A Little Breathing Room

April 2024

This should be a good year for returns.

The economy continues to perform well. Geopolitics, while not comforting, have not worsened. Stocks in the first quarter moved higher linearly, led mostly by artificial intelligence hardware and software players, and bonds have been flat to down as interest rates have risen. Big picture inflation is improving, but month-to-month remains an inconvenience for Federal Reserve policymakers.

Consumer price inflation for March was slightly higher than expected, for the third month in a row. Investors see this as a sign that the Fed will wait longer to cut interest rates. This is a psychological negative, as everyone from credit card users to home buyers to governments like to have lower costs of borrowing.

Speaking of, interest paid on the national debt is a yawner for most newsletter readers, but it is an important issue, and it’s not getting better - it was more than the Defense budget in 2023.

What is more fun to discuss is artificial intelligence. It is thought of so grandly by industry insiders, I must not be doing a good job of appreciating its breadth of applications. Even if you discount their enthusiasm - that the productivity improvements are on the order of the light bulb and the computer - you’re looking at a significantly more efficient labor supply and economy going forward. Like the plow, the engine, the internet - society was slow to adopt those too - higher productivity means you can do more with less. Costs fall, inflation is tamed, demand increases, and the economy surges.

In the short run, however, inflation is a sticky thing. When it’s your experience that rent, insurance and food go up 3-4% every year, it takes a few years of actual prices being up less for you to reduce your expectations. Those expectations are what the Fed is fighting, just as much as the actual prices.

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For the last few years, punctuated by this first quarter of 2024, large cap growth stocks have stolen the show. Tech stocks specifically have outperformed other areas of the stock market. I love the economic dynamism of tech. But investors can and do get carried away in their ebullience, and overvalue them so that future rates of return may be lower. I don’t want to avoid big tech companies as they benefit from AI adoption, but other segments like small cap and value may show better relative stock price performance.

This chart dates to the 1920s and shows the fluctuation of how much of the market the largest stocks make up. They’ve only reached this high a concentration a couple times before, with the stocks of smaller companies enjoying better relative performance for several years after.

Who knows if large caps have peaked, but history suggests it’s wise to include small cap and value in the portfolio going forward.

Sincerely,

Chip