Hello friends! I hope you’re having a great weekend!
One of the very first posts of my newsletter, in Nov’22, was about financial markets and whether we had any insight on them being at the bottom of a “crash” (especially in tech stocks). Less than 2 years from then, I am sitting here and hearing a lot of commentary around me from friends, colleagues, people I meet in the office about “how long is this bull run going to last?”.
For people not familiar with finance market jargon, a "bull market" refers to a period where prices are rising or are expected to rise, often characterized by investor optimism and economic growth. Conversely, a "bear market" is when market prices are falling or expected to fall, typically marked by investor pessimism and economic downturn. These terms reflect the general mood and trends in the market, with "bullish" indicating positive sentiment and "bearish" signaling negative sentiment. The origin of these terms is often attributed to the way each animal attacks: a bull thrusts its horns upward, while a bear swipes downward.
As you see in the chart above since my first post the S&P500 is up 28%, fully recovering the 2022/23 correction and establishing every day all-times-high record levels. I can’t claim I had any part in that recovery but… well correlation is clear! :)
Last week a friend forwarded a very interesting piece by Ray Dalio, the founder of the largest hedge fund in the world, Bridgewater, and the author of books that sit on the shelves of every “self-proclaimed” investor (I read all the books and admit I found them underwhelming, but that is clearly me given their popularity!).
Starting from that article I gathered some lateral insights from other sources and thought this could be a good moment to write about the current market situation and show experts’ opinions about future prospects.
There’s no need to say that nothing of this is investment advice, I am one of the worst traders I have ever met so please do not trust me with your money! :)
Most of the content below refers to the US stock market, but I believe that a large portion of these insights are actually relevant also for other geographies.
Are We living a Bubble?
In his post Dalio uses a tool he developed to understand whether the indicators point us towards a bubble scenario in current market dynamics.
The Concept of the Bubble Gauge
Developed from extensive experience and refined over the years, the bubble gauge incorporates a series of indicators and metrics to evaluate market conditions. These indicators include an assessment of price levels relative to traditional valuation measures, conditions that may or may not be sustainable, the influx of new and potentially inexperienced investors, overall market sentiment, the extent of debt-financed purchases, and the level of speculative and forward purchases.
Current Readings of the Bubble Gauge
As we apply this bubble gauge to the current U.S. stock market, the results are actually quite encouraging: overall, the market does not exhibit the classic signs of a bubble. Instead, it appears to be positioned in a mid-range, avoiding extremes on either side. This moderation suggests a market that, while experiencing growth, does not seem to be overextending into the dangerous territory of irrational exuberance or speculative frenzy.
The Role of Tech Giants: The "Magnificent 7"
One of the most noteworthy aspects of the current market is the role played by the "Magnificent 7" – leading tech companies that have driven a significant share of market gains. Their collective market cap has surged, now constituting a very material portion of the S&P 500:
However, even within this group, the bubble gauge readings are not ringing alarm bells. These companies show signs of being slightly overvalued (and part of this is surely the AI frenzy) but not in a full-blown bubble territory. This cautious optimism is tempered by the uncertainty around the impact of generative AI and other technological advancements on their future earnings and growth.
I think a key factor behind this point is that while we all comment market cap growth, we often forget how fast the earnings (i.e. how much profit they bring home) have also grown. As you can see in the charts below, the market cap of these companies has grown by and large in line with earnings.
In other words a part of the bull ride is the fact that a large part of the market is now formed by highly profitable, very large scaled businesses.
Deep Dive into the Sub-Gauges
Dalio then looks into other indicators to see if anything rings alarm bells, but frankly all of them look ok-ish:
Price Relative to Value: The price gauge places U.S. equities around the 73rd percentile, suggesting a market that is somewhat expensive but not excessively so.
Sustainability of Conditions: This gauge, focusing on the required earnings growth rate to justify current stock prices, indicates a market expectation slightly on the higher side but not unrealistic.
New Market Entrants: The influx of new investors, often a sign of bubble conditions, is higher than average but not at concerning levels. Similarly Retail players continue to be active in the market, but their level of activity has come off COVID-era highs:
Debt-Financed Purchases: The leverage gauge shows a healthy market, with less reliance on debt for stock purchases.
Forward Purchases: Assessing forward and speculative purchases, the gauge indicates a market that is cautiously optimistic but not overly speculative.
Dalio’s conclusion: no bubble!
The bubble gauge's current readings suggest a market that, while buoyant, is not in the throes of a speculative bubble. This analysis portrays a market that is cautiously optimistic, aware of potential risks, but not driven by irrational exuberance.
How about the banks?
While Dalio’s analysis is quite compelling, when reading other perspectives there’s an angle that I always look into and find quite relevant to the discussion: the credit system. I actually listened to a really cool Odd Lots podcast episode where Anat Admati (a banking journalist) had some really cool points about the financial industry and why we should pay a lot of attention to it.
The key reason why we should keep our eyes open is that in the last months analysts have noticed how the inflationary crisis, and the interest rate spikes, have basically had no negative impact on the large banks results. And actually, with the small parenthesis of the Silicon Valley Bank shock (that scared everyone), banks are doing very well.
A key factor could be that the pandemic was a great period for banks to “clean” their balance sheet, mainly trough access of low cost capital from public aid programs. This “spring cleaning” might have reduced the banks need to put their houses in order (or better, it allowed banks to “put a lot of dust under the rug”). This could indeed create a delay in the feedback loop of the credit system, and banks might be doing worse than we think.
A quick example to explain this concept: with current inflation rates, in the past we have always seen delinquencies on credit growing (i.e. people not being able to pay their credit card or mortgage bills). This is not happening today, or at least it’s not as evident as one would expect. And this might be because banks have a healthier Balance Sheet than in the past decades, and they would therefore more willing to refinance these loans (i.e. tell the customers “it’s ok, you can pay me in longer time but I am not going to default the loan”). This would obviously mean that there’s a percentage of hidden risk in the credit system, that could burst if macroeconomic conditions change materially.
And that’s what everyone freaked out about when the Silicon Valley Bank said they needed to raise equity, everyone took it as a signal of “they’re full of non performing assets”.
Too public to fail
Anat Admati in the podcast has a very long and well argumented thesis about how the credit system is flawed today and how it needs deep reforming. Her main argument is that Banks' preference for debt over equity creates a inherent risk.
Bankers have a natural incentive to increase the leverage, as their compensations is tied to return on equity (and hence it factors risk only to a minimal degree). This situation has been further aggravated by the role that public administrations have taken into funding banks with large sums of zero interest rate money during pandemic, often completely “de-risking” the banks from risk of failure.
She argues that current regulations, including the Basel rules, fail to adequately address these issues and she argues for more robust measures, including higher equity requirements.
This topic of the situation of the credit industry is a very complex and nuanced topic, on which I am still forming an opinion. Please share if there’s something cool to read about it!
The Bullish Case for Alphabet
As I said in a recent post I have stopped doing stock-picking investments, and fully embraced Warren Buffet’s recommendation of buying a passive low cost index fund:
In 2008, Buffett made a million dollar bet with a hedge fund manager that a passive Vanguard index fund would outperform any five hand picked actively managed investment funds over a period of ten years. The index fund won, and it wasn’t even close – while the five actively managed funds returned 36.3% after fees over the decade, the index fund returned a whopping 125%, all by doing just about nothing.
I read extensively about his bet with the Vanguard owner, but more importantly I learnt from my track record that I suck at choosing stocks and that beating the index is a very hard game.
Having said this, I think it’s fun to do a thought exercise and pick a stock that I think will outperform the index in 2024 and see how the prediction goes. And my pick for 2024 is Alphabet Inc. (GOOG), the parent company of Google.
I have read an interesting piece by Scott Galloway on this, and agree with the analysis in all its core points. So why do I think Google will outperform the index in 2024?
Pricing does not look too bubbly!
As also Dalio points out in the analysis I referred to above, among the magnificent 7 Google is the one that has the lowest P/E multiple:
Alphabet's Market Position
Quoting Galloway: “Alphabet still sits on cash volcanoes (as does Meta), and if 2023 was AI Star Wars, 2024 will be AI The Empire Strikes Back”.
Alphabet's robust market position is central to its potential for growth. The company's stronghold in search and digital advertising sets a strong foundation for sustained revenue. Galloway mentions Google probably invented the best business model of the millennium (i.e. printing money at incredible Gross Margin through digital ads).
Furthermore it has some of the most visited and recognized brands worldwide (YouTube, Gmail, Google Docs) that form an incredible distribution platform. It also plays a very material role in Cloud Computing, with GCS being the third player in the segment.
Google Search is likely the best (most lucrative) business model of this millennium. The company’s monopoly on search garners a 24% net profit — on 91% of the $190 billion search business. Google redeploys some of these earnings to dig moats, offering free apps for email, word processing, videos, mobile OS, and mapping which protect the Red Keep (search) from marauders.
AI promises
Obviously Big Tech companies these days are very influenced by their opportunities on GenAI developments and I actually think Google has several arrows in its quiver.
Everyone’s under-estimating them. To be honest this is a self inflicted factor as the Bard and then Gemini launches were both spectacular fiascos. This is a stark contrast vs OpenAI, that instead has kept a launch momentum that is really impressive. I believe that this, however, could be a pro in the long run.
I believe that in the long run a key factor for AI value will be the differentiation offered by proprietary datasets, on which the models are trained on. And frankly Google has arguably the best proprietary dataset of all. Think about Gmail and Google Docs, or the maps data that all the Android users share. But most importantly think about what a goldmine YouTube is for video, audio (and text, through transcripts) training. Every minute there are over 500 minutes of video uploaded by users on YouTube! And most of it is exclusive content… Currently data ownership might not be a huge differentiator (and yesterday OpenAI CTO basically admitted they leveraged youtube videos to train their video generating Sora algorithm) but as legal frameworks evolve this will become a key aspect.
Google still has an incredible talent pool, all of the recent developments in AI (the transformer, most of the scientific papers on neural networks) basically come either from Google Labs directly or from Google employees. This concentration of talent the company ammassed over the past decade will be an incredible asset in the long run, as R&D is pushed to the frontiers.
Finally, Google has a distribution that very few players have: Android is basically 70% of the smartphones globally, gmail is the most used email provider, etc. Once they figure out exactly the best GenAI product, they will surely benefit from a distribution advantage.
The Kodak Curse
The biggest risk, in Galloway’s eyes and mine, is actually what he refers to as the “Kodak curse”.
Kodak dominated the photography industry for decades, delivering the highest-quality film and paper to the most demanding and profitable customers. It wasn’t ignorant of digital photography; the company actually pioneered the category, developing the first digital camera in the 1970s, and it offered a variety of digital cameras for sale throughout the 1990s. Kodak didn’t go all-in on digital, however, because digital offered considerably lower-quality than film and had different virtues, and because the company’s business model was built around selling consumable film. Most discouraging, its best customers had no use for it. Kodak left the digital field to innovators who offered cameras that produced inferior images, but these firms found favor in other, neglected parts of the market.
Google stands in front of a similar challenge, which is the classic problem of the Innovator’s dilemma that Christensen brilliantly formulated 20 years ago.
Google has been on the disruptor side of this story in the past, will they be able to play the role of the incumbent successfully and avoid that their biggest blessing (the great businesses they built) doesn’t become a curse?
I am personally very positive, but 2024 will surely be the year that will tell us who’s right!
Have a fantastic weekend!
G