Trees Don’t Grow to the Sky

In this episode, Lori and Lisa explain that seven stocks accounted for most of the market rally in the first half of 2023. They suggest that if the market is going to continue to go up, there needs to be a broadening out of the market with participation from other stocks and sectors. Absent that increase in participation, the market is vulnerable. Trees don’t grow to the sky.

Find out more and reach out to us on our blog.

Transcript

[00:00:00] Lori: I'm Lori Zager, and I'm here with my partner, Lisa James. We're 2X Wealth Group. We are a team at Ingles and Snyder, a registered independent investment advisor. Today we're going to address something that we wrote in a quarterly letter to our clients. The title of it is Trees don't grow to the sky and Lisa insists that most people don't know what that means.

[00:00:23] Lisa: I don't know if it's not most but I asked six people and six of them said I don't know what you're talking about so this is the basic explanation. It's used a lot on Wall Street but it's actually not a Wall Street expression and it basically means just because we have a really strong trend such as what's going on with the tech stocks and they've gone up a lot.

[00:00:46] They don't keep going at that rate forever. That's why it's trees don't grow to the sky, even though you might think that trees actually do grow to the sky. 

[00:00:55] Lori: Maybe it should be called trees don't reach the sky. Maybe that would be better. 

[00:01:01] Lisa: They grow towards the sky. It's often used in wall street when something's gone up a lot and people think it's just not going to continue at that rate.

[00:01:10] Lori: And so the reason we want to talk about it is the S& P continued its rise in the second quarter. And the same sectors are leading the charge. Technology, communications, and consumer discretionary stocks. 

[00:01:23] Lisa: And the crazy thing is that the top ten stocks in the market have gone up so much more than the rest of the stock market that the NASDAQ 100 is doing a special rebalance.

[00:01:38] To basically curb the dominance of the what's called the magnificent Seven stocks and those are the stocks. We all know that are the largest stocks in the market microsoft apple tesla google meta amazon 

[00:01:53] Lori: and nvidia 

[00:01:55] Lisa: So right now those stocks actually account for more than Half of the index's weight, which is just a giant overweight for this small number of stocks.

[00:02:06] Lori: And something I learned actually today is over 80% of active managers have underperformed the market and When I started thinking about it, it made sense because mutual fund managers, for example which are most often active mutual fund managers, they mostly have a diversification rule which requires them.

[00:02:31] to not be as concentrated and be called diversified. So they couldn't have half of their portfolio and those seven stocks and still be called a diversified mutual fund. So just when you were trying to do something good you know, So, it ends up having a problem, like drinking a glass of red wine at night,

[00:02:52] it ends up being bad for you. 

[00:02:54] Lisa: Right. 

[00:02:54] Lori: It seems to me at this point, given how much you've gotten from these ten well, I'm sorry, these seven magnificent stocks that one of two things has to happen. Either other sectors have got to really start to outperform, the market's got to broaden out, so to speak, and broaden out a lot.

[00:03:15] Or the whole market's going to go down because it's been so dominated by these seven stocks. 

[00:03:22] Lisa: So, the thing that's sort of interesting for a lot of people in the market this year is we've watched quite a few negative economic indicators. But they've really had no impact on the performance of the S& P 500. So we thought we'd discuss the reasons behind this incredible rally in the face of a fair amount of not so great economic news.

[00:03:49] Lori: So you know, why have you seen the S& P go up so much? What, what are people excited about? One of the things is that artificial intelligence is going to lead to this massive productivity boom. Or so people think. Yes. And the art, anything that has artificial intelligence, you know, in their name or on their conference call or any way associated with them, people get excited about it.

[00:04:17] Lisa: Kind of like com in the 1990s. 

[00:04:20] Lori: Yeah. I was listening that Schlumberger is now being said that they have used artificial intelligence in their oil, in helping find oil. So let's hope it helps. 

[00:04:30] Lisa: I mean we're not belittling it for certain AI can add to productivity and people are using chat GPT and idea generation and shorten the timeframe for doing certain things.

[00:04:42] So we're not, we're not dismissing it as just a question of, is it going to be such a big boom that all of these stocks are really worth the prices they're trading at today? 

[00:04:54] Lori: Trees don't grow to the sky. Also there's been a fair amount of liquidity provided by the Treasury, 580 billion, and that was done because there was concern about the debt ceiling.

[00:05:08] And that amount that was put into the system was bigger than the liquidity being taken away by the Fed as they were letting their balance sheet run off. They took out about 300 billion, so more money in the financial system. Usually leads to rising equity markets. 

[00:05:25] Lisa: Another important reason for the market going up is that the consumer price index has really fallen dramatically, faster than people expected.

[00:05:35] Even people that did think it was going to come down, didn't think it was going to go from over 9% in 2022 to actually only 3% in June of 2023. 

[00:05:49] Lori: But the market's ignoring that the Fed's preferred measure of inflation, which is different than the CPI, it's called the PCE, it is not easing. In fact, it's gone up a little bit.

[00:06:01] And I don't know, anybody that's gone to the gas station or gone to the grocery store or done anything, I think has experienced a man on the ground at higher inflation.

[00:06:13] The other thing that's really helped the market is that some of the sectors are reporting better than expected earnings.

[00:06:20] Now you could say this is a little bit of a game because earnings expectations have been lowered quite a bit, but consumer discretionary technology and housing companies have reported some pretty good numbers, and there's a couple of reasons for why this is happening. 

[00:06:40] Lisa: So one of the reasons is that consumers really drive the economy and people in the United States have jobs.

[00:06:49] Employment continues to go up. And consumer balance sheets are flushed with cash, and that means that they can continue to spend. And they are spending. It's shifted. It's shifted from spending on goods to spending more on travel and restaurants and other types of services, but the spending is continuing and consumer spending is about two thirds of the U.

[00:07:14] S. GDP. So that's very meaningful. 

[00:07:17] Lori: The housing market is, is, is tight and the problem is there's a dearth of existing homes after the we overbuilt in the 08 09. Time frame that ended and people are forming families and wanting to buy homes and there haven't been as many homes built. So you have a, a lack of new houses and people that are in their existing homes don't want to sell them.

[00:07:44] And another reason they don't want to sell them is. They may have a very low mortgage rate that if they were to go out and buy something now just on the, you know, the mortgage expense would be twice as much as what they're currently paying. So, people are kind of sitting there saying that they'll just stay in their, their homes.

[00:08:03] Exactly. 

[00:08:04] Lisa: And one other thing that has been helpful to the market is that companies. have refinanced a lot of their debt. They did it when rates were low. So, when, I mean, during 2020 and 2021 to zero and even for corporations they were in the one to two percent range for better quality corporations. So they issued a lot of debt because it was a great rate and to the extent that they wanted to either buy.

[00:08:35] Lori: You're off, you're off, Lisa. You're way off. You're a whole page off. After, after housing, after housing, we need to talk about, after the housing market, Lisa's going to talk about lower commodity prices. Okay, 

[00:08:50] Lisa: go for it. So, another thing that's really affecting the market is lower commodity prices. So if if gas prices go down, lumber prices go down, et cetera, these are all the input prices that go into things like technology semiconductors use energy builders use wood and other materials, so when these prices are lower, it makes companies more profitable.

[00:09:18] Like, if they can keep their price that they sell their product at the same and their input prices go down, that, that's a great benefit for companies. 

[00:09:28] Lori: And then lastly, there's there's FOMO, which is fear of missing out. And those of you that know me, know that I don't have an ounce of FOMO in me. So I guess we still think there's a likelihood of a recession.

[00:09:44] Really the best indicator of recessions has been an inverted yield curve, but the timing of when that can lead to recessions you know, it can, it can take quite a while. And 

[00:09:56] Lisa: the other thing is that if you look at past history, The stock market can stage a giant rally right into the beginning of an economic downturn.

[00:10:08] And if you listen to Federal Reserve Chair Powell, he often says that the economy It reacts to the Fed tightening, and the Fed has tightened a lot, raising interest rates and letting bonds roll off in their portfolio, that, that the economy reacts with long and variable lags. He's probably said that about a hundred times since they started raising rates, so.

[00:10:32] Well, we have these signs, the signs aren't about what's going to happen tomorrow, it's about what's going to happen eventually in the future. And often it can take 12 to 18 months after the Fed has been tightening for a recession to occur. And one thing a lot of people don't know about is that the majority of recessions are caused.

[00:10:55] By the Federal Reserve tightening because what they're trying to do is slow down the economy so they can bring down inflation. And this recession might not, if we have a recession, It might not come in as quickly as people think because we had an enormous reaction to COVID. We had a lot of stimulus and a lot of cash being put into the system.

[00:11:22] And, and there's been a giant bounce back of the economy and that's been so strong. It's going to take more to curb it. And the Fed is saying... They will. They're going to raise rates again in July, so, you know, it's not like they're stopping here. 

[00:11:37] Lori: So, really, the consumers, they have jobs and their balance sheets are flush with cash, so that means that they can continue to spend.

[00:11:46] And that's something you haven't really gone into you know, other difficult times with. On top of that companies they refinance much of their debt when rates were low so they don't need to raise money at current high interest rates and They can use the cash that they've got on their balance sheet or their load relatively low debt levels to Purchase equipment their own stock or buy other companies So even though it hasn't happened yet we do think it will happen and I guess You know if you wait long enough anything can happen, but it just seems to us that you know, just because the market is going up doesn't mean that we aren't going to have a recession.

[00:12:30] Lisa: Yeah, given all the indicators that one is relatively likely to happen. But, you know, if you look at what market prognosticators are having to say about the timing of any recession, uh, are some people who think we'll have a soft landing and no recession will occur, but a lot of people think. It's probably later into the fourth quarter of this year or the first quarter of 2024.

[00:12:57] And right now the market is having a very strong rally and it's broadening out to include more stocks. So while that's happening, you know, people go along for the ride. So I don't think we're going to really see a reversal until we get some negative news. 

[00:13:15] Lori: The question is what's going to, you know, what's going to cause that?

[00:13:18] Is it going to be continued rates, rate hikes from the Federal Reserve? Is it going to be you know, a problem on the commercial real estate business that Lisa and I were talking about earlier in this country? I mean, especially, yeah, they've got them, you know, which is a problem for the banks. 

[00:13:38] Lisa: Return to work has not really been strong enough to help the commercial.

[00:13:42] Real estate companies because they still don't have enough occupancy 

[00:13:46] Lori: of offices No, so that's, that's going to be a problem. I mean, in San Francisco, we've had horrendous problems in downtown San Francisco where, where we live. You know, one of the biggest malls on Market Street, which is a pretty famous street here in San Francisco is I guess what they, they are going bankrupt.

[00:14:07] Is that correct? Yeah, 

[00:14:08] Lisa: a lot of businesses have 

[00:14:09] Lori: pulled out and that the, yeah, Old Navy and Nordstrom that were. You know, where anchor tenants are gone well Old Navy wasn't, but it was proximate to that mall. Two of the biggest hotel chain, or two hotel complexes have just abandoned, you know, said they weren't going to pay on their note anymore.

[00:14:29] So. You know, so I know a lot of people here in town are very negative on San Francisco and are very Concerned including a young friend of mine. I sent him something today today. It's been like I don't know I think oh, it's 10 year the 10 year anniversary of when Detroit defaulted on its debt and so I sent him the article from a news publication and I said San Francisco will come back, but it could take, it could take a decade.

[00:14:56] Lisa: Yes, but we've been through this before and we have come back before, but I do think that San Francisco gets a pretty bad rap also because of the homeless situation and sometimes I feel like it's a little overdone because I seem to find myself going to other cities where there are homeless issues.

[00:15:15] So, uh, you know, I'm not sure that San Francisco deserves quite as much attention on that front as it 

[00:15:22] Lori: deserves. Nationwide issue. So anyway, we are cautious. On the market we are invested, but we are the last thing I want to do is throw a ton of money into the market to watch, to head right into a downturn.

[00:15:38] And the indicators are still Pretty negative out there. The yield curve remains deeply inverted. And that's 

[00:15:47] Lisa: actually related to a Statistic that is provided by the New York Fed And it's it's considered the probability of recession in the u. s. 12 months ahead And so if this is a great chart that we have in our blog and it shows that based on this probability the, the number is actually close to 71% probability of a recession.

[00:16:19] So I mean, you know, it has predicted pretty well most of the recessions that we've gone into. And certainly at 80%. It has, it has always led to a recession. So you know, things can always be different, but we don't think it's highly likely. 

[00:16:37] Lori: Money supply is measured by M2 is still shrinking. You've got corporate profits on a trailing basis peaked in the second quarter of 2022.

[00:16:48] And that's as measured by the national income and production accounts. income and product and product accounts. And third quarter 22 2022 is when it peaked according to the S and P. Bank lending standards are tightening. 

[00:17:06] Lisa: Yeah. And that's really a bigger issue because. Bank lending standards tightening means that it's harder for people to get money to grow their business or buy a house or, you know, whatever it is they might need a loan for.

[00:17:21] And when this happens, it's usually associated with future job 

[00:17:26] Lori: losses. And the other thing that is concerned to us is given how much some of these stocks have gone up, and given the fact that, as I said, it's a little bit of a game, that earnings estimates have come down and that's why people have beaten expectations, you've had margin expansion.

[00:17:45] Right. And so that's 

[00:17:47] Lisa: So this, in terms of margins, it means that, I'm sorry, not margin expansion, it's, it's 

[00:17:54] Lori: It's multiple. It's multiple expansion. It's multiple. Yeah. That's a problem. We just found a problem in the blog. 

[00:18:00] Lisa: Okay, maybe we should start that one again. Okay. It was bothering 

[00:18:04] Lori: me. It was bothering me too.

[00:18:07] Okay, we'll start again. As, you know, you've had stock prices going up and you've had earnings, although they're beating expectations, they're not going up as we just said. You've had earnings. So, corporate profits actually peaked either in the second or third quarter, depending on which service you're listening to.

[00:18:27] So, the reason why stocks have gotten gone up or gotten more expensive is because of multiple expansions. So, people are paying more for any. Set given amount or set amount of earnings So that 

[00:18:41] Lisa: tends to be a riskier market environment Absolutely, if earnings were going up and multiples were kind of staying the same you'd say well that makes sense because the company is making more Money, but if earnings aren't going anywhere and the price is going up you're saying well, I'm just now paying More for every dollar of earnings than I was last year, which is basically what's happening 

[00:19:04] Lori: Okay, so The problem is, do you really want to throw all your money into the market right as you may be going into a recession?

[00:19:14] Yeah. And the problem 

[00:19:15] Lisa: is that stocks usually bottom in the middle of a recession, not even the 

[00:19:19] Lori: beginning. Definitely not before. So given that it looks like we're going to have a recession, and according to the New York Fed's probability, the chances are at 70. 9%. We just want to have a little bit on the sidelines.

[00:19:37] Now we've also said, and we'll see if we end up being right about this, that inflation is going to be slow to fall further because of tight labor world, labor markets in the world and also because of deglobalization trends. And it appears that And we'll just have to see. Let me just say that.

[00:19:59] We'll just have to see whether we're right. Cut that, Collin. No, no, no. I'm just saying I can't talk 

[00:20:05] Lisa: anymore. Okay. Because I have to go do 

[00:20:07] Lori: this appointment. Okay, so we'll come back. We'll come back. I'm going to hit stop at this point. Okay, 

[00:20:15] Lisa: well, people think prices are higher. Partly because we had so much inflation in 22 inflation was 9%.

[00:20:25] If they go to the grocery store, I think grocery store inflation was, you know, in the teens. So they go to the grocery store. Even if we had zero inflation this year, they would still be noticing the 12% increase that happened in 22, but, But really what's going on is we had a big move. Everything seems expensive, but in 2023, in fact, inflation has now fallen to 3%.

[00:20:51] So it's not like prices are going up in the same leaps and bounds that they've gone before, but they aren't going down either. They're just increasing at a slower pace, you know, more like 3%. And so that's noticeable, but obviously not nearly as much as last year. 

[00:21:10] Lori: And they've been on the rise really since 2019.

[00:21:17] Went down a little bit at the beginning, at the end of last year, but they've been kind of on the rise since then in terms of, of expectations of inflation. And as I said, if you go to the grocery store, or have any service done, or fill your car with gas you know what, what it feels like. And actually...

[00:21:36] Well, we've 

[00:21:36] Lisa: had inflation already, so the price change last year was really what people feel, so... Just because prices stay the same, they're still high. The question is, are they going higher as fast as they have before? And in fact, that is not happening because we don't have 9% inflation this year. So, it's a little bit different.

[00:22:00] I mean, the prices aren't going down. 

[00:22:03] Lori: What happens is... They're going up, just at a slower rate. You get disinflation, 

[00:22:07] Lisa: which is the rate of inflation is falling. But it doesn't mean that prices are falling. It just means they're not rising as quickly. 

[00:22:16] Lori: And on that note, we have an interesting chart in our blog that show that lower energy prices are really the big reason why the CPI has come down so much.

[00:22:27] Not included in the ex food and energy part of the CPI, but the regular, if you just look at the CPI itself the biggest reason why the CPI has come down is because of energy costs. And what we would say about that is watch out. And it's just that you know there's been a concern on our part about supply.

[00:22:49] Um, the IEA last week just raised their forecast of demand and set prices going up. And the IEA is always too low in terms of their demand assumptions. And, uh, you know, we've had very, very warm. Winters, which have been good. Now we'll see how bad these... Hot summers are for energy prices. They aren't good for energy prices.

[00:23:13] It's just something the Fed can't control and so They can try and put the brakes on as much as they want to but they can't really control energy prices They can control a bit of the demand but as we've talked about a lot of the demand these days is for energy, uh, is coming from outside the developed countries.

[00:23:33] And places like China and even developed companies, countries like Germany, who've decided to decommission their nuclear plants, are burning coal, which I would argue is even worse for the environment. 

[00:23:46] Lisa: So, we'll close with a, another commonly used market experience, uh, market expression, which is, don't fight the Fed.

[00:23:56] A lot of market experts are concerned that the Fed's going to ultimately harm the economy by pursuing their goal of lowering inflation to 2%, and historically when the Fed tightens dramatically A recession typically follows and while this one seems to be taking quite a long time because of all of the stimulus that's left over from the pandemic there's still a fairly high likelihood that a recession will once again be created by the Fed.

[00:24:32] Lori: So, as we've said, our portfolios have a bit of a value bend and, uh, we are underweight the tallest trees. That's all for now. Please feel free to reach out with any comments or questions. You can reach us on our website at 2xwealthgroup. ingels. net 2xwealth. 

[00:24:54] Lisa: ingels. net 

[00:24:55] Lori: You can reach us on our website at 2xwealth.

[00:24:59] ingels. net or email us laurie at 2xwealth. ingels. net or lisa at 2xwealth. ingels. net Until next time!