Dimon’s Take On An Overheated U.S. Economy
Speaking on CNBC, December 6th, 2022, Jamie Dimon said U.S. spending is still 40% above pre-pandemic levels. American consumers are still burning off the stimulus cash injected in 2020 and 2021. In other words, the U.S. economy is still overheated.
It seems to me that China and Europe have already experienced a spending recession in 2022. Now, it looks as though the United States is headed for the same eventuality in 2023. In the same CNBC interview, Jamie Dimon estimated Americans will burn through the remainder of their excess cash by mid-2023. He’s exclaimed several times now that there are “storm clouds” on the horizon.
Warren Buffett has often compared buying stocks to buying a farm. Farmers understand there will be good years, and there will be some bad years, perhaps even a drought from time to time. That needs to be factored into the purchase price of the farm. The same is true for the S&P 500 (NYSEARCA:VOO) and the Nasdaq 100 (NASDAQ:QQQ). When you buy these ETFs, you’re buying a collection of American businesses. These businesses have enjoyed an exceptional boom over the past 5 years. But, legendary macro investor Stanley Druckenmiller’s warning that the U.S. economy could be headed for a few bleak years following this tremendous boom.
The last time there was a major equity bubble in the United States was the year 2000. Unfortunately, stock market exuberance didn’t forecast better business. Earnings fell for 3 years straight from 2000 to 2003. It took 13 years for the S&P 500 to surpass its 2000 peak. Now you may say, “This won’t happen again, right?” Well, it could.
Below are the S&P 500’s earnings per share over the past 30 years (In Orange):
Are rocky earnings factored into the price of this farm? Not yet. In the decade ahead, I project returns of 4% per annum for the Vanguard S&P 500 ETF (VOO) and the Invesco QQQ ETF (QQQ).
The Growth Trap
There’s much talk in investor land about “value traps,” and they certainly do exist. But, there is little talk about “growth traps,” perhaps you’ve never heard of them. A growth trap, as I define it, is a company displaying remarkable growth in revenues, cash flows, and earnings over the past 3 or 5 or 10 years. But, there’s one problem. That company’s financials are about to fall off a cliff, and its high multiple is about to fall with it.
There have been thousands of growth traps over the decades. Legendary value investor Benjamin Graham wrote about several in his book, “The Intelligent Investor,” and that was back in the 50s, 60s, and 70s. In the interest of time, I’m only going to discuss one growth trap, Microsoft (MSFT), in the year 2000 (The Dot-Com Bubble).
Microsoft was a dominant player in computer operating systems in the 1990s. Not only this, but it held the key to the internet in its browser “Internet Explorer,” launched in 1995. You could easily have argued that Microsoft was a “wonderful business.” With 40% profit margins, you’d say, “Wow, what a moat this company must have.” Then came the year 2001.
A 2001 New York Times article read, “Microsoft Profits Fall 42%,” citing investment losses and slumping PC sales as the reason. Microsoft’s net income didn’t reach a trough until 2002, and it took years to recover. Microsoft’s profit margins and return on assets also fell off a cliff:
After trading up to 60x earnings in 2000, Microsoft’s stock plummeted. And, along with the S&P 500 and the Nasdaq, Microsoft’s stock went nowhere for 13 years:
Microsoft’s “Internet Explorer” is now an afterthought. What will be an afterthought 15 years from now? Will it be Google’s (GOOG) search, Amazon’s (AMZN) AWS, Meta’s (META) Instagram, or Apple’s (AAPL) iPhones? The reality is, we just don’t know. Yet, these companies make up trillions of dollars of market cap within VOO and QQQ’s underlying indexes.
Microsoft eventually turned things around, albeit a decade and a half later. But, others like Nokia (NOK), Yahoo, and General Electric (GE) never did.
Information Technology’s been the hottest performing sector over the past 5 and 10 years:
The Information Technology sector is up 395% over the past 10 years, followed by Health Care at 219%. But, as you saw, trees don’t grow to the sky.
The biggest problem for these ETFs is the cyclicality of earnings. Let’s take a look at the cyclically-adjusted PE (CAPE ratio). This uses the average (inflation-adjusted) earnings of the past ten years. The ratio’s still sitting around 1929 levels:
If you head over to multpl.com, you’ll see that the S&P 500’s price-to-book and price-to-sales ratios are also quite stretched. As for QQQ, at the end of 2021, the Nasdaq 100 reached a CAPE ratio of 60x.
Profit margins are stretched as well:
Why Will Earnings Fall?
GMO’s Jeremy Grantham once said:
“Profit margins are probably the most mean-reverting series in finance.”
The U.S. money supply’s decreasing as the Fed engages in quantitative tightening. Higher interest rates are bad for most companies’ profit margins. The same goes for cost-push inflation. The Fed may find itself stuck between a rock and a hard place in the next recession. Cut rates or print money, and inflation will accelerate; do nothing, and the recession will be prolonged.
Another thing to watch out for is the global debt bubble. Consumers leveraged up with interest rates at zero. When debt bubbles burst, consumers tend to hoard cash. There’s a correlation between high levels of government debt and increases in corporate tax rates. I wouldn’t be surprised to see corporate tax rates rise in the United States.
My 2033 price targets for QQQ and VOO are $408 per share and $450 per share, implying returns of 4% per annum with dividends reinvested.
- The Nasdaq 100 has a PE of 23.7, giving QQQ earnings per share of $12.16. Meanwhile, the S&P 500 has a PE of 20.9, giving VOO earnings per share of $17.60. I expect the Nasdaq 100 and S&P 500’s earnings to grow at 7% and 5.5% per annum, respectively. This gives you 2033 EPS of $24 for QQQ and $30 for VOO. I’ve applied terminal multiples of 17x and 15x.
Where I’m Finding Alpha
Below are the returns by asset class over the past 10 years:
In investing, the decade to come is often completely different than the decade that came before. To make outsized returns, you often have to go where others won’t. The last decade was one of low interest rates, discretionary spend, and fiscal stimulus. Things that have underperformed over the past 15 years should benefit as the environment changes.
Everyone wants to invest in wonderful businesses, but many forget that Warren Buffett compounded his wealth at a much higher rate when he was buying cigar butts. Today, there seems to be more opportunities in the mediocre businesses. Especially businesses set to benefit from a change in management or even the macro landscape. Some of these businesses have been prospering for 50-150 years. Time is the true test of an anti-fragile company according to the book “Antifragile: Things That Gain From Disorder,” by Nassim Taleb.
I’m actively avoiding the darling better businesses that trade at high valuations, not because I want to, but because I don’t know which will be the next growth trap. Sir John Templeton and Ben Graham outperformed the market for decades by buying cheap and selling dear. As Howard Marks, who witnessed the implosion of the Nifty Fifty bubble, likes to say:
“Success in investing doesn’t come from buying good things, but from buying things well.”
So, where am I finding opportunities? In international, deep value stocks. There are anti-fragile companies out there, printing cash flow, and trading below tangible book. If you’re solely an ETF investor, I like the long-term tailwinds in emerging markets. There may also be some great value funds out there. Let me know what you find. Until next time, happy investing.