The Weekend Edition # 123 - Lessons from Buffett

Welcome to another issue of the Weekend Edition!

Thank you to all who’ve read and welcome to all the new subscribers this week!

Here's what we cover

• Market Recap - Equities Melt Up

• Lessons from Buffett

• Earnings - Increasing S&P 500 Targets

• Closing Thoughts - Uncertainty in the Air

• Calendars

Market Recap - Equities Melt Up

February 19 - February 23, 2024

A mixed week as markets adjusted to higher rates and the idea that the Fed will hold rates higher for longer. The Fed’s meeting minutes and Fed speakers during the week indicated that they are in no rush to cut rates and with that we saw the market starting to price in 3.5 rate cuts down from 6 cuts earlier in the week.

However, the positive sentiment and investor positioning in the market are quite high, bolstered by better-than-anticipated data from the US and indications of an upcoming recovery in global manufacturing.

Add to that we saw Nvidia smash its earnings result fueling a global rally in developed markets and technology stocks.

The path of least resistance for the market is quite likely higher. But we’re looking at a “blow-off top scenario” here. Led by the narrow Mega Cap Tech stocks, we’re seeing a massive divergence between stocks and bonds. Can the market go up from here? It certainly can. But with yields inching higher, and the bond market pricing in the reality of fewer Fed cuts, we best be cautious over the next month.

Commodities

A quick note about EV battery materials:

• Nickel producers outside China cut 2% of global supply due to cost pressures, leading to a temporary 5% rise in LME nickel prices amid US sanctions uncertainty and market speculation.

• The nickel market's supply glut persists despite production cuts, suggesting the price increase may be short-lived.

• Lithium has seen potential supply disruptions reported, but data does not yet show a significant impact, with ~40kt supply reduction by Australian producers offset by lower EV sales forecasts.

• Lithium prices may continue to fall until substantial supply reductions are implemented.

Some of the charts in the recap section have been sponsored by Koyfin. We have a special discount of 15% for MacroVisor readers for any new sign-ups to Koyfin. To take advantage of this promo please sign up here - Koyfin MacroVisor Discount

Lessons from Buffett

Berkshire Hathaway released their earnings report and Warren Buffett’s annual letter. This year’s letter starts with a tribute to the late Charlie Munger, Buffett’s long-time friend and mentor. He quotes Charlie’s most important lesson:

We’ve heard this quote countless times but, we often forget it. We still bottom-fish for companies, and buy thinking we’ve won because they “seem” cheap. Quite often there is a reason that a company is cheap, and not always a good reason.

Of course, this is not always easy.

So there always remains an element of uncertainty in picking stocks… nothing is ever a sure winner! A lesson we need to remember now, more than ever.

Then comes the other side to it… whether we’re paying a fair price for those wonderful businesses. Much of what we see in the markets is chasing for “fear of missing out”… a term that’s on the tip of our tongues all the time - FOMO! We’re driven by emotions rather than reason, and quite often it’s just easier to jump on a bandwagon and not do the work.

As Buffett later talks about in his letter, quite likely the reason for this is:

We have gamified the stock market… but not to the advantage of individuals investing their hard-earned money.

This year Buffett mentioned analogies to 2001, 2008, and of course 1914 - all periods of market crashes, warning that investors are no more stable than when they were back then. A stark warning of sorts:

All the above quotes are from the annual letter.

I could never do justice to Buffett’s letters and these are but some of my own takeaways. I would urge you to read the letter for yourself. It won’t take long and it’s always very simple.

Earnings - Increasing S&P 500 Targets

Over the course of the last week, both Goldman Sachs and UBS increased their price targets on the S&P 500.

Goldman Sachs increased their target from 5100 to 5200 with EPS growth to $241 from $237.

UBS increased their target from 5150 to 5400 with their 2024 EPS to $240 from $235.

A bullish earnings season, and better-than-expected US GDP growth have led both to factor in an increase in earnings for the year.

UBS, however, is also quoting a reflationary scenario that will drive earnings. Now, while it’s true that we are seeing manufacturing come back to a large extent, on the negative side we are also seeing good demand fall. Both Home Depot and Walmart reported this week and discussed a slowing consumer.

In fact, if we do get a strong acceleration in inflation from here that is expected to drive earnings, that could mean rates will remain higher for longer. In a situation where that happens, we’re likely to see margin compression and multiple compression.

So, I find it interesting that many of these calls are predicated on the fact that P/E multiple is at 20x to 21x.

We know that’s not the long-run average (which is about 16x - 17x for the S&P 500) and we also know that the current P/E of 20x is based on a lopsided increase in multiples of the Mega Cap tech companies.

The companies that dominate the market have a higher P/E and therefore have pulled up the multiple for the overall market. The equal-weight S&P 500 index still retains a P/E of 16x.

Multiples for the rest of the market can and probably will increase… but that will come with rate cuts. When rates start to normalize, we are likely to see multiple expansions. But, then that negates the view that inflation is what is driving earnings growth.

What none of the banks dispute is that the growth will continue to be largely driven by tech, and then buybacks. I don’t dispute this to be true. However, I do think that there will be somewhat of a slowdown in earnings growth for Mega Cap tech, as the market starts to broaden out.

I can definitely understand the case both the banks are marking and they are viable. However, I think the real growth in earnings will likely come towards the end of the year - Q3 and Q4 of 2024. By that time, we are likely to see a decline in rates because the Fed starts cutting and that could very well increase the margin and multiple expansion for the rest of the market.

Now, whether the market actually reaches 5200 or 5400, will likely be based more on momentum and positioning. We learned the hard way last year that setting these price targets can be a very academic exercise and that the S&P 500’s levels can be driven by the momentum of a handful of stocks.

We’d really like to see earnings growth driving price for the rest of the market and we think that turning point will come later in the year, which is why we still have opportunities to buy undervalued stocks in energy, healthcare, and industrials, outside of Mega Cap Tech.

Closing Thoughts - Uncertainty in the Air

The path to normalization is mired with landmines for developed markets. We have the sticky last mile of inflation which is now more internal, we have recessions brewing and geopolitical tensions – all of this make the next few months quite uncertain.

Geopolitical tensions are being acknowledged but we don’t see that in the way markets are hedged for the left tail risk. This is because supply is still intact, production is ongoing, and the decline in demand is absorbing some of the pressure. But we do still consider this to be a risk that should be hedged further.

Even with equity markets, all we’re seeing is euphoric call buying and even though markets are at an all time high, downside hedging is minimal. The bullish macro backdrop and improvement in earnings is certainly helping but, we seem to be at extremes.

I can’t help but ruminate on the lessons from Buffett this week. A good part of his letter was a discussion in risk management and how well-placed Berkshire is, to withstand a crash. It felt very ominous. He also talked extensively about the difficulties of the railroad business and regulatory changes in utilities, something he didn’t anticipate fully. It just goes to show that not even the best investors can avoid risk.

Let’s be careful out there.

Have a great week ahead!

Sincerely yours,

Ayesha Tariq, CFA

There’s always a story behind the numbers.

Calendars

US Earnings

US Economic Calendar in Eastern Time (Source: Trading Economics)

None of the above is Investment Advice. I may or may not have positions in any of the stocks or asset classes mentioned. I have no affiliation with any of the companies other than explicitly mentioned.