3Q24 MARKET COMMENTARY
Easing Like Sunday Morning
It is often said that markets climb a wall of worry. Follow them long enough, and economic history can seem like one long series of crises, bust after boom, boom after bust, repeated ad infinitum. Investors have faced uncertainty and calamity since time immemorial, only to rise again, frequently surmounting the seemingly insurmountable.
Recent experience confirms this. Despite the COVID pandemic, the 2008 Financial Crisis and 9/11, the S&P 500 index has returned nearly 8% since 2000. Our young century has presented three recessions, a financial panic, numerous wars and a global health crisis, yet returns have hardly been catastrophic.
A logical conclusion is that worry can be counterproductive to the long-term investor. While this may be true, it is not a free pass to ignore risk. The first and oldest commandment in investing is don’t lose money. Every so often investors forget this and need markets to remind them.
Perhaps that’s why the risk-averse among us (you know who you are) find the current environment so confounding. The five-year return of the S&P is 16%, a full 6% above long-term averages, and that assumes you bought the index six months before a global pandemic. I’m not inherently mistrustful of strong returns per se, but when economic reality suggests caution is being thrown to the wind, I like to keep mine within easy reach.
The challenge of pricing risk today is that most economic indicators would suggest tempered expectations if not outright pessimism. 13 of the last 14 hiking cycles have resulted in a recession and an inverted yield curve is generally agreed to be the best predictor we have (it first inverted two years ago and only recently turned positive). The Sahm Rule posits that every time unemployment rises by 0.5%, a recession ensues. It was triggered in July.
Yet markets seem all-in on a soft landing. I struggle to think of a time when investor optimism has been more at odds with economic indicators. The S&P 500 has hit 39 all-time highs in 2024 and had the best start to a year since 1997. It finished September up five months in a row and seven of the past eight quarters. I will concede that GDP has been better than feared, corporate earnings have impressed and AI is really cool. But valuations were extremely demanding to begin with and seemed to capture much of this upside.
Apologists claimed the S&P deserved to trade at a multiple north of 20 when interest rates were zero and inflation was benign, neither of which are currently the case.
Trading at 26 times last twelve months earnings, the S&P 500 seems extremely rich in the context of 3% inflation and a 4% risk-free rate. Outside of the stimulus-induced frenzy post-COVID, the last time the S&P was this expensive was, you guessed it, the dot-com boom.
Suppose I approached you three months ago and said the next quarter would feature an assassination attempt on a former president, a sitting president would withdraw his candidacy four months before an election, the VIX Index (the market’s so-called ‘fear gauge’) would see its largest spike ever, and the Fed would cut rates in response to rapidly deteriorating employment data. How many of you would have surmised the market would hit a new all-time high? I don’t consider myself to be a reactive investor, but this strikes me as complacent.
My professional investing career began in 2010, and the Federal Reserve’s influence on markets has only grown since. Equities are behaving like a one-way bet on Fed policy and investors seem convinced that equities can’t go down if rates are too. While the cost of capital is important to security pricing, I would argue growth and valuations are equally important, both of which seem priced for perfection. Apologies to Lionel Ritchie, but the Fed’s decision to ease this quarter has overshadowed all else, leaving cautious investors (including yours truly) left behind.
Because I acknowledge a complete inability to time markets, I continue to look for special situations, companies that are undergoing structural change that aren’t reliant on a strong economy to succeed. Many companies I analyze are beneficiaries of government spending, whether energy efficiency, decarbonization or infrastructure budgets. It’s not because I necessarily like government spending, but because should the economy sour, it tends to continue unabated. Several are in industries that benefit from falling rates like utilities, title insurance and companies with reoccuring revenues. I’ve tended to avoid economically sensitive companies, should the employment situation worsen or consumers prove less than resilient. Time will tell if my risk-aversion is warranted. But should a recession materialize, I’d prefer to feel foolish before than after.
Thank you for your interest in Epigram Capital.
Sincerely,
Dan Walker
General Manager
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