Those who ignore history are doomed to repeat it.

The stock market in 2023 ended on a positive note as the economy has proven more resilient than most thought in the wake of higher interest rates. Furthermore, late in the year, investors began to anticipate significant rate cuts in 2024 as inflation has come down from 40-year highs. This has sent valuations for some stocks skyrocketing yet again and left the lessons of 2022 and history in general by the wayside.

Although it has been 16 years since the last (non-pandemic induced) recession, we believe it is a bit too early for central banks to declare victory.
While investors have cheered the prospect of lower rates, they should be careful what they wish for. Aggressive interest rate cuts may signal underlying economic weakness that would hurt the very stocks they have been bidding up.

The excesses of 2021 have returned. Technology stocks rose over 50% in the past year. Crypto currencies have somehow rebounded amidst massive frauds and increasing government regulation. Artificial intelligence (AI) emerged as a tangible reality with an announcement of a partnership between Microsoft and ChatGPT. Minds immediately spun at the possibilities (and threats) of AI. One company, Nvidia, was able to take advantage of the excitement given their chips are well suited to support this technology. Large technology companies fell all over each other trying to buy up as many of these chips as possible. A gold rush mentality ensued.

Remember the lessons of history. Back in 2000, the internet was booming, and prospects also seemed infinite. There is no doubting the progress in the 23 years since, but it did not happen overnight. Bandwidth seemed to be the only bottleneck, so any company with fibre in their arsenal was bid to the moon. Unfortunately, investors in WorldCom and Nortel will remember how that gold rush ended. Much of the fibre laid leading up to the crash of 2000 remained unused for years. Similarly, AI is a revolution that will play out over years if not decades, not quarters.

Another red flag in the market is the lack of breadth, especially in the US. This is a way of saying that most of the returns of the S&P500 were generated by a very small number of stocks; just seven in fact. These seven stocks alone generated over 70% of the S&P return. The price to earnings multiple for these stocks is above 40x earnings compared to 22x for the index. This is expensive by any standard, but particularly in a higher interest rate regime. In Canada, it was a similar outcome though more muted, given a smaller weight for technology in the TSX.

While optimism is a hallmark of all equity investors, it’s important to temper that optimism in order to protect against downside risk. We believe that, in many cases, current valuations are difficult to justify based on corporate fundamentals. While much of this is reminiscent of the late 90s internet boom it also brings to mind the “Nifty Fifty.” This was a group of stocks from the 1970s that investors were expected to blindly own regardless of valuation. While many of these companies were growing profitably, their P/E ratios exceeded 40x on average (seem familiar?), and when the market crashed these companies significantly underperformed. Valuation mattered! Many a good company took years to recover their values while others ceased to exist a decade or two later.

What is interesting about these history lessons is the similarity in the environments of today and then. In 2000, it was an internet fueled boom and “gold rush”. In the 70s it was the idea of blindly buying a basket of growth stocks. In both instances extreme valuations led to significant losses. Moreover, in the 1970’s, inflation and higher interest rates were the catalyst to the crash.

So, what now? The economy has been resilient, and inflation has subsided, but is not necessarily beaten. Geopolitics are an ongoing concern which could lead to further instability and supply chain shocks. We have a 2024 election looming in the U.S. that will be hotly contested and closely watched. We have stock markets, particularly in the U.S., which are expensive.

The good news is that we do not own “the stock market”. We invest in companies. There are many sectors of the market that have been ignored as momentum drove investors back into speculative assets. Telecom, consumer staples and healthcare stocks, for example, generate consistent and considerable cash flow, and healthcare in particular is inexpensive by most measures.

Predicting short-term market moves is very difficult, as the last few years have shown. Building durable portfolios that generate stable cash flows and capital growth requires discipline, particularly during times when the most speculative stocks are leading the market higher. We are not traders, and we do not believe that it is possible to consistently predict short term market movements. Any company that is added to your portfolio is subject to intense scrutiny by our investment committee in the context of holding it for at least 5 to 10 years.

We greatly appreciate the trust you have placed in us and look forward to working with you in the coming year. All the very best to you and your families in 2024.