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It's a data-driven world, we just live in it. Before you retire to your August vacations, time to look at some charts.
Markets spent the first half of 2024 riding a wave of optimism. But peeling back the onion reveals an interesting trend. Per-share earnings of the S&P 500 are lower today than they were in the fourth quarter of 2021, almost two and a half years ago. And that *does not* include inflation, which was roughly 20% over that time period, meaning that real earnings are down more than 20%. (Remember that inflation tends to give corporate earnings a tailwind.)
If you look at earnings estimates for the S&P 500 though, analysts are optimistic that a steady increase is coming. Markets base their current prices on future results.
The news on inflation is generally good. We graphed the two primary inflation metrics for you below (via CPI-U). The Fed's inflation target remains at 2%, and progress toward that goal continues:
The Consumer Confidence Index remains relatively high. This metric tends to reflect what happened. It serves as a historical look-back. It's not predictive of what is going to happen.
The unemployment rate is steadily rising. The Federal Reserve is watching this closely as unemployment has a history of going quickly from a steady rise to a quick spike. From Fed data:
And credit card delinquencies are rising to 10-year highs across all age groups, which shows spending power on the decline:
Finally, on the stock market side of things, here's an incredible stat. From January of 2023 to July of 2024, the seven big tech firms of the S&P 500 are up over 140%. The other 493 remaining firms, also weighted by market capitalization in the graph below, are up about 25%. Keep in mind that investors cannot predict when mean reversion will begin, but that historically it has been a powerful force.
We have an economic slowdown, which markets wanted. Whether we will have too much of a slowdown is unclear. Analysts peg the overall chances of a U.S. recession at 30%.
Dan Cunningham
1. The Consumer Confidence Index is a trademark of The Conference Board.
2. Additional Chart Sources: Operating earnings: S&P Global / CPI-U: Bureau of Labor Statistics / Unemployment Rate: Bureau of Economic Analysis
Vanderbilt's former Dean of Students Madison Sarratt once summarized the university's honor code as such:
"Today I am going to give you two examinations, one in trigonometry and one in honesty. I hope you will pass them both, but, if you fail one, let it be trigonometry, for there are many good men in this world today who cannot pass an examination in trigonometry, but there are no good men in the world who cannot pass an examination in honesty."
The financial world should take note.
The main topic today is one that no one ever disagrees about, and one that engenders no emotion: taxes. I promised you an update on capital gains taxes, and after the quote about honesty, I feel compelled to deliver.
You cannot have a productive economic system without labor and capital, and if you are short either, things do not work well.
The reason this relates to capital gains tax rates is that if the rates are high, capital tends to lock into silos. When you are raising money for a startup, for example, an investor who wants to invest in your startup generally has to sell something else to do so. If that investor has a 30% tax to pay, she is going to think twice about doing so. In many cases she won't, and a good idea or business will wither because of the tax-imposed friction. No capital means no jobs.
This shows up in publicly traded mutual funds and ETFs all the time. One of the advantages to being an established fund player when capital gains rates are high is that you worry less about investors leaving your fund, because you know in brokerage accounts those investors will have a tax on the way out. This protects you as the establishment, and puts a headwind on the more efficient disruptor. At One Day In July, we try to figure out how to unwind this predicament for new clients, but there isn't always a good solution.
Frequently, we see similar funds from the same ETF provider, priced at different levels. It's obvious what is going on: they want to preserve the high profit margins in the older fund, knowing many of the investors cannot leave due to capital gains taxes, and yet they want to capture new money inflows and need a more competitive price. So they create a new ETF that is basically the same thing, but at a lower price.
We have inquired to these fund companies about this, and the responses would be amusing if so much money weren't on the line. Ok, ok, trying to get back to the honesty thing... the responses are amusing. We feel a little badly because the employees at those firms can't just say what we know or they'll probably lose their jobs. I mean I would be tempted to respond:
Well Dan this thing is a cash cow at these price points. I mean we have a fund manager, a few associates, a sales team, and a bunch of software on this beauty and it's running $44 billion at 0.15%. It's tracking an index we license, so not much to do! While we're out on the golf course do yourself a fun-one and run that through your calculator." (Hypothetical me did, it's $66 million in revenue.)1
We at least feel like we should put some pressure on them to lower prices.
One way to address this would be to drop the capital gains rate to zero. But this would have other issues in that capital can compound disproportionately. With no taxation on capital, ever, the system will go out of balance.
This is a hard problem. One idea is to lower rates on people who are alive and making decisions, and offset that by raising them via the estate tax on people who are not alive and not making decisions.
- Dan Cunningham
1. Note that 0.15% is still an excellent price to the investor versus most funds. One Day In July averages at about 0.06% fund fees on new portfolios, though it varies by portfolio and circumstance. Click here or here to learn more on our site (sources listed here as well).
I want to discuss two effects that often are misunderstood in American business. Both are critical to the functioning of a market system, and hence the indexes that you own. The effects are at opposite ends of the success spectrum.
On the positive side, you can see the giant profits Nvidia is generating. The gross (gross, not net) margin is coming in at 76%, and because the firm smartly does not run its own fabrication plants, every incremental chip sold drives that margin slightly higher. Nvidia invested for over a decade, taking huge risks to establish its AI infrastructure. In this case the gamble worked, and they are being rewarded.
The important thing to observe is how everyone else is reacting to Nvidia's windfall. Notice the flood of competitors trying to chip into that profit pool. AMD and Intel are furiously innovating. ARM is outsourcing designs for its customers to help them speed up their processes. Most of the big tech firms are designing their own processors, partly in an effort to pay Nvidia less. Startups are back into chip design, putting the "silicon" back in "Silicon Valley." (Sorry DoorDash).
People do not let these profit pools sit around, they go after them, trying to take some for themselves, and in the process the profit pool is competed away. This drives innovation forward.
We discussed this previously, but notice that there is a problem here with the indexer. The indexer (that's you) doesn't necessarily care if Nvidia or AMD wins the battle. The indexer owns them both. This is why I believe the index holders should not get voting say in the running of corporations. Only active shareholders, including active fund managers, should get to vote.
On the other side of the success spectrum is bankruptcy. Like profit pools, this is critical to the economy functioning well. Without bankruptcy, assets get tied up in poorly run firms, and something has to be the wildfire that burns out the dead wood, that reignites the new seedlings from the pine cones on the economic forest floor.
This is important, and you can take it to the bank: no system is going to run well that doesn't have the ability for participants to fail.
As an example, one of the reasons religion is so nominal in Europe is that for hundreds of years the church was hooked to the state. Despite Martin Luther running around nailing stuff to doors, the church couldn't really fail, and it would say pithy things but not be responsive to its members. There was no way to improve the system, so it dwindled but could not be killed off. In contrast, over the course of the American experiment, religion has been quite competitive, and churches fail all the time. This has kept them more responsive to current day needs and higher American churchgoing participation reflects that.
Back on the corporate side, the bankruptcy system in the United States is well designed, in that it is intended to preserve jobs, potentially protect bondholders, and wipe out equity holders and management teams.
By the time a firm is near bankruptcy, it generally has been removed from the index, so it's not affecting your investments directly. But well-run firms that are in the index might be buying assets from bankrupt firms and trying to refactor them, which adds value. And it matters to overall economic health.
- Dan Cunningham
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