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Quarterly Memos

Q2'23: Animal Spirits

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By: Jack Schibli

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Economist John Maynard Keynes first coined the term “animal spirits” to capture the instincts and emotions inherent in human behavior. In modern market commentary, it’s used to describe the tendency of price to rise and fall based on human emotion rather than intrinsic value, or in other words, explain the irrational. 

TLDR – “too long; didn’t read.” We recognize our posts can be lengthy and challenging to digest, so here’s our executive summary:

  • Generative Artificial Intelligence enthusiasm has driven a sea change in Big Tech valuations, almost single-handedly driving the market higher this year.
  • We suspect market structure driven flows, representing price insensitive buyers (401k flows, corporate buyback, rules-based strategies), have been outsized contributors to market returns this year.
  • We are skeptical of present equity valuations at the index level, primarily driven by the concentration of Big Tech and the availability of 5%+ risk-free returns in short-term U.S. Treasuries.
  • Low levels of implied volatility increasingly point to a complacent market, which appears to be ignoring many of the potential risks and headwinds on the macro horizon.

The Magnificent 7 🪄

A glance at the stock market’s recent and dramatic price appreciation and one might think many of the geopolitical and economic uncertainty-inducing headwinds have been resolved. Yet, the Russia/Ukraine conflict is ongoing, the East vs. West divide is deepening, inflation remains above the Federal Reserve’s target, and interest rates, now the highest in fifteen years, are still rising. What’s all the hype about? Artificial Intelligence (AI), or at least that’s the prevailing narrative.

OpenAI’s introduction of extraordinarily capable Generative AI (GenAI) surprised many. In our view, AI large language models (LLMs), such as ChatGPT 4, will ultimately be commoditized, which positions fine-tuning inputs (data) as the competitive advantage. Who has the most data? None other than Big Tech, of course. Big Tech also conveniently owns the tolls for computing, and GenAI requires far more computing power than traditional analytics.

The market is voting with its feet, proclaiming the so-called Magnificent 7 (Apple, Microsoft, Google, Amazon, Nvidia, Tesla, Meta) as key AI winners. As of this writing, the Magnificent 7 have added more than $4.6 trillion in market cap (+67%) in 2023, bringing their cumulative market cap to 11% of global GDP. The S&P 500, better known as “the market,” is up 19% this year, though the S&P 493 (excluding the Magnificent 7) is up just 5.2%.

For Illustrative Purpose Only

Despite the hype around AI, Wall Street consensus earnings estimates for the Magnificent 7 have remained largely unchanged. The median 2023 EPS estimate has risen 1% since the beginning of the year and is down 17% since last year. We are sensitive to the sell-side estimates lagging actual results, as the magnitude of AI’s impact lacks clarity. Yet, we would expect earnings estimates in the out years (2024, 2025, 2026) to reflect a more meaningful AI impact. Below we see that, except for Nvidia, earnings estimates for upcoming years have generally materially decreased since 2022. Either the market is overly enthusiastic, or Wall Street is underappreciating AI’s impact. We suspect reality lies somewhere in between.

For Illustrative Purposes Only

As of Q2, the Magnificent 7 comprised 27% of the S&P 500 and a staggering 55% of the Nasdaq 100. Thus, for every new dollar invested in the S&P 500, 27 cents are allocated to the Magnificent 7, which also receives 55 cents of every dollar invested in the Nasdaq 100. The rise of passive indexing has resulted in trillions of dollars passively invested in these indices, including through employer retirement plans. The lauded hallmark of passive investing is diversification, yet investors are experiencing further concentration in practice. We wrote at length about the reflexive passive phenomenon in our Q3’21 piece, Passive Aggression, whereby outperformance within the index receives a higher weighting, furthering outperformance all else equal. For the first time in over a decade, extreme concentration in the Nasdaq 100 index has triggered a special rebalance whereby the Magnificent 7 will have some proportion of their weights re-allocated to the remaining 93 stocks in the index after the market close on July 21st. 

We do not mean to downplay the significance of GenAI as a technology, though we caution that prices might be ahead of (at least immediate) fundamentals. As investors in the dot com bubble learned the hard way, several expected winners turned out to be long-term losers. For example, former darlings Cisco and Intel have yet to recover their 2000 highs. 

More Than Meets the Eye 👁️

Too often, Wall Street media create retrospective narratives to explain price action. We want to highlight a few structural market forces, exclusive of AI, which have likely had a material impact on price action this year.

First, we must begin with the basic economic premise that the marginal dollar sets the price. The price of stocks does not reflect what the average market participant thinks stocks are worth but rather the price the buyer who values them highest is willing to pay. While the total stock of U.S. equity markets is roughly $45 trillion, daily flows in the tens of billions of dollars can significantly impact price. With this framing, we hypothesize that flows, not the absolute value of total stock, are the primary driver of price movement. 

What if the marginal buyer of stocks is insensitive to price? There are several sources of such flows. Passive flows through employer retirement plans are entirely price insensitive, as with each paycheck, funds are allocated to ETFs with a single prerogative: buy. The recent high employment rates have provided supportive flows to equities, and the possibility of a prolonged rise in unemployment may cease this tailwind. The most recent Department of Labor data puts total retirement plan contributions (defined benefit plans, defined contribution plans, 401(k)) at $1.2 trillion in 2020[1]. We expect this number has only grown since, alongside the increase in employment rates and wage growth, further accelerated by the 2023 implementation of the Secure 2.0 Act stipulation, which requires employers to automatically enroll every employee in their retirement plan at a contribution rate of at least 3% of wages[2]. Perhaps shockingly, the same legislation requires the automatic minimum rate to increase by 1% annually starting in 2025 until a minimum of 10% of wages is contributed[2].

Another source of rather price-insensitive flows is corporate buybacks. The low-interest rate environment popularized this capital return strategy, as excess cash on balance sheets carried virtually no return. In Q1, corporate buybacks contributed $215 billion to equity inflows, nearly 50% of which were concentrated among the top 20 companies[3]. Rules-based strategies are yet another contributor of price-insensitive flows. Volatility control strategies, for example, follow a simple ruleset; if(volatility < chosen target), then(decrease exposure/sell). Volatility has been in cyclical decline in 2023, and consequently, vol control funds have notably increased exposure.

For Illustrative Purposes Only We have previously mentioned the formative findings of Gabaix and Koijen’s inelastic market hypothesis. They empirically note that investing $1 in the stock market increases its aggregate value by roughly $5. Importantly, this presumes the marginal invested dollar is coming from outside of equities, as the vast majority of trading volume is intra-equities. They suggest a key reason for the low price elasticity of demand is most equities are owned by institutions that, over time, have stable allocations to equities, meaning newly invested dollars find comparatively fewer willing sellers and therefore push up aggregate values disproportionately. Using just the three outlined sources of price-insensitive flows (retirement contributions, buybacks, and vol control strategies), we estimate inflows in the neighborhood of $920 billion through the first half of 2023, which the inelastic market hypothesis would suggest can contribute to roughly $4.6 trillion in aggregate market value increase. This estimate would account for 77% of the nearly $6 trillion gain in market cap during the same period for all U.S. equities. These structural market forces don’t know or care about the meaning nor true impact of AI.

Uncertainly Certain ❓

Given the macro landscape, we are perplexed at the seeming lack of fear, uncertainty, and doubt equity markets are reflecting. The popular price-to-earnings metric can be inversed to calculate the earnings yield of the stock market, which represents the percentage return of each dollar invested generated from corporate earnings. Subtracting the risk-free interest rate awarded by U.S. Treasuries from the earnings yield equals the equity risk premium. Basic logic and the Capital Asset Pricing Model (CAPM) would reason that the equity risk premium should be positive, meaning investors are compensated for taking the inherent risk in equities versus the guaranteed return of U.S. government paper. The chart below depicts the equity risk premium using the 10-Year and 1-Year US Treasury interest rates. Typically, investors would compare the 10-Year interest rate to equities as the duration associated with equities is longer. However, the yield curve is currently inverted (short-term interest rates are higher than long-term interest rates – generally a strong predictor of recessions), so we have also included the 1-Year equity risk premium. 

For Illustrative Purposes Only

Why should investors take equity risk for an earnings yield of 3.1% when U.S. T-bills are paying nearly 5.5%? If equities are the most expensive relative to bonds than at any point in the last 20 years, one might expect market participants to seek hedges or insurance. The price of insurance, quoted as implied volatility, is also approaching a multi-year low.

For Illustrative Purposes Only

We suspect this is thanks to the rise of 0DTE (zero days to expiration) options; these contracts, freshly minted each morning, enable speculators to bet on single-day price movements. The CBOE (Chicago Board Options Exchange) launched 0DTE options for all five trading days starting in 2022, and they have steadily grown to account for 44% of all option volume[4]. The notional value of these options is roughly $1 trillion daily[4]. 0DTE popularity has coincided with a significant decrease in demand for longer-dated option tenors (ex., 30-day), leading to the discussed reduction in implied volatility. Meanwhile, 0DTE dynamics are also suppressing realized volatility. Remember those vol control strategies? The expansion of 0DTE options has significantly driven their increased equity exposure.

For Illustrative Purposes Only

We highlight low implied volatility to emphasize the level of complacency in this market and the implied fragility should any shock factor materialize. In other words, the summer doldrums are in full swing.

On that note, let’s update a few of the uncertainty-inducing headwinds we mentioned at the onset. The BRICS-led East continues to challenge U.S.-led Western hegemony, particularly via de-dollarization. Recent rumors have included a gold-backed BRICSs currency, which may receive further clarity at the upcoming August BRICS summit. Over 40 nations have expressed interest in joining the BRICS coalition, underscoring the growing discontent with Western dominance.

The headline battle in the growing East vs. West divide is China vs. the U.S., which continues to heat up. Kyle Bass, investor and macro analyst, recently gave a compelling presentation on China’s preparation for war, specifically the invasion of strategically important Taiwan. Bass identifies three areas of change worth monitoring that would indicate impending action:
  1. From a military standpoint, the People’s Liberation Army (PLA) has run several simulations and combat readiness exercises in the Strait of Taiwan at an increasing cadence.
  2. President Xi Jinping has made several changes on the mainland, including several changes to the legal system, one of which gives Beijing the legal authority to nationalize foreign assets and investments under special circumstances, including war. China has also built 18 new air-raid shelters in the Fujian province (closest to Taiwan) and the world’s largest combat hospital.
  3. China has been preparing its financial system to minimize the effect of sanctions, including reducing its holdings of U.S. Treasuries and decreasing the share of bilateral trade in dollars. The Yuan accounted for 49% of China's cross-border transactions last quarter, eclipsing the dollar for the first time. 

We see the odds of an invasion far higher than the market appears to be (nonexistent-ly) pricing. Such an event would be the most significant escalation in global conflict since the cold war and have a long list of profound global economic impacts, resulting in shortages and higher prices (inflation). 

What does all this mean for investors? 

Regular readers of our blog will know we are partial toward an allocation to real assets, including precious metal and commodity-related equities. These stand to benefit from rising geopolitical tensions, such as the one noted above, and the Western agenda to 1) re-arm, 2) re-shore manufacturing capacity 3) affect the energy transition. Amidst the uncertainty and near-record valuations, cash is no longer a zero-return asset and therefore deserves more attention as a tactical intermediate holding. While we have harped on the S&P 500 index, and more so the Nasdaq 100, which are heavily skewed toward the Magnificent 7, we believe plenty of attractive businesses are at attractive prices outside the indices, and it's our job to find them. 

Thanks for Reading!

P.S. As a continuation from the end of our last post, we will share another mindblowing implementation of GenAI: 

Disclaimers:

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status, or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur. 

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Sources: 

All financial data is sourced from Refinitiv unless otherwise noted.

[1] Department of Labor: Employee Benefits Security Administration. Private Pension Plan Bulletin Historical Tables and Graphs 1975-2020. October 2022. 

[2] ADP. SECURE 2.0 Act of 2022 Makes Sweeping Changes to Retirement Savings Plans. 

[3] S&P Global. S&P 500 Q1 2023 Buybacks Again Tick Up. June 2023. 

[4] Ahmed. Explainer: The rise of 0DTE stock options and how they could be a risk to markets. Reuters. February 2023.