The three big market uncertainties

Good morning. Target’s earnings report was bad. We’d like to see this as a timely confirmation of our argument in the last letter, which said the US consumer was getting a bit less frisky. But Target has unique problems that prevent us from taking a victory lap. Yet, we are still wondering if US retail’s Christmas season is shaping up to be a disappointment. Send us your thoughts: [email protected] and [email protected]. 

Three market uncertainties

Every moment seems especially uncertain when you are living it. It is always an illusion. In the shadow of several elections and a couple of wars, with central banks pivoting and equity markets on an unusually long bull run, late 2024 may feel especially dangerous. One way to remember that risk is just the water we swim in is to enumerate and describe our uncertainties. It makes them feel tractable. 

What follows are my three big questions, and my guesses at their answers. I choose the word “guess” deliberately. Confidence in the answer would knock the question off the list. Another required feature of a question is temporal specificity. Of course I’d like to know what GDP or CPI will be in a year’s time, but I always want to know that. 

Here’s what I lie awake at night thinking about: 

Is there a level for the 10-year Treasury yields that will crack the equity markets, and are we going to hit it sometime soon? To generalise wildly, stocks don’t like high and rising yields because they represent tightening financial conditions and they compete with stocks for capital flows. The recent history of the 10-year Treasury yield and the S&P 500 shows the tension:

Unhedged’s guess: Yes and yes. The market is pricing in a decline in rates, and stocks are expensive enough that investors will be looking for an excuse to reduce risk. At the same time, inflation is not going quietly; president-elect Donald Trump’s policy promises don’t seem likely to help with that. A crash seems very unlikely — there is still too much global liquidity around for that. But a meaty correction (something like late 2018?) seems eminently possible. 

Are we in a credit cycle? And, if so, what part of it? Corporate bond spreads over Treasuries are about as tight as they have ever been. In a normal world, that is consistent with late-cycle prosperity, suggesting that spreads’ next move is up and it is time to reduce risk. But are we still in post-pandemic suspended animation? Or is this actually a recovery? Opinions on Wall Street vary.

Unhedged guess: No. Cycles begin and end with downturns, which “reset” markets by wiping overleveraged players and forcing a general repricing of risk. There was no real downturn this time, because fiscal policy prevented it. It will take another downturn to return the economy 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 are the ones that develop profitable AI products. And maybe most companies will get a productivity boost from AI’s automation of white-collar work. If that’s true, there’s no bubble, and so there will be no pop. 

Unhedged’s guess: Yes. Railroads and the internet changed everything, too, but their first manifestation was in bubbles that burst. The combination of the fact that AI is obviously an amazing, important thing, and the fact that we don’t really understand how it will work as an industry, makes it absolutely perfect bubble fuel. AI hype has loads of room to run, and there will be a reckoning at some point. But you can’t know when, so you can’t trade it. You probably can’t even get out of the way. Buckle up, everyone. 

Earnings

Nvidia’s report yesterday marks the informal end of earnings season. It’s been fine. Companies in the S&P 500 have (as usual) mostly beaten expectations for revenue and earnings. Despite some skittishness around the election and high valuations, we have avoided market turmoil.

According to some number crunching by John Butters at FactSet, 75 per cent of companies in the index beat expectations on earnings per share — slightly below the five-year average of 77 per cent. The picture is worse for revenues: 61 per cent of companies beat, against a 5-year average of 69 per cent. 

To some extent, this reflects high expectations. The market is expensive on every measure. Investors want to see a lot to justify these valuations, and will reward those who deliver while punishing those who don’t. According to FactSet, the average price gains for expectation-beaters was 1.5 per cent two days before the earnings release through two days after. The average price dip for companies that reported negative earnings surprises was 2.9 per cent. Both figures are a bit larger than the historical average. 

Target was a case in point. Yesterday, it reported that its same-store sales were down 1.9 per cent, and its share price fell 21 per cent. By contrast, in Q1 of this year, its same-store sales were down by 4.8 per cent and its share price fell only 7 per cent over a five-day period. 

The Magnificent Seven tech stocks were subject to a similar dynamic. Microsoft, Apple and Meta beat earnings and revenue expectations and still saw their stocks fall. For Microsoft and Apple, the culprit was slightly disappointing forward guidance. For Meta, it was declining user growth. The market is looking particularly closely at AI investment, too. Investors are still bullish on AI, but they want a clear story about future returns, and are doling out judgments accordingly. Meta, Apple and Microsoft announced high capex but still have little revenue to show for their AI ventures. Google and Amazon have a stronger case to make, and their stocks did better.

Some good news: the market returns depend less on Big Tech. Scott Chronert at Citi notes that while the Mag 7 stocks are still posting big numbers, the rest of the index is delivering some growth. After a two-year earnings growth slump, the other 493 companies have posted positive aggregate earnings growth in the last two quarters. 

Looking ahead, expectations are still high. Investors are looking for S&P 500 earnings per share growth of 11.5 per cent this year, 10.9 per cent growth for 2025 and 12.6 per cent in 2026. Unhedged thinks the progression is unlikely to be that smooth. 

(Reiter)

One good read

Olivier Blanchard on Trumponomics.

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