Cicadian Rhythms

Welcome, everybody to the April, late April 2024 for Eye on the Market podcast.

This one’s entitled Cicadian Rhythms as opposed to circadian rhythms, and refers to the cycle of blooms that are taking place this year, mostly in the Midwest. And the reason that I’m using this as a metaphor is there are two blooms that are taking place, two broods that are taking place at the same time. Brood 13 and brood 19.

They coemerge only once every 221 years. So that’s kind of a big deal. And they serve as a metaphor for something. The markets were pricing in earlier this year. That’s also really rare, which is a disinflationary boom. They, well, they don’t happen very often. They refer to periods when growth is rising and inflation is falling. There was one in the early 1980s.

There was another one in the early 1990s that lasted for a few months. It looked towards the end of last year and in January like one was happening here. But the, the prospects for a disinflationary boom are fading, and that’s had an impact on markets, and so I wanted to talk about the implications for investors and also talk about Tesla, China, Japan and some other topics.

And in this week’s piece. So the disinflationary boom that the markets were pricing in the growth side of that picture is still intact. And one of the things we show in the AI in the market is a table that shows the 18 leading indicators we track that, that projects certain things about the economy or profits, and how last fall a lot of these indicator, leading indicators were looking pretty weak, pretty dismal.

And how that picture has improved a lot. So not only did the contemporaneous growth numbers look good, leading indicators of future growth looked pretty good right now as well. The problem is with that sustained resilient growth picture, we've had a U-turn in inflation, so inflation has gone back up, as you can see here, as it relates to the core services component of the CPI, around half of last year’s decline has already been regained.

I don’t think it’s heading up to the peak where it was, but this is certainly a few months of data that’s moving in the opposite direction of what the Fed was hoping that we’ve seen the obvious consequences. The markets are now pricing in only one to two Fed cuts 10 years back up to 4.7, and PE multiples have gone down, particularly on growth stocks, and all of that makes sense.

And now, while not all the inflation news is bad, the producer price report was a lot more benign. The consumer price inflation data, most of the labor market and wage inflation data are still pointing towards lower inflation rather than higher inflation. So now the CPI stands out a little here amongst all the data as being the most problematic, and putting the Fed on its heels a little bit.

But I, and that’s the primary reason that this disinflationary boom that the markets were pricing in is it looks like the prospects for that are fading. Now, that said, whatever kind of correction we get here should be a pretty modest one. First, we knew that we were at risk of this kind of thing in the last time the market we talked about how multiples on tech stocks, whether you look at it on a market cap or an equal weighted basis, were back up at the highs of 2020, 2021.

So, yes, earnings have improved, but multiples this year had gone up even way past the improvement and forward earnings projections. And so the markets were kind of at risk of some negative news, which we’ve now gotten. But the magnitude of any correction here should be kind of modest. And I want to show you a couple of charts that we started showing last fall.

We talked about them again in the in the outlook when we were talking about our soft landing thesis. And everybody’s aware that that the inverted yield curve has a pretty good track record of predicting recessions. But I want to show you the other two things that coincide with inverted yield curves that are not happening this time, that are that are very different this time around.

One of them is the corporate sector. Financial balance, and that is basically a proxy for corporate cash flow net of capital spending, and in almost every circumstance in prior yield curve inversions, the corporate sector was hemorrhaging cash. So when rates went up and the corporate sector retrenched, you had a deep recession. Today, the corporate sector is, is in pretty good surplus.

The other thing that happened in the past is every time the Fed would raise rates, corporate interest expenses would go up a ton relative to profits, and that would also hurt the markets for investors this time around, probably because there’s so much fixed-rate debt that the corporate sector has taken on compared to floating rates have gone up 500 basis points, and we haven’t even seen any increase yet in interest costs relative to profits.

So there are a couple of things taking place this time that should mitigate the magnitude of any sell-off. And, you know, I would add to that a chart that we show here on net equity supply and, you know, the people were upset for years that equity supply was, was slowing down then. Sometimes, you know, be careful what you wish for.

We had an explosion of issuance, you know, SPACs included in 2020 and 2021. But net equity supply has now been negative three years running since then. And that tends to be good for investors. It means you don’t have a lot of excess supply as large institutional investors rebalance and redeploy cash. There’s a smaller subset of equities are investing in, right?

So this should be this is kind of a technical issue, but it should be helpful to the markets as well. And it indicates a lot more investor scrutiny on new issues. So the biggest challenge right now for the markets is that you’ve got a lot of people that would be very tempted to, to increase their cash positions. The ratio of cash yields to S&P dividend yields was at the highest level that it’s been at since the 1930s, with the exception of a temporary peak in the year 2000.

So in other words, the cash yields, you know, on T-bills are, you know, more than three times the S&P dividend yield. Now, those peaks tend not to last very long, but they can correct in a number of different ways. And it is an indication that on a risk-adjusted basis, you know, cash does have a place in investor portfolios right now as we, as we watch this all unfold in terms of what’s going to happen with the Fed, I still think just to wrap up this whole thing, even though the prospects of a disinflationary boom look like they’ve gone down, we don’t anticipate a large correction.

I still think this will be a year of single-digit returns on U.S. equities. The same thing that we thought last January. But I’m increasingly focused and do acknowledge the risks around the election and the election issue. Typically, divided governments tend to be better for investors than unified government, and we now have to look at two different possibilities: a Trump victory where Republicans take the House and the Senate, and a Biden victory where the Democrats take the House and the Senate.

In both of those circumstances, you might see an even wider budget deficit, but for different reasons. And then if you’ve got a Trump victory and unified government, you also have the risk of a 60% tariff on Chinese goods, up from 20 to 25% currently. I can’t imagine the Fed’s going to like the inflationary consequences of that. But you have a repeal of the corporate AMT repeal and the buyback tax.

The corporate sector will like that. But when combined with increased defense spending and a full extension of the personal tax cuts from 2017, you’re going to have a very big budget deficit. And that if you end up having militarized mass deportations, that’s going to impact labor force growth and wage inflation, and also in ways that are going to be challenging for the Fed.

So a unified Republican government poses risks and a unified Democratic government poses risks. I’m not going to spend too much time on it. We’ll talk about it later in the summer. But the Biden people kind of outlining the possibly idea of $2 trillion in tax increases on the corporate sector and high-net-worth individuals to support $2 trillion of safety net expansion.

There’s a lot of things that can go wrong there as well. And I would point to the energy bill, which was ironically named the Inflation Reduction Act. I don’t think there’s ever been a bill in the history of the United States that was more wrongly an Orwellian named than that one, because we are seeing surging electricity prices, surging prices for transformer and transmission equipment, and a massively bigger budget hit from this bill than was initially priced in by the CBO.

So anyway, those are the risks that we’ll have to grapple with later than the year, later in the year. The other circadian rhythm reference that I think is worth mentioning is, is Japan. And I don’t remember ever meeting anybody in my whole career that said to me, you know, hi, I work in Japan and my job is unlocking shareholder value in large cap companies, and but, but now I do meet people, you know, over the last 18 months to do that.

And you can see we have a chart here showing a fairly dramatic pick-up in corporate finance activity in Japan, whether it’s buyouts, carveouts, private debt recap realizations, spin-offs, secondary buyouts. I mean, this is a pretty big deal for Japan and a very big deal for investors. And the reason is the, the issue with Japan. Japan’s free cash flow yield of Japanese equities was never that much different than the U.S. The low valuations had to do with what was done with that cash flow and how shareholder value wasn’t being paid any intention to.

And if that’s changing, that’s a pretty big deal for investors. We showed this table a few a few months ago, and it’s kind of amazing. Every time I look at it, I still can’t believe it. Cash as a percentage of market cap and Japanese companies four, three times higher. In the U.S., the share of company is trading below book value 50%.

Half of all Japanese companies, compared to just 4% in the U.S. Equity allocations in pensions much lower than the U.S. and in households, 55% allocations to cash compared to 15 in the U.S. So there’s massive room for Japan as a society to re-equitize. And I think a lot of this, this, this cicadian emergence of corporate finance and M&A activity in Japan is, is a clue that that might be happening now.

Nothing’s outperformed U.S. equities in recent years, but we are seeing some outperformance of Japan versus Europe in emerging markets, which is an indication that things are happening that are worth paying attention to. So sorry, I’m having a Fresca. I don’t know if it’s if they’re safe to drink, but I do drink a lot of them. So I like to answer emails that I get and an Eye on the Market mailbag section.

And I want to conclude with, with a couple of topics. There were six. There were six emails that I answer in the mailbag this week, the ones on Tesla and Elon Musk. One is on housing, one is on weight loss drugs. One China truth, social valuations and then Meadow’s new open source language models. I’m only going to talk about two of them here, Tesla and China. For the other, for, you know, please refer to the actual AI in the market piece that has some good data in there.

So on. Tesla is a fascinating company for all obvious reasons. The stock’s down 41% this year. It’s one of the worst performers in the S&P and the Nasdaq. So people are obviously paying very close attention to what Tesla management is saying about what it’s going to do next. And Musk announced a pivot to Robotaxis. I find that kind of puzzling for a number of reasons.

First, San Francisco and Austin are the only two places that we know of the major cities where robotaxis are being widely tested. And there has been, you know, some issues in each one. And we see no evidence that Tesla is engaging with city planners there for robotaxi adoption. A lot, a basket of light car stocks, which are the companies involved in the technology associated with self-driving cars, that, that basket’s down 90% from 2021.

That’s not going anywhere. And, you know, Tesla’s level two features seem to work well and historically have reduced accident rates compared to cars that don’t have those features enabled at all. But level two features like lane following and braking, an acceleration support, that’s a long way from full self-driving level five capabilities. So I was kind of surprised to see Tesla focus on that and, you know, as I mentioned, Tesla’s, you know, had a very difficult year.

Here we have a chart showing different analyst price targets. The lowest one happens to be J.P. Morgan’s investment banking analyst. The highest one also, unsurprisingly, is Morgan Stanley, which has always been the kind of Tesla fan boy society. But even they’re warning in their research against assuming any kind of near-term commercialization of robotaxis. You remember a couple of years ago in 2022, Tesla talked about focusing on humanoid robots, a fascinating project, but one that doesn’t appear to have any near-term revenue benefits.

And this year they’re dealing with the cybertruck issues, and the last thing I read was that Inside EVs described it as a sixty-eight hundred pound missile because of the issue associated with the jam accelerator pedals. So the big issue for Tesla is obviously the model two. That’s the, the car that they’re developing. It’s supposed to cost somewhere in the neighborhood of $25,000.

What we’re hearing is that Tesla has invested an enormous amount of money in giga casting equipment that can cast large parts of the car’s body in a single piece, reducing the number of metal pieces from 170 to two, and then requiring something like 600 fewer wells. So that’s fascinating. I totally buy into the notion that there could be some enormous production, mass production benefits from that, but it now looks like that’s a 2026 or maybe even a 2027 story in terms of when they’re going to be able to ramp that up to more than 500,000 units a year.

So back to, you know, what’s ailing Tesla right now. One thing is that there’s some great news on the truck they’re developing, but that doesn’t seem to be closer to commercialization either. The National Association for Commercial Freight Efficiency held this demo project last year. And I think this is fascinating. A Tesla truck went a thousand miles in a single day delivering on an actual Pepsi route in California, and only stopped three times for manageable, less than an hour periods each time to recharge.

Now we have a chart here that shows the miles cumulative miles traveled over that day. And you know, the percentage battery charge, and they’re using a 750 kilowatt charger. There’s been tremendous advances in charging capabilities on these EV trucks. And I think almost certainly this is a category killer for hydrogen trucking, which people used to like for the fast charging times.

But now that this technology is improving, you know, the roundtrip efficiency on fuel cells is just so abysmally awful. This, this certainly means that the future of the long-haul decarbonized trucking is going to be electric. Although I did see something recently that I thought was interesting, not sure exactly what to make of it yet, but there was a journal article that talked about some of the challenges that Tesla is facing and, and how Musk might be alienating some of the Tesla buyers.

And what they did was they cited a study from last fall showing the Democrats buying, the proportion of Democrats buying Tesla vehicles fell by more than 60%. And that happened to coincide with a barrage of Musk tweets last year on, you know, religious immigration, climate, COVID and a bunch of other stuff. But Tesla’s reliance on Democratic buyers is pretty well documented.

It’s a paper from Lucas Davis at UC Berkeley showing that, you know, almost more than half the Teslas purchased over the last decade went to a handful of very Democratic counties across the country. So it’s pretty clear that Tesla is heavily reliant on Democratic buyers. And, and so that’s why it’s kind of amazing to see Musk doubling down last month, saying there, quote unquote, there’s either a red or a red wave this November in the election or America’s doomed.

It’s a, it’s an interesting political experiment to see the CEO of a company that is so reliant on a particular demographic of people publicly project positions and policies that are presumably antithetical to their buyers. And if anything, I guess I’m surprised that there hasn’t been some kind of buyer backlash against Tesla before. Some of Musk’s other recent tweets have been supportive of Pizzagate, or what he’s tweeted about, you know, Paul Pelosi, Mackenzie Bezos, Soros, Foushee, a British cave diver that disagreed with him on the feasibility of using a submarine to rescue some trapped divers.

We walked through them in the Eye on the Market. And, you know, you can make your own judgments, but I think it’s pretty clear that a lot of those tweets would, would rub some Democratic buyers the wrong way. And that’s taking place against the backdrop of, of, of what’s happened to Twitter. And Foreign Policy magazine published a long piece last year that described Twitter as a sewer of disinformation.

And in the fall, the EU announced formally that it is, it is investigating Twitter for breaching rules regarding illegal content and disinformation. They did their own study of all the social media platforms and found the highest misinformation and disinformation rate on Twitter. Of all the platforms that they looked at. So this, this issue about Tesla fires and Musk is something that’s interesting to follow here.

Tesla still has massive market share, but over time there are going to be more competitors, more low-cost competitors. And this is obviously something that we’re going to continue to look at as it relates to China. Just to wrap up here, you know, nobody loves a good deep value story more than I do, right? Almost everything for investors has a price.

And at some point, almost anything can get cheap enough to where you would hold your nose and take some exposure to it. I just don’t happen to think we’re there yet on China. So to answer a couple of questions on China, there are signs of life, although it depends what indicators you look at. We have a China activity monitor in the, in the market this week.

One of them is a source that Bloomberg puts together that’s hooking up a little bit. The one that we construct happens to be rolling over the latest data that we’re seeing. Even though growth was 5%, that’s manipulated. Capacity utilization numbers are going down. China is still in deflation. So I don’t see a lot of evidence of a real turnaround or even kind of leading indicator.

Green shoots in China. And then as it relates to the more important question for investors, in February, we said, okay, China’s trading at a ten PE. That sounds pretty cheap. A lot of things are trading at a 10 PE, right? There were, there’s over 40 markets around the world or sectors trading at a 10 or less. And, you know, since February, MSCI China is up 4%.

Most, most of the other low PE sectors that we looked at or countries have done better. Argentina, European and then U.S. oil and gas. S&P airlines.

Spain. Italy. Chile. European. Financials. S&P banks. All of these markets and sectors. Or things that have done better than China. China is only up 4% or so since then. So again, there are places around the world to bottom fish that I think better have better fundamentals than China. And I, I don’t see the policies or the contemporaneous data that suggest that China should be at the top of a deep value list.

Obviously, that’s something we’ll continue to track in the months ahead. So thank you very much for listening. Take a look at the China market cell for all the details, and I’ll talk to you sometime in May. Thank you.