May Market Review

Another good month for the market, with a large part of the equity indices rising thanks, for the umpteenth time, to technology companies and specifically Nvidia, which rose by 26.9%. Fixed income also joined the party due to the fall in yields (price increases) of bonds at a global level.  

Referring to the latter two indices under the same name, the difference is the result of the fall in the dollar this month.

• S&P 500: +4.8%.
• Nasdaq: +6.3%.
• Stoxx Europe: +2.63%.
• BBG Global Aggregate Bond (global fixed income index in euro): -0.22%
• BBG Global Aggregates Bond (dollar-denominated): +1.31%.    

Since the beginning of the year, all financial assets have risen except government bonds. Gold is also rising, but if gold is a safe haven asset, why is it rising when equities are rising?

There may be several explanations, but for me there are two fundamental ones:

Firstly, there is still the high level of liquidity, which is increasingly concentrated in the technology sector, together with the ever-increasing passive investment. Let’s break these two elements down.

Regarding technology companies, as we have discussed on other occasions, they are linked to Artificial Intelligence (AI), which is indisputably revolutionizing the world today. I remember at the beginning of the century the words of one of my bosses, who said: “the internet is the devil’s work because it’s like magic”. Indeed, AI is doing extraordinary, almost “magical” things, with very positive applications in our daily lives that undoubtedly make our lives easier. Sometimes I think it is better not to have life so easy because it is not taking away the ability to think.

As in the past, every technological revolution is accompanied by investment euphoria, which makes sense because these companies see their profits grow exponentially in short periods of time, and everything suggests that this growth will be unstoppable. However, it is common knowledge that there is a limit to all growth.

Therefore, we already have one of the ingredients to understand this response: the euphoria to buy these companies. The other ingredient that is part of this response is the growing demand for passive management funds, the management used by some funds or ETFS that consists of investing in exactly the same proportion as the market indices. Thus, if a company in the index weighs 2%, the manager is obliged to buy exactly 2%. The weight of the technology sector in the S&P 500 is 40%, so it would be necessary to buy that 40%, concentrating an increasingly high percentage in a few companies. 

We conclude that the combination of both ingredients causes the market to rise steadily, until, as someone would say, “they take the punch bowl out of the party”. What punch? – The reality of valuation. At some point we will realize that these companies cannot go up forever. We base these rises on “(infinite) growth” and that is impossible.   

Let’s look at it in figures. The following table shows the evolution of the S&P 500 index over the last 10 years and you can see the growth of each of these concepts in comparison with the growth of the shares from December 2013 to the same month in 2023.

Source: Factset

It can be seen that aggregate sales in the technology sector are up by 9.2% annualized, book value (in accounting) by 6.3%, free cash flow (more reliable because it does not influence accounting methods) by 7.9% and sales by 7%, while the technology sector is growing by 20.1%. Given that the price of a share correlates in the long term with the growth of its profit, then how is this difference possible, the fundamental reason is the optimism that investors have in these companies that they will continue to grow in the future.

Many investors are aware of this reality, but are unwilling to be the first to “leave the party” because, if there were still room for these companies to continue to rise, how would they justify their exit to their managers?

Others will think, “no, this AI stuff is the future”, I have no doubt it is, but how many of these companies will continue to be successful in the future? And those that do exist, will they be able to continue to grow at these rates? I am convinced that no one can know for sure, but what is certain is that there will come a time when it may be necessary to go to Mars to continue implementing AI because here on Earth everything is already done. Anything can happen.

If we look back, history shows us that the reflection I am making is not far from what has happened in the past. The following table shows the “Top 10” of the largest companies by market capitalization, in the different decades from the 80s to the 20s of the 21st century. Curiously, and except in certain specific cases, companies do not “survive” decade after decade. And this makes perfect sense. The logic of this fact is that you cannot grow forever at very high rates, and although they are still good, as the years go by they mature, their growth rate is slower and therefore their multiple is also lower.

As Mark Twain said, or at least it is attributed to him, “the past does not repeat itself, but it rhymes”.           

Secondly, the other answer may lie in the depreciation of the currency as a consequence of increased public spending.

Without getting into technicalities, in order to finance public spending, states can increase the money supply (printing money) as much as they want, with the risk of increasing inflation (a necessary but not sufficient condition). This financing of spending can be done by raising taxes, increasing debt or printing money. When the first two mechanisms have already been used and exhausted by various circumstances, states resort to printing money. Whatever the means, in the end it always affects citizens’ pockets, and perhaps printing money is chosen because the effect on the citizen is not so obvious.

This is what is currently being done in the United States, the world’s leading economic power, where the fiscal deficit is being increased in order to finance growing public spending. I recently read an article by Daniel Lacalle that the current US debt is $34 trillion and the deficit is $2 trillion a year, which sounds like a lot to me, it is 130% of US GDP. But if I tell you that the United States has a debt to its citizens through social security and Medicare (health insurance that provides coverage for the over 65s) not included in the above debt of $175Tn, that is 640% of GDP, this is much more than the “very much” of before.

If the United States has to pay for all this, it prefers to pay for it with a depreciating asset because its burden will be less. Let me give you an example to understand it better: if I owe 1000 € to a friend and I have to pay him back in 1 year, what would be better for me, for the currency to depreciate, which is the same as saying that prices will rise, or for it to appreciate? Well, let’s imagine that I have bought with that €1,000 some good that I am keeping. Just because of the effect of inflation, that good will have gone up in nominal price (the value of the currency will have gone down). I am not talking about it being the fruit of the investment. When my loan with my friend comes due after one year, I sell the asset and, as a result of inflation, I will get, for example, €1,000 + €X. I will be able to pay back €1,000 to my lender and I will keep €X profit. I would therefore prefer the currency to depreciate.

Will the American state be aware of all this? Mmmm…. I don’t know, but I don’t like it very much.

The question we were asking at the beginning was why, if risk assets (equities) are going up, why is gold going up? Let’s replace the asset in the example with gold. The state depreciates the currency for interest, but my alternative is to replace the currency with another good that maintains the value or invest in productive assets. In my opinion, this may be an explanation that makes a lot of sense and answers the question, i.e. investors are beginning to notice the increasing depreciation of the dollar and prefer to take refuge in other assets, including gold. The biggest buyer of gold in recent times has been China.         

This depreciation occurs worldwide to finance each country’s fiscal deficits, so the alternatives are investments in companies that have the ingredients to grow in an orderly manner and if we do not invest, we have the alternative of gold, so that at least the effort of our work does not lose value.        

You can access the previous month’s market commentary here.