Lament of a Bear

“Exponentially rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.”

— Bob Farrell’s Market Rule #4

The bottom line: One can reasonably debate whether the stock market has risen exponentially but there is no arguing that the surge in the S&P 500 these past two years has been nothing short of extraordinary. And it has clearly gone much further than I thought it would, especially in these past twelve months, and so at this point, it is worth the time and effort to discuss and interpret the message from the market; tip the hat to the bulls who have, after all, been on the right side of the trade, and provide some rationale behind this powerful surge. This is not some attempt at a mea culpa or a throwing in of any towel, as much as the lament of a bear who has come to grips with the premise that while the market has definitely been exuberant, it may not actually be altogether that irrational. Read on.

Rethinking the “Bubble” Thesis

It’s high time for me to stop pontificating on all the reasons why the U.S. stock market is crazily overvalued and all the reasons to be bearish based on all the variables I have relied on in the past — from valuation, to sentiment, to overcrowded positioning. So, what I am going to start doing is assessing what it is the market is saying, because the market can certainly move to excesses in both directions and make faulty assumptions, but the market is not stupid.

What is the market telling us, in other words? Especially since this bull phase has now lasted long enough that those of us who have been on the wrong side of the trade need to take a different tack. This is not about throwing in the towel as much as trying to get a grip on what is going on beyond just calling this a “bubble” every single day. There must be more than that to what we have been seeing over the past two-plus years.

The AI-Induced “Model Shift”

The market is telling us that we are in a “Model Shift” when it comes to future growth and profits. The S&P 500, by its nature, is a long-duration animal, which means that gazing at the trailing or one-year forward P/E multiple is looking at things over a lagged or coincident time frame. Investors are clearly looking out beyond one year across an entire gamut of indicators and developments, so the classic way we look at valuations may not be appropriate today. While we may well be in a bubble, it may take years to find out, as was the case with the Internet in the mid-to-late 1990s — a period of high and rising productivity and profits growth, which only came crashing down once all the excess supply and malinvestment was exposed when the earnings cycle in Tech peaked out and rolled over in spectacular fashion beginning in 2000. Keep in mind that back then, the Greenspan Fed was busy raising rates while today’s Powell Fed is cutting rates, and the only question is how much there is left in the easing cycle. One can also state the case that lower interest rates mean a lower discount factor with respect to the present value of future cash-flow streams — another item not worth debating since it is nothing more than a truism. But as we saw then and are witnessing today, a speculative asset class like equities will always price in a certain future, and when we have technological breakthroughs as we have with AI, the stock market is going to extend its time horizon, build in expectations that transcend just one year, and a bear market only ensues if and when these expectations prove to have been excessive. That day may well come, but Mr. Market has been saying for some time: “not quite yet.”

So, the lesson and epiphany for me is the realization that it is not helpful to be looking at lofty multiples on a one-year trailing or one-year forward basis in an era where we are going through a major technological revolution. The benefits are next to impossible to estimate, but the one thing we know about the equity market is that it typically is a very forgiving asset class. And the market clearly continues to anticipate and price in a future boom in productivity that will lead to a secular shift in the trendline for corporate profitability. It may be wrong, but that is the bet — and it does not look as though Mr. Market is about to fold. Not at least until we actually do get an earnings recession, or all those AI and related orders don’t end up getting filled and we find out that the TAM (Total Addressable Market) was far too inflated. It doesn’t seem as though we are at that point yet, but we will need to keep a firm eye on the supply-demand backdrop for AI, just as everyone should have been doing for fiber optics and telecom equipment of all kinds in the Internet mania in the late 1990s.

That is the first part of this revelation: the fact that generative AI is a game-changer for the future. And if it is, then the multiples based on a long time frame may not be in a bubble at all. This comes back to the view that traditional valuations, at the least, are not that helpful right now. If it weren’t for the “Model Shift” generated by the AI boom, which is spreading to all sorts of industries and triggering a rare significant expansion in R&D spending (which shows up in GDP but not in the monthly durable goods orders and shipments data), it would be easy to label a 22x one-year forward P/E multiple as some sort of bubble. But I now realize that investors have shifted out their earnings projections way into the future, and if the technology experts are prescient, this will be a difference-maker from a productivity growth backdrop in years to come, and at a time when the pandemic has unleashed an unexpected upward shift in the productivity curve. One productivity enhancer followed by another.

Now, it needs to be said that no, this is not the case where I wasn’t on top of what was happening in this technology wave over the past year. We published reports on the outlook for AI and also held a special AI webcast at the beginning of 2024. What I clearly underestimated was the dramatic impact this was going to exert on market psychology and the powerful upward shift in investors’ long-term earnings expectations that were the primary drivers of valuations this past year. And I have gained a greater appreciation that it is going to take a whole lot to upset this apple cart and trigger a fundamental re-evaluation of what AI will exert on productivity growth and profitability in the future.

Turning a Bit More Positive on Bonds Too

As for the bond market implications, this is a wash: higher productivity growth ipso facto means a higher real interest rate, but it also means lower inflation expectations. It is extremely difficult at the present time to statistically determine which one will dominate the other, but there is no doubt that higher productivity growth reduces business costs, improves margins, and is a structural positive underpinning to the stock market. This has never been a point of debate with me, but I come back to this significant point, which is that this is what investors are pricing in: the future, and not just 2025 and 2026, but the next decade. Again, this is not abnormal in the context of an inflection point in the technology curve, and we will only likely find out in the course of time whether or not what we are experiencing today is indeed a true bubble. This is where my thinking has changed. I have shifted from my view that we are in a classic bubble to now questioning — not totally abandoning, but indeed questioning — that thesis.

A Business-Friendly Trump Also Needs to Be Addressed

Then we have to layer something else on this technology breakthrough, which is the political dynamics. I am not convinced that Donald Trump is going to get his tax cuts through a House that is replete with fiscal conservatives on both sides of the aisle and where the GOP has a razor-thin majority. The appetite for more deficit finance in Congress is thin, and even the Democrats recognize that the blowout budget gaps of these past several years were a huge mistake. Of course, the 2017 tax cuts about to sunset next year will be extended, the only question is whether they will be made permanent. But lower corporate tax rates are basically a side-show, in any event. Investors have been bulled up this past month and have become even more positive because of three things: (i) we clearly have on our hands a much more pro-business administration; (ii) we have a President who can deregulate a lot on his own, and, in contrast to deficit-financed tax cuts, there is more than enough Congressional support for “dereg!” That also is going to support a lower corporate cost curve and, as a stand-alone situation, generate a positive boost for future profits. Finally (iii), we have a move to expand energy production, which will reduce energy costs and that too will help underpin margins for every other industry outside of the oil & gas sector.

One may wonder what happened to all the tariff fears, but they have abated somewhat because it is becoming clear even before Trump takes office that trade policy is being used as a tactic to get other countries to change their policies on different fronts. It looks like it is already working, at least in relation to Canada and Mexico. And the markets have given the proverbial “thumbs up” to many of Donald Trump’s choices for his economics team — a sigh of relief, if you will, that he will be restrained when it comes to engaging in a global tariff and trade war. China is another matter, but that “cold economic war” continued even under Joe Biden’s tenure. In fact, just a few weeks ago, I exercised caution over the outlook for both bonds and stocks coming out of my tariff concerns, but these concerns have abated and I have no problem being bullish on the Treasury market again as a result. A short hiatus.

The Economy Is Less Strong Than It Appears (And the Fed Will Keep Cutting Rates Even if It Pauses Near Term)

I was unimpressed with the latest rounds of economic data. The JOLTS data show hirings on a notable downtrend. The ADP report showed acute job weakness in the key small-business sector. The ISM services PMI was quite soft, and the pressure-points on inflation receded. And the Beige Book, while seemingly less pessimistic at the headline level, revealed a softening underbelly for the labor market with wage growth receding and the wage outlook also under some downward pressure. The Fed likely cuts on December 18^th and sounds cautious while reducing the 2025 dot plots to just two cuts from the four it predicted last September — but this is already priced in, and I would not be surprised to see the March dot plots next year show more rate cuts coming. While my concern over the Fed’s reaction function with respect to Trump’s tariff (and immigration) policies has not totally abated, I am feeling better about the situation than I was a few weeks back, so back to business on the bond market. I said I would advocate a return to above-neutral duration once a cloud or two started to part, and Trump’s cadence so far (though admittedly early days yet) and his picks for key economic positions (especially regarding trade policy) have me, at the margin, less concerned. I don’t usually whack around an asset mix shift this quickly, but the situation, shall we say, is fluid.

Still Concerned Over Sentiment and Market Positioning — But Any Near-Term Correction (Which I Expect) Will Likely Be Bought (Yet Again)

A few last items to cover before wrapping up. As I said, this piece is about a revelation, an epiphany, and an explanation as to why this market in Bob Farrell style has definitely gone much further than anyone thought. It’s not just me — the consensus S&P 500 target for the end of 2024 published in December of last year was near 4,900 and change, and the index is already north of 6,000. Some will obviously say, “Where were you last year?” and others will say, “Rosie, stick to your guns,” and then there will be a few who will simply say, “Thank you for updating your thought process.” All that said, I do have concerns over what will happen in the near term because there is a ton of good news being embedded in any valuation measure, and both sentiment levels and bullish market positioning are simply off the charts.

So, we cannot dismiss the potential for some near-term rounds of profit-taking or early-2025 rebalancing or even the prospect that we get hit with some unanticipated adverse economic news or a more hawkish Fed that could trigger a drawdown of even 5% or 10%. Ergo, the answer is no — I am not advocating a move to jump into the equity market today or even tomorrow. I expect a correction to take place. But the issue is what then to do with any correction in the context of what does indeed appear to be a secular bull market, and my shift in view, for lack of a more sophisticated term, will be to “buy that dip.”

For this bull market to confront a more difficult experience where “buying the dips” will not work requires one of: a shift in Fed policy towards a tightening cycle (which will require a surprising revival in inflation), convincing signs that the recession that so far has been averted finally does arrive, Trump following through on his tariff pledges, or evidence that the AI spending craze is stalling out (which, after all, is what happened in the dotcom cycle in 2000 — but remember, that did come about five years after the Internet went viral with the Netscape IPO in 1995). But if any or all of these developments do not occur, there really is nothing to stand in the way of this bull market being extended, intermittent corrections notwithstanding.

I do hate to ever use the term “new era” or “it’s different this time,” but we do not have a large sample size of data points historically on such major inflection points on the technology curve. But when they do occur, what you do find is what we have on our hands today, which, once again, is an investment community lengthening their investment horizons and rendering classic valuation metrics obsolete (at least for the environment we find ourselves in currently). That’s the major point. Once (if?) we ever do revert to a backdrop where investors shorten their timelines to what has been the norm of the past, which will mark the end of this technology super-cycle, the gig will be up. Remember what happened in 2022, just before this AI craze took hold — it was not exactly a pretty picture. The business cycle and market cycle have not been repealed, but I am definitely now keeping a more open mind that we could end up seeing Bob Farrell’s Rule #4 in that this bull market continues to go further than anyone thinks. The latter part of that rule on not correcting by going sideways is still relevant, but as we saw in the 1995-2000 Internet era, that fundamental reversal could still be several years away. Like I said — the way to redress the lament of a bear is to keep an open mind as we head into 2025 and learn from the mistakes of the past year.