The System Is Rigged

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David Kostin, Unplugged

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Soundbite: Goldman Sachs Chief U.S. Equity Strategist David Kostin is retiring and gave his final outlook last week. He sees the top-heavy concentration of the S&P 500 as a major concern, but big tech earnings power and high margins make it difficult for managers to abandon these large caps. He thinks there is an AI bubble, but not for listed stocks, which are rich but not in a bubble relative to 1999. Interestingly, Kostin believes private markets have crossed into bubble territory based on overheated deal activity and pricing. Investors need to adjust for low single-digit returns in the S&P 500 for the next decade, not only due to high valuation at 23 times forward earnings, but more importantly, concentration. The S&P 500 is far from a broadly diversified portfolio, and investors are not pricing in the dangers inherent in such severe concentration. We agree with that view and expect investment advisors who stick to a passive indexing approach will encounter poor performance that risks losing clients over the coming years.

Kostin acknowledges that AI products could end up priced as commodities, leading to revenue forecasts that are far too optimistic. For now, discussions with Goldman clients across sovereign wealth funds, pension funds, hedge funds, and insurance companies reflect their continued enthusiasm for the momentum trade. These investors are comfortable with optimistic analyst earnings expectations.

Kostin noted that the current valuation of 30 times earnings for big tech is conservative relative to the 1999 bubble, where the largest firms traded at 50 times earnings. He cites that deal demand for IPOs is also reasonable: there have been 55 transactions above $25 million this year, while the frenzy in 1999 absorbed 400 deals of that size. However, alarm bells are ringing when he turns to the private markets, where the strategist believes a bubble has formed in the prices and number of deals.

We expect bubbles bursting in the private market would create major tremors in public equity markets.

The cycle of capital chasing inflated valuation is similar to 1999-2000 and represents a dangerous form of recursive financing. Aside from the problems of vendor financing, a reflexive process is put in motion when nondepository financial institutions supply capital to a firm. Additional capital boosts the firm’s growth forecast, which increases that firm’s value, and that in turn attracts more capital. This escalation continues as long as there is new capital demand.

His warning of “as long as there is new capital” rings true to us. At some point, the current virtuous cycle of high margins and high earnings forecast hits an unsustainable level. As in 2000, we face a real danger that the repetitive process turns on itself. A flip to a vicious circle where capital stops flowing and that causes a drop in the value of these investments creates the potential for an accelerated move to the downside.

Looking farther out, the picture dims. Goldman’s Portfolio Strategy Team forecast 10-year S&P 500 returns at 6.5%, a level that Kostin views as too confident. First, today’s price-to-forward earnings valuation levels, second only to 2000, should lead to multiple contractions. Second, David believes the inherent concentration risk in big tech’s heavy index weightings generates a “greater level of prospective volatility than in a broadly diversified portfolio.” Under normal circumstances, he continues, “you would think about an investor being compensated for the potential above-average expected volatility…associated with a narrow-concentration market. But that is not the case.”

Therefore, investment advisors need to brace their clients for uneven performance at best and look for pockets of value in depressed health care and consumer discretionary stocks. Many investors and advisors were not around for the rough environment that followed from the 2000 peak to 2009-2010 lows, but passive investing left too many opportunities unexploited.

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It’s Not the Illuminati

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Soundbite: Newsflash: The system is biased to make the wealthy wealthier. However, there is no cabal; it is institutional. There is a feedback loop that has developed between the rise of stock market wealth and growth, but it is institutional, not intentional. The K-shaped economy did not happen overnight but has been developing since 1975. Stanford professor John Paron examines the coexistence of a booming stock market and a lagging economy. The explanation for both is the severe decline in Research and Development (R&D) spending, which began when the largest corporations entered an era of buy versus build. M&A spending has doubled that of R&D spending. Paron estimates that Innovation Productivity has collapsed by 47% since 1975. Because firms no longer reinvest profits in R&D, preferring acquisitions and buying back their own stock, wealth has become concentrated among larger corporations. The problem is that their fortune has come at the cost of lower economic growth. This dynamic explains the upward trend in the Buffett indicator (the ratio of U.S stock market capitalization divided by GDP). New tax treatment calling for immediate expensing of R&D may lift declining research productivity, but there are five decades of inertia to break.

One can hope that the AI revolution will be transformative as moats to innovation shrink, and smaller firms are incentivized to become acquired, but the concentration that makes David Kostin uncomfortable will persist.

We are living through a generational cycle where the most efficient firms gain a significant advantage over smaller competitors. Capital is drawn to these efficient firms, giving them greater capital to increase their Merger and Acquisition (M&A) activity. This allows them to gain market share (dominant firms’ share doubled to 30% since the 1970s), pushing their stock price higher. Unless companies embrace innovation through their own research, excessive concentration will continue to plague the broad indices. Therefore, we are condemned to repeat this cycle over time.

As Professor Paron warns, households are disadvantaged relative to shareholders, and the increasing wealth gap is accompanied by lower overall economic growth. In the professor’s words, the disconnect between the growth of stock prices and the economy “has less to do with innovation and more to do with wealth being concentrated in the hands of established corporate giants…As bigger, more efficient firms dominate the market, they have pushed up stock prices as the slowdown in new ideas drags on productivity and growth [and wages].”

We contend that this explains why “trickle-down economics” is designed to fail. Subsidizing the wealthy will never help lower income earners unless it is accompanied by policy incentives directed at promoting R&D spending. New policies are needed because the sobering reality is that gains go to the top and stay there.

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The Woman Who Knew Too Much

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Soundbite: Nearly a century ago, an economist by the name of Joan Robinson correctly explained the instability of free trade. Trade surplus countries make the decision to subsidize manufacturing at the expense of consumption, and they take manufacturing share away from other countries that need to transition to a consumption-led growth model. This creates a reflexive process where the trade deficit countries’ persistent trade deficit gets so unbalanced that they put up trade barriers to reverse the situation. Trade collapses as one or more deficit countries withdraw from globalization. As with the U.S. in the 1920s, Germany in the 1980s, Japan in the 1990s, trade surplus countries had to restructure their economies, and a difficult period of adjustment ensued. China is doing everything it can to direct investment capital to avoid that adjustment process. The problem is that Beijing is running out of productive areas in which to invest, and at some point, it will hit a ceiling where it will be unable to expand its Debt/GDP ratio further. The U.S. has runaway debt to support consumption, while China’s soaring debt supports its production. Both trading partners are getting into debt trouble, and that is the unsustainable impasse that Joan Robinson described. Markets are far too optimistic in the face of the inevitable adjustment that the globe is facing.

We are reliving Joan Robinson’s global view that free trade is the dark side of the moon. She warned back then that the tension between surplus and deficit countries creates an unstable equilibrium. The deglobalization cat is out of the bag, and it is not going back. Trade war followed by trade contraction was as inevitable a century ago as it is now.

There are important lessons investors are ignoring from history.

There are two ways countries in the past have adjusted to a high savings, extended investment, and high growth economic model. In the 1920s, U.S. production far outstripped consumption. The gap was closed by a drop in production relative to consumption. The good news: it was quick. The bad news: consumption fell by more than 15% as production fell 35%. Japan decided to close their gap in the early 1990s between high manufacturing and weak by maintaining stable consumption. This decision caused growth to go to zero for their lost decades. The country avoided a U.S.-style depression, but while world GDP has grown 35% over the last 10 years, Japan’s share has fallen from 17% in 1991 to under 5% today.

Chinese consumers are retrenching, putting the government in a bind. The U.S. administration is negotiating with a government that realizes a reduction in its trade surplus depresses production, which results in unemployment that further depresses consumption. Beijing wants to avoid any economic dislocation, so it continues to accelerate investment to generate growth, hopping from infrastructure to property to manufacturing. We are finally concerned that China’s nonproductive investment is beyond the point of diminishing marginal returns. Beijing has reached a point of abandoning looking at profitable investment opportunities, but investing simply to maintain employment.

Investors are hoping that China, specifically, and the U.S., coincidentally, can rebalance without slowing GDP. While theoretically possible, much must go right. First, the debt fountain must continue for China to continue directing unproductive investment, but the fact is that no country has unlimited debt capacity. When you run out of debt capacity, the difficult adjustment period becomes inevitable. If their AI investments produce the hoped for major technological breakthrough that causes a surge in productivity. As with the U.S. in the second Point, if you direct those productivity gains to consumers, you can achieve a rebalancing. To narrow the wealth gap in the U.S. and the production/consumption gap in China, investors need to root for transformational change in productivity growth that will solve all deficiencies.

The problem we have with asset markets is that this is their base case. Unfortunately, the outcome is not guaranteed.

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What to Look for This Week

(All times D.S.T.)

1. Wednesday, December 10 at 2:00 p.m. The Federal Open Market Committee releases its interest rate decision followed by Chair Powell’s 2:30 p.m. press conference.

2. Monday, December 8 at 11:00 a.m. The New York Federal Reserve Bank releases its November Survey of Consumer Expectations. The report will contain updates on 3- and 5-year inflation expectations that the FOMC will consider at their meeting. It will also publish data on the probability of losing a job over the next twelve months. Consumer Sentiment is key after strong early holiday sales. An hour earlier at 10:00 a.m. we will find out the results of their Multivariate Core Trend Inflation model that generates estimates of inflation persistence. Through October, the model identified increased persistence in the common components of services ex-housing and core goods.

3. Wednesday, December 10 at 8:30 a.m. Employment Cost Index for Q3. For Q1 and Q3 the ECI rose at a 3.6% annual rate. We will see if Wages and Benefits continue to improve. Earlier Wednesday, the Mortgage Bankers Association Purchase Index is released at 7:00 a.m. The series just rose to a three-year high, so that is one measure pointing to a housing revival.

FOMC Voters Speaking: We are in the Blackout Period before the Dec 9-10 FOMC meeting. The first speakers after Chair Powell’s press conference on Wednesday are Anna Paulsen from Philadelphia and Beth Hammack from Cleveland on Friday December 12 at 8:00 a.m. and 8:30 a.m. respectively. Both regional Fed Bank presidents will be FOMC voters at the January 27-28 meeting. Departing voter Austan Goolsbee, the president of the Chicago Fed, speaks afterwards at 10:35 a.m.

Earnings: Scraps before Wednesday and Thursday. Monday December 8 Toll Brothers (TOL) reports after market. AutoZone (AZO) before market Tuesday, December 9. Wednesday December 10 after the FOMC after market, Oracle (ORCL) reports and traders will be listening to the company’s rebuttal to circular financing concerns. The tone will be set by the Fed and the press conference, so any tone against the tide set that afternoon will be a focus. Thursday December 11 after market, Costco (COST) reports and a stock that has been improving in Pave’s rankings Broadcom (AVGO) reports after market.

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By Peter Corey

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