Christmas Special 2023

Season's greetings to you, my esteemed readers and fellow stonk enthusiasts! The stock markets have continued their Santa Claus rally as interest rates are going down. The world's most important stock index, the S&P 500, is virtually at all-time highs.

In my last post of the year, the traditional Christmas Special, we take a reflective look back at the past stock market year. Investors were expecting a recession and muted returns in 2023, but what we got was a real bull market acceleration.

I then go through next year's forecasts, expectations and share valuation levels.

I would like to take this opportunity to thank all my readers for the past year. What’s Up with Stonks will be back on your screens small and big in mid-January.

A reflective look at the past stock market year 

The past stock market year has been a busy one. The global bull market continued, albeit unevenly. Many investors and forecasters were expecting a recession and subdued stock market performance. However, what we got was a proper boom year around the world. The US economy is roaring even as Europe and the rest of the world is slowing down or flirting with recession. Interest rates finally started to fall sharply as inflation eased.

The technology-oriented Nasdaq100 index is up more than 50%, the S&P 500 23% and the European equity index 14%. Not a bad year, even if inflation is eating into real purchasing power a bit. The OMXH25 index of the Nasdaq Helsinki ended up losing a good 3%. I have included dividends in the returns.

Within Nasdaq Helsinki, the differences are large. At the time of writing, the biggest riser has been Sotkamo Silver with a 100% rise in share price since the beginning of the year. Of the large cap companies, Wärtsilä is 67% more valuable than 12 months ago. The sauna company Harvia has made a comeback with a 50% rise. On the flipside, Lehto went basically bankrupt. Motorsport wholesale Duell is down 80%. In other words, all sorts of things have been happening under the surface of the index.

Against the background of this rally, it’s interesting to reflect a little on what investors expected a year ago.

What’s more, I went back and read the Christmas Special of 2022.

A year ago, there was talk of stubborn inflation, investors' expectations of a turnaround in interest rates and subdued prospects for a rise in equities. Investors were a bit too aggressive in waiting for a turnaround in interest rates. The market now finally seems to be right in its persistence, albeit a year early as it’s only now that the Fed has started talking about rate cuts.

It's interesting to go back to old episodes every now and again and see what the market was thinking and expecting back then. These posts are like diary entries of my thinking at different points of time. I certainly wasn't talking about a mega-tech rally, and that came completely out of the blue for me. During the year, it was mainly the Helsinki and Chinese stock exchanges as well as small companies going flat, while the global bull market continued, albeit unevenly and with hiccups. The Bloomberg terminal even talks about the death of small companies as an asset class, which piques the interest of contrarian investors.

The price rises of the spring were about to be interrupted by a small banking crisis. The Fed's rapid rate hike lowered the value of banks' paper assets, while deposits disappeared in the wake of higher interest rates. During the time, I wrote a couple of Emergency Editions. The biggest victim was eventually found in Europe when the usual suspect, Credit Suisse, fell in an orderly fashion into the arms of a competitor.

Investors' long-awaited interest rate peaks have been found so far this fall. The interest rate on the US 10-year bond, which can be seen as a gravitational force for the global economy, was running at 5% and has now rapidly plummeted to below 4%. No wonder it's been good to sit on growth companies’ stocks.

One concern about the bull market has been its narrowness, especially in the US. This concern has now receded as the rally has become more widespread. Just a moment ago, only a quarter of stocks had outperformed the index, led by the Magnificent Seven. In recent weeks, the situation has changed. The S&P 500 balanced index, which better reflects the performance of the average company, is also close to the peaks. Small companies and small banks, the riskiest place to sit in the stock market, have rocketed. In Europe, the German DAX index made new highs. The Swedish stock market has rebounded from its bottoms close to its all-time highs.

The sun is shining around the world, and the sun's rays are likely to hit Nasdaq Helsinki soon too. I have stressed how attractive the Finnish stock exchange is looking both in the spring and in the fall.

Theme of the year: AI hype

I have read the reviews of various analyst houses. A recurring theme in strategists' reviews for 2024 is, of course, this year's hype topic, also known as artificial intelligence. AI companies such as Microsoft and NVIDIA have skyrocketed on the stock market this year. Investors tend to get excited about what has been the hottest thing lately.

The top companies in the AI hype have risen more than 100% this year. Companies worth several hundred or a few thousand billion, such as Apple, Microsoft, or NVIDIA, can hardly be expected to double every year.

It’s difficult to underestimate the long-term potential of AI in areas such as medicine (e.g. to find potential drugs and speed up drug testing) or education (e.g. personalized learning assistants). However, it’s always noted how the biggest winners in the California gold rush were those who sold picks and shovels to miners. Even in the AI boom, e.g., semiconductor manufacturers and suppliers of data centers are also beneficiaries. And hey, someone has to train employees to use the new AI applications too.

A Blackrock review had a good illustration of how an investor can think about the different levels of AI, from hardware and cloud providers to data, infrastructure and applications.



As the AI hype heats up, investors need to be careful not to overpay for shares in companies in the sector. People tend to overestimate short-term developments. While it now seems that you simply can’t over-invest in the sector, and strategists see investment boosting the sector's performance well into the future, at some point there will always be diminishing marginal utility for the money spent.

As an investor, it’s also always worth considering how companies will be able to convert AI products and services into cash flow for owners. The internet changed the world, but fewer of the dot-com bubble companies of the 90s were a good investment. AI is certainly changing the world in a big way, but in a market economy, changes are often passed on to the consumer in the form of, e.g., better products and lower prices. It’s also difficult to find the ultimate winners at the start of the game, as we Finns know well from the fate of Nokia's cellphone business.

There is also much ado about the impact of AI on productivity and hence economic growth. However, in the big picture, productivity growth, measured as how much is achieved per hour worked, rarely takes dramatic leaps. This graph shows US productivity growth indexed to 100 in 2017 over the last 70+ years. Although work has changed a lot since the 1950s, productivity has been on a steady, and more recently even slowing, trajectory. It has not yet been transformed by robotics, computers, the internet, or artificial intelligence, at least not in leaps and bounds. Of course, productivity is difficult to measure, and the factors mentioned above have definitely changed the economy and captured parts of it for themselves. For example, if a hundred years ago horse-drawn carts still dominated urban transport, now that economic advantage has shifted to cars.

 

Outlook for 2024

As for the economic and market forecasts, they are cautiously worded. Predicting the direction of the macro-economy is virtually impossible, as we have seen during this stock market year. Expectations of a recession and subdued equity performance were dashed, especially in the US. So, this year the forecasts have been more vague. Most forecasting houses, such as Goldman Sachs, Paribas or Morgan Stanley, do not believe in a US recession. Among many others, Morgan Stanley and Invesco speculate that stocks would rebound, especially towards the end of the year as growth picks up. In contrast, ING and Fidelity believe in a cyclical downturn, as does Allianz, which also believes that interest rates will remain higher for longer.

This uncertainty is also reflected in strategists' cautious target prices for the S&P 500 index. According to Bloomberg, the average expectation for the S&P 500 at the end of next year is only 4,800 points, almost equal to its current value.

Uncertainty and the lack of precedents for the current cycle have also made analysts uncertain. Blackrock had a good observation about how the spread of analysts' forecasts has increased since the pandemic to a level higher than in previous years.

Instead of forecasting, an investor can look at the present and consider which businesses will work in a difficult environment and don't cost too much. The margin of safety makes forecasting unnecessary.

When reading forecasts, it’s worth remembering Warren Buffett's words: "Forecasts can tell you a lot about the forecaster, but nothing about the future."

Equity valuation: cheap and expensive

 The global equity valuation picture is mixed. On the other hand, a top company at the technological heart of the global economy, such as Apple and Microsoft, is paid around 30 times its forecast earnings. In general, the US market, as far as the S&P 500 is concerned, has become very expensive. However, this is normal, as stocks take a head start at the beginning of a bull market, but results recover only afterwards.

If the bull market continues, the next step should be a recovery in earnings and more moderate valuation multiples. This graph from Fidelity shows well how the P/E ratio has behaved over the cycles. The consensus among analysts is that the buoyant earnings growth should continue in the coming years, as I have said before.

Many investors seem to think about stocks in terms of their recent performance, not their valuation or fundamentals. However, it’s good to dig deeper into the drivers of equities. American equities have done much better than other markets now and actually for the last 15 years, because that is where listed companies’ revenues and profitability have developed the most. But earnings growth is not the only factor.

This graph of the AQR shows the return components of the S&P 500 index over the last ten years. The index has outperformed cash by an average of 12% per year when inflation is taken into account, which compares well with a longer-term historical excess return of 7.1% over cash. Of this return, 2.1% has come from dividends and 4.5% from real earnings growth. As much as 3.6% has come from the increase in valuation multiples and 1.7% from the negative real return on cash. Interest rates have been at zero, so even a small amount of inflation in recent years has dented the purchasing power of the investor’s current account. If you look at past returns, it’s reasonable to assume that the same thing won’t happen again in the next 10 years. Valuation multiples are already high. Sure, they may stretch in the short term, but this is unlikely to happen over a 10-year horizon, unless we go into another bubble. With interest rates rising, you can also get proper returns on your cash, especially in the US. Thus, the excess return on equities is not as clear-cut as it used to be. 



Another explanatory factor for America's overperformance in recent years is the continent's disproportionate stimulus. The asset management company Lazard estimates that just under $11 trillion was spent on global recovery during the pandemic. The world economy has a GDP of $85 billion to bring this to scale. Half of this recovery took place in the United States, which accounts for a quarter of the world economy. If we compare economic developments with IMF forecasts before the pandemic, the US is the only economy to have exceeded forecasts thanks to the stimulus. Everywhere else, growth has lagged behind what was forecast before the pandemic.

Despite the new highs in stock markets, equities in Europe still look cheap. European stocks are priced at around 13x (Helsinki at 12.6x) their forecast earnings. Europe is, of course, plagued by slow or non-existent economic growth, the slow decision-making at Brussels, greater dependence on an unpredictable China and raw material scarcity. Having a belligerent neighbor like Russia isn’t exactly a strong selling point for EU either. But as I have often said, Europe also has skills, especially in solving the problems of the physical world, in fashion and medicine.



An excellent company is not the same as a good investment. Even mediocre companies can offer good returns if the price is low enough. Time will tell how long the US overperformance compared to the rest of the world continues and whether the rest of the world is cheap enough already. I, for one, have been buying mainly on the Finnish stock market - why look any further when there are attractive opportunities right at hand?

If investing has taught me anything, it's that short-term forecasts are like shots in the dark - as you can see from the diverging views of the strategists.

If I had to make a bet, I don't think the cheap stocks bought this year will turn out to be a bad investment on average over the next few years. There are good reasons to expect interest rates to fall in Europe and globally, supporting the economy and equities. It would be a miracle if, after a major stimulus, economies went straight into crisis.

As debt becomes cheaper and investors' appetite for risk increases, even the smaller, riskier stocks on the stock market may become more palatable again after a couple of years of brutal beats. Of course, you really have to do your homework when investing in smaller companies. 

In the long run, the world economy will grow, the number of people will increase and living standards will rise.

There is also a lot of permanence in the world. I recently read the following anecdote about Warren Buffett.

Driving in Omaha in the bleak winter of the financial crisis in 2009, a friend asks if Warren is worried about how the world will ever recover from the recession. Warren answers the question with a question of his own: Do you know what the most popular chocolate bar in America was in 1962? It was Snickers, continues Warren himself. Warren then asks what the most popular bar is now - again answering himself that it's Snickers.

Among other things, strong brands last. Another example is that it’s hardly a coincidence that Jeff Bezos, who has led Amazon's success story, has said that he will focus on what will never change. In the case of Amazon, customers want low prices and fast delivery.

The moral of the story is that an investor should focus on what doesn't change.

Thank you, my esteemed reader, for the past year! This Christmas, remember to spend time with loved ones, eat and drink in moderation and take a break from stonks. Those companies aren’t going to disappear in a couple of days.

Thank you for reading the post, Happy Holidays and New Year! See you next year!