

–the incoming president’s most important credential is that he’s been elected twice to the highest office in the land. Prior to this epic achievement, he was best known for playing the role of a successful businessman on a TV show, The Apprentice, that ran for ten seasons. The biggest challenge he faced in his first term was, to my mind, the pandemic, a test I think he flunked pretty badly.

My guess is that either plank in his economic plan–shrinking the workforce and launching a tariff war–would be enough to trigger a recession if implemented.

All in all, playing defensively will most likely be the order of the day in 2025. If this were baseball, we’d be thinking about pitching and defense, not swinging for the fences.

more tomorrow

Donald Trump announced today that he intends to impose 25% tariffs on all imports to the US from Canada or Mexico and will also tack on an additional 10% to all import duties on Chinese merchandise, as soon as he takes office. The former seems to me to effectively upend the US-Mexico-Canada agreement (USMCA) that replaced NAFTA in 2020.

Trump’s rationale, as I understand it, is that in the decades following the Civil War tariffs imposed by Washington on imports of machinery into what was a chiefly agriculture-based US economy ended up raising money for the government. Therefore, tariffs should do the same today. That didn’t work with levies on sales of US soybeans to China during Trump’s first term, but maybe this time things will be different. And, of course, the Republican supporters of the McKinley tariffs of 1890 were pretty much all tossed out of office in the following election.

I have mixed feelings. The declared purpose of the tariffs is not to protect US companies from “unfair” competition, but to force China and Mexico to suppress shipments of illegal drugs to the US. This is a noble goal, in my view. On the other hand, the Trump first-term agricultural tariffs hurt US farmers (who voted for him back then and again this time around–go figure) so badly that the federal Commodity Credit Corporation had to dispense close to $30 billion in aid to offset lost revenue.

What is the stock market saying?

–Ford and GM are both down today, since both make considerable use of manufacturing in Mexico. Foreign carmakers, too.

–NASDAQ, filled with multinationals and tech (i.e., non-manufacturing) is up. The Russell 2000, composed of mostly domestic firms and with companies that manufacture things, was down. This makes sense, too. These last, whose stocks were just starting to catch up with their loftier-multipled tech brethren, are playing the role filled by the soybean farmers in 2016. If I had to guess, there won’t be a bailout for them.

The biggest beneficiary of the new tariffs? My guess is that it’s Trump mega-donor Elon Musk, since the tariffs may delay/derail the plans of BYD, the world leader in EV sales, to build a plant in Mexico that would serve the US market.

How to shape an equity portfolio? That’s always the key question for us as investors.

If we go back to first principles (at least my first principles), the starting point is always the index, the S&P 500, or the NASDAQ for the more risk-prone.

I imagine the index as being like a round ball of clay. If I take my own portfolio clay and shape it so it looks just like the index, I get the market return. To get a different return, I have to pull my clay out or push in so that I create a different shape.

Anyone can do that part. The real trick is to be clever enough to make a small number of significant alterations in the shape–maybe even just one–in a way that produces not only a different return than the market’s, but a better one. With every alteration, I am betting that I know more about the current situation than the market. This is the height of arrogance. But it’s what we all do when we step on the field and start to play the game.

Of course, once we’ve made our alterations, overweights or underweights, we’ve got to watch them like a hawk to make sure they’re doing what we expect. One other thing: experience tells me that no one can watch twenty over-/underweight positions. In all likelihood the deviations are all too small. But in 28 years in the stock market, I never encountered anyone who could monitor anywhere near that number of positions. Much better to have five, in the hope that two will work out and you’ll catch the losers and eliminate them before they do too much damage.

more tomorrow

One January in the mid-1980s I spoke up at the initial investment committee meeting said I thought that that year would be especially tough. Everyone laughed ,,,apparently because that’s what I said every January.

Nevertheless, I do think that next year will be especially challenging.

my general rules

Because of that, I think it’s important to go back to first principles, namely:

–almost all professional equity portfolio managers routinely underperform their benchmark indices, even before subtracting operating costs and management fees. So an index fund/ETF is probably the best option for all of us for most of our money. In my case, about 3/4 of my equity exposure is in Vanguard index products. Yes, Vanguard’s web infrastructure may be clunky, but I don’t see this as a big deal. And it’s really cheap. I manage the rest myself, because I think it’s fun

–for any money any of us actively manage, it’s important to study our own tendencies–what we typically do right and what we typically do wrong. The way I do this is through periodic post-mortems.

In my case, over twenty+ years as a pm I’ve generally outperformed in up markets and have counted myself lucky not to get beaten up too badly in down markets. About half my outperformance has come from industry/sector selection and half from overweights in individual stocks.

I know nothing about Healthcare or Staples and only a little about Financials. So it would take a lot of convincing for me to believe I’m not the dumb money in any of these. On the other hand, I think I know more than the average person about Energy, Materials and IT. Just about anyone can more or less wing it with Consumer discretionary. That leaves Industrials (really mostly suppliers to Consumer discretionary), Utilities and Real estate in no-mans land for me. Experience tells me the heart of my individual stock selection will be in IT and Consumer.

Taking a very wide perspective, what do I think next year will look like, from an economic perspective?

More tomorrow.

If we look back to the start of NVDA’s fabulous run of delivering extremely strong results and positive earnings surprises, it was clear from the outset that two factors were driving the gains:

–strong sales growth of the company’s cutting-edge AI chips, and

—operating leverage, the fact that the expenses of running the company’s research and sales efforts are rising at a much slower rate than sales. Over the past twelve months sales are up by 94% and expenses by 44%. The consequence of this is that profit growth has far exceeded that of sales.

It’s been evident to anyone who looks at the NVDA financials, however, that while sales are still expanding faster than costs, the rate at which they’re doing so has decelerated. In addition, the absolute gross margin, at 75%, is at eye-popping levels. Noticing this (how could anyone not?), TSMC has upped the price it charges to manufacture NVDA offerings.

This adds up to the likelihood that profit growth has lost the turbo boost operating leverage has been giving it and will depend solely on sales growth, at least for the near future, to make earnings gains.

All this was crystal clear on August 28th when NVDA reported 2Q25 earnings. The stock dropped by 20% in the ten days or so after the results were published. Arguably, though, the decline was triggered by the announcement that NVDA’s latest AI chip was having teething problems. In any event, the stock then roared ahead by 40% to a new all-time high just before the 3Q earnings announcement. It’s down slightly today as I’m writing this.

Where to from here?

I think that for the first time in a while, valuation will be based more heavily on current earnings rather than factoring in the possibility of large future positive earnings surprises. My sense is that, again for the first time in a while, the stock is fairly valued. I’m holding most of what I bought years ago, but I’m selling enough so that, for now, it will no longer be my largest position.

I own both stocks.

As I was writing yesterday, WMT stands out as the retailer best able to cope with the current economic environment.

I thought TGT was also putting its pandemic-related issues behind it. But no! The company reported earnings per share of $1.85 for 3Q24 this morning. This compares with analyst estimates of around $2.30. And the company said it expects to earn the same during the traditionally stronger holiday season quarter that we’re in now. That compares unfavorably with the $2.65 Wall Street had penciled in for the three months. To my mind, it’s the latter that explains the sharp negative reaction in opening trading.

In a nutshell, sales are flat and margins are being squeezed. The earnings call now under way will likely have more detail.

What I read this as saying about the general economy, comparing these results with WMT’s:

–although I lumped the two retailers into the same category in yesterday’s post, WMT is a bit more don-market than TGT. My guess is that WMT (maybe the overall economy has a role, as well) has been more than usually successful in persuading TGT customers who have traded down during the pandemic not to trade back up

–WMT sells a lot more food items than TGT, and food has been particularly strong

–TGT’s attempt to mimic Amazon’s online presence is less far along than WMT’s. Though online sales for TGT are strong, unit profits are lower than from in-store sales–maybe forever, but for now at least while TGT continues to build online and delivery infrastructure.

–also, TGT has much more exposure than WMT to California and the Northeast, as well as to city dwellers

–TGT’s inventory issues, which I had thought were in the rear view mirror, have emerged again. Hard to know what to make of this.

I’d like to hear more before I decide what to do with TGT. The general message, though, is that the overall economy seems to be more fragile than I’ve been thinking. WMT’s and Lowe’s’ recent statements that Trump tariffs will be bad for business–stating the obvious, but noteworthy that conservative managements would take the risk of offending the Trump-leaning part of the customer base–underline this.