Earnings, A.I., and Where Stocks Are Cheap

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This is the year of the bond. Bonds in America are a little bit like the cicada bug. I mean, they show up once every 17 years and then they disappear again. I think we'll get one good year out of the bond market. So this is the year.

Hello and welcome to the Barron Streetwise Podcast. I'm Jack Howe, and the voice you just heard is David Kelly. He's the chief market strategist at JPMorgan Asset Management, and we'll hear from him on all kinds of market-y things. Should we sell in May and go away? What to make of Bitcoin's recent run-up? How worried we should be about the debt ceiling standoff— normal worried or extra worried? We'll also say a few words about earnings season, big tech, AI, and movies, including the Mario Brothers one. I got an X game and I'm definitely Bowser on the landship, if you know what I'm saying.

Mamma mia!

Listening in is our audio producer, Meta. Hi, Meta.

Hi, Jack.

It's late April heading into early May. You step outside, you breathe in, what do you smell? Uh, first quarter earnings season. Exactly.

And it's going to say allergies.

You got to take a Claritin for that. The earnings at least are going better than expected. We'll talk about that in a moment. Let me just say a quick word about movies. I'm curious about if and when movie theaters are going to get back to pre-pandemic levels. McQuarrie says that last year's box office revenue was down 35% from 2019. That's the pre-pandemic benchmark. But the first quarter this year is only down 28% from the first quarter of 2019. In other words, we're getting closer. And McQuarrie says that the movie slate for the rest of this year looks particularly strong. I'm looking at a list here. There's Guardians of the Galaxy 3 starting quite soon. Maddow, it would help the podcast if you would do just some voice sound effects for these. I don't mean to put you on the spot, but Fast and Furious 10. Vroom, vroom.

Exactly.

Little Mermaid after that. Ah, ah. I don't know what that is. Indiana Jones, then Mission: Impossible, then Barbie. There's a Captain Marvel 2. I will not ask you for Hunger Games, but I will ask you for Aquaman and the Lost Kingdom in December. That's Aquaman. Thank you. And the report points out that the theatrical window seems to be making a comeback. By that I mean the amount of time where a studio will send a movie to just be in the movie theaters. They're not yet putting it on streaming. For a while there, they were putting them in the theater and on streaming on the same date because the movie theater business hadn't come back yet, but they're gaining confidence because there's been some big movies.

All right, that's the goal.

There's the Super Mario Brothers movie, which has now generated about $900 million in global box office. I believe that's the best-selling video game-based movie of all time. Meta, did you ever play Mario Brothers or Mario Kart?

I think I did when I was like a very little kid.

Was there a little guy jumping around and hitting some mushrooms and there were gold coins? Exactly. That's the Mario Brothers. And then the new one, or, you know, not new, but the one that is very much still getting a big audience is the Mario Kart. And that's where you race around as characters from the Mario universe.

So $900 million sounds like a lot for an animated movie. Is it?

Yeah, just for comparison, the top-grossing animated movie of all time is Frozen 2, and that's $1.4 billion worldwide. So the Mario Brothers are probably pretty soon past The Lion King. It'll probably creep up toward Toy Story 3, Toy Story 4 territory at just over $1 billion. Let's move on to earnings. We are about halfway through the reporting season for first quarter earnings for the S&P 500. It is always important, but it's particularly important now because the index has run up this year, earnings estimates have been falling, and that seems like the kind of thing that can't continue forever. We're already expected to have an earnings decline for the quarter. So if things get much worse than that, you wonder if stock prices can hold up. But so far, so good. I'm looking at a report from a data source called Refinitiv IBES, and they say that the blended earnings growth estimate— in other words, you take the companies that have already reported and you mush those together with estimates for the ones that haven't yet reported for the first quarter, that estimate is a 3.2% decline for earnings. That's a little better than we thought it would be. They say that companies are reporting earnings that are 7.9% above expectations. And the long-term average upside surprise— I mean, there's always an upside surprise because companies and analysts seem to magically guide low every quarter, but The average is 4.1. So if we're getting 7.9, we're running above average on the upside surprises. So, you know, a lame quarter for earnings, but not as bad as it could have been, maybe. Revenue growth is estimated at 2.3%. That inflation is coming through and it's driving revenues higher. Companies aren't necessarily improving their margins. In fact, their margins are declining a bit. This past week, we saw earnings from big tech and big tech could not be more important at the moment. One investment bank this past week pointed out that the market rally this year has been driven by the narrowest leadership of any upmarket since the 1990s. Among companies driving returns have been Microsoft, Google, Amazon, Meta, Nvidia, and Salesforce. That explains more than half of the market's performance. And it points out that what those have in common— I mean, they're big tech companies, yes, The performance has been driven by the giants. Yes. These are all companies that have something to do with artificial intelligence, and that has been a hot topic because of the popularity of ChatGPT, which is Meta.

What will soon be doing this podcast.

Exactly. A lot of the AI applications I hear of seem distant, like self-driving cars. Or already here, but maybe fluffy, like a deepfake video of your favorite or least favorite politician doing a goofy dance. But increasingly, Wall Street is focused on AI applications that are making real money for big companies right now. Morgan Stanley points out that at its recent tech conference, a Microsoft vice president of cloud and AI said that A developer tool called GitHub Copilot was increasing productivity of its developers by 55%. There are also sales tools that can handle summarizing notes and planning meetings and sending emails. In the past, users on Facebook and Instagram saw content based on their family and friend connections. Increasingly, they're seeing it based on AI recommendations, and AI is helping to recommend the ads too. Things like these mean you need fewer workers. Morgan Stanley says forward hiring levels should arguably be smaller and more targeted due to rapidly emerging AI productivity drivers. And labor is a big cost for tech companies, so that could be an earnings driver going forward. As an example, Morgan Stanley's financial model for Facebook's parent Meta, it assumes 10% headcount growth in 2024, but Now, Meta says that it doesn't expect to add more than 1 to 2% going forward. So Morgan Stanley now points out that if you had 2% year-over-year growth in 2024 rather than 10%, the difference would add $1.20 to earnings or 8%. That's a big difference. Meta, we should take a fresh look at AI in the weeks ahead. Would you say we should do a deep dive? That's what people say. Corporate settings.

We should do an extraordinarily deep dive.

I'll put my flippers on right now. Did this scuba suit shrink? I feel like this used to be roomier.

I got to be honest with you. I think it did.

Coming up, my conversation with David Kelly from JPMorgan Asset Management. That's next after this quick break.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.

Welcome back. I feel like it's a good time for just a broad market market checkup. How are stocks doing? How are bonds looking? What's going on with Bitcoin? How nervous should I be on a scale of— well, I'm at a 4. Should I stay at a 4? I feel like 4 is my resting level. I can go to a 5 if there's bad stuff out there. Let's ask David Kelly. He's the chief market strategist at JPMorgan Asset Management, and I had a chance to speak with him this past week. I want to ask you about sell in May and go away. First of all, it sounds pretty arbitrary, but it does rhyme. So it's got that going for it. Should I do it? I mean, maybe, maybe not in general, but how about right now? I guess how does the stock market look to you?

Well, I don't know. I don't think people should sell in May. I mean, if you're a long-term investor, I think you really have to look at what the overall fundamental picture is and where are valuations. And the fundamental picture, there's plenty of uncertainty. We may slide into recession. I think people realize that. But on the positive side, I think inflation is falling and that means that by next year the Federal Reserve will be cutting interest rates. And indeed, they'll probably cut interest rates throughout 2024 and probably in 2025. So there's a bit of positive, a bit of negative in the outlook. It could be bumpy getting there. But if you're a long-term investor, the outlook is really that we're probably going to get back to a low interest rate, slow growth environment. And then if you look on the other side of valuations, this isn't the cheapest the market's been by any means, but it's not expensive, certainly not expensive by, you know, relative to where we were at the end of 2021. So on that basis, I think this is probably a good time to be invested as a long-term investor. I wouldn't mess around with trying to time it over the summer.

You say back to a low interest rate environment. How low can we go? Are we talking about back to zero or are we talking about something north of zero and more normal?

No, I think we're not talking about getting back to zero. I hope and I think that one of the lessons the Federal Reserve has learned is that if you push policy interest rates down to zero and you achieve, in fact, negative real interest rates, it doesn't really help the economy. It doesn't stimulate demand in the economy, but it builds up instability within financial markets. It really leads to asset bubbles. And I think we've seen What we're seeing this year really is some of the consequences of keeping rates way too low for way too long. So I think when the Federal Reserve cuts rates over the next few years, it's going to be to a more medium level and we won't get back to the zero interest rates that dominated over the last decade.

You've convinced me. But do you have reason to believe that the Fed is convinced that going back to zero would be destabilizing for the financial system?

I think they probably do. The problem is they haven't admitted their mistake and that, you know, that's What are the 12 steps towards getting—

Is that the first step? That's the first step, right? You have a problem or anyhow, go ahead.

Well, maybe that is the first step. So they may have admitted it internally, but they've not admitted it to the public. But I do think they must recognize this. I mean, it's as obvious as the nose in your face that you wouldn't have this problem with, for example, regional banks if you hadn't caused them all to buy long-term bonds at super low interest rates and then jacked up the interest rates once they're balance sheets were full. So it's clear that they caused the problem. They must know this. And so I do think they'll take some lesson from that.

The stock market has had a nice little run this year, and I saw that a lot of the gains are concentrated in just a handful of stocks. Big tech is doing very well again. Is there anything in the shape of the stock market that, that you find concerning or that you find, you know, not concerning? I mean, the fact that big tech is off to the races again, what should we make of that?

I think the story is a better story on inflation. If you go back to the middle of last summer, we originally printed a CPI year-over-year rate of 9%. They revised that down to 8.9%. But still, last June, we were at 8.9% year-over-year. And by March, we're down to 5% year-over-year. Now, in the long run, the Federal Reserve wants to get to 2%. But that's 2% on what's called the consumption deflator. That's about 2.3% on CPI. So if you were at 8, 9, you're now at 5 and you're trying to get to 2.3, you're actually most of the way there. And what I really think is going on in financial markets, both in the bond market and the stock market, is a recognition that inflation, while it's not as low as we'd like, is firmly on the path to getting back to normal.

What looks attractive to you? Where do you think the good deals are to be found right now in financial markets?

I think mostly outside the United States. I mean, one, trend that we've seen begin to emerge really just over the last 6 months as the dollar has begun to come down. It peaked at the end of September of last year. It's down more than 10% since. And you can sort of see why the dollar ought to keep falling. I mean, the dollar has actually been rising on a trade-weighted basis all the way back to the, to the great financial crisis. And we had a 15-year uptrend in the dollar. But going forward from here, we can see why the US economy will grow more slowly.. We can see why international economies will probably grow a little bit more quickly. We can see that the Federal Reserve is close to a peak in interest rates and will very likely be cutting interest rates aggressively in 2024 and 2025. We think that the Europeans and the British and the Japanese will be much more likely to push rates up from here and hold them at higher levels for longer. So when you look at those things and you look at the huge US trade deficit, which really tells you the dollar is too high, All of these things tell us the dollar will likely come down. And if the dollar comes down, that is the first thing that I think will help international equities and fixed income outperform US equities and fixed income. And then the second thing is just valuations, because years of the dollar going up and people getting burnt in international equities really led to international equities getting very cheap relative to US equities. You can basically buy a dollar of forward earnings in international stocks at a 30% discount from the US. I think there are valuation opportunities in international equities. So not many people are excited about international equities. They've been burned for too long by international equities. But I do think that that's probably where the best opportunity lies right now.

Are the economies good enough? Let's say, let's say Europe and Japan, you know, developed markets overseas, are the economies good enough? Are the companies prospering as much as you need? Or doesn't it matter because everything's so cheap? What's the appeal? How well they're doing overseas or how cheap things look?

Well, a bit of both. I would say this: in Japan, it's mostly about, you know, these stocks are cheap. And also, I think that the yen will probably end up rising against the US dollar. In Europe, particularly in the eurozone, I think there is something of a renaissance going on here. We know as soon as the British left the European Union, everybody else realized why they like being part of the family. And they are actually working much better together. They worked very well together over the pandemic. They've worked on a common fund to try to rebuild the European Union. They seem to have gotten past some of the problems that were associated with the European debt crisis. They seem to have gotten past the problems caused by high energy prices due to Vladimir Putin's invasion of Ukraine. So they've gone past all the problems. They're acting in a unified way. Their economies are growing. So I think Europe is genuinely on a better path right now. But European stocks are very cheap, and so are Japanese stocks.

Last time I checked in with you, you were not a Bitcoin bull. I'm going to assume that you haven't come around yet. But Bitcoin is still alive and kicking. It's making another kind of run here. So is there anything to that? And if crypto is kind of like a mania, don't those things usually They run up, then they blow up, and then they go away. I mean, it's still here. What does crypto look like 10 years down the road?

Well, I mean, I think Abraham Lincoln was right. You can fool some of the people all of the time. Crypto is nonsense because there's nothing of value behind crypto. It is simply worth whatever the next person is going to pay you for it. And, you know, I think the last few years, while crypto has hit a peak, Bitcoin hit a peak and then came down and has rallied recently. We still have not seen any widespread use of cryptocurrencies as a transaction mechanism. And that, you know, I think that's really pretty key here because it's obvious that this is simply a vehicle for speculation. Now, as interest rates come down, the cost of speculating falls. And that, I think, has caused money— the same money that was going into long-term US growth stocks and some mega-cap growth stocks is going into crypto. But the big distinction is there is no earnings behind crypto. It is simply worth whatever the next person is going to pay you for it. So I think it is still very, very vulnerable to some future market downturn or some future liquidity crisis. And I still wouldn't be investing in it.

I'm going to mark you down for still bearish on crypto. Let's talk about fiscal chicken in the US, the debt ceiling standoff, each side trying to make the other side blink, I guess. People don't seem that concerned about it. They seem to assume that it has sorted itself out in the past and it will again. Will it? Should we be more concerned than we are?

Well, we should be concerned. It sort of reminds me of two teenagers dancing on the grass beside the cliffs of Moher, and they all say they're not going to fall off the side, but they don't really know how firm the ground they're standing on is, and they just shouldn't be doing it. I can see a path by which this gets resolved. I mean, the reality is there is a division of power in Washington. The administration and the Senate have got some power. The House of Representatives has got some power. And so ultimately, we'll come to some sort of compromise on government spending priorities. And I think that's reasonable. It is not reasonable at all, ever, to use the debt ceiling as a bargaining chip here. But having said that, you can see some sort of compromise. Eventually, an appropriations bill is going to have to make its way through Congress, which is going to need both Democratic votes and Republican votes. There's no budget that's going to get through the House of Representatives on Republican votes only that's going to get through the Senate and get signed by the, by the president. So some compromise will have to be found in Congress. And when that's found on the appropriations bill, I expect that they will tack on an increase in the debt ceiling to that bill. So that way, the president can say, well, we didn't negotiate on the debt ceiling, we simply negotiated about appropriations. And Speaker McCarthy can talk about how he got some concessions for House Republicans. And so I think there'll be some compromise, but I get very nervous when I watch them play these games because we just shouldn't be playing games with the debt ceiling.

Dancing cliffside sounds bad. I've been told I shouldn't dance anywhere, not just cliffside, but that sounds particularly bad. What about bonds? Is the getting still good in bonds for an investor who feels like, well, I missed my chance because now rates are going to come back down? Are there still attractive deals to be found in bonds?

Oh yeah, there are. I mean, you know, I think rates will come back down more in 2024 and '25, but I think 2023 will be a good year to be buying bonds. So last year was a dreadful year because of rising interest rates. Now interest rates have backed off a little bit from their peak, but they're still looking good relative to what they looked like for the last decade before the pandemic and even into the pandemic. And they probably look good relative to what we're going to see for most of the next decade. What we think is going on is the Federal Reserve's overdoing it. This economy is going to get very close to recession, if not actually in recession. We're going to have low inflation, low interest rates, and that's just going to drag bond yields down. So, you know, I think the good news is there's an opportunity in bonds today. Today, I think bonds provide income. They provide the decent potential for total return over the next year. They provide diversification benefits. This is the year of the bond. But bonds in America are a little bit like the cicada bug. I mean, they show up once every 17 years. And then they disappear again. I think we'll get one good year out of the bond market. So this is the year. So if you're going to invest in bonds long term, this is the time to put them in a portfolio because I don't think such attractive deals will be around a year or two from now.

Is there anything out there that you just scratch your head about and you say, wow, investors are really getting this wrong? Are they making any particular mistake right now that they should stop making? Is there something happening that they're missing? Are they not sufficiently worried about something?

What do you see? Well, there's plenty of things that people are worried about. I still worry about what's the endgame in Ukraine, because you have a crazy man with nuclear weapons who's clearly made a huge miscalculation in Vladimir Putin, apart from being horrendously evil. And so you wonder how that's going to play out. But on the positive side, you know, I think people are misunderstanding inflation. We've been on this inflation roller coaster, but everything I see about inflation says look, it's going to come down. It is coming down. It's coming down at the same pace it normally comes down when it spikes. This process just takes a while. It's like a Slinky coming down the stairs. It's not going to come down in one fell swoop. It's just going to take a predictable amount of time. And that's exactly what it's doing. And I think people think that we're in some sort of structurally higher inflation story, and we're not. The best way I describe it is it's kind of like a roller coaster. And the thing about a roller coaster is you actually get off where you got on. No matter how bumpy it is along the way. And we got on this roller coaster, 2% inflation. We're going to get off at 2% inflation. And I believe that by 2025, the Federal Reserve is going to be looking at inflation and wondering how can they push it back up to 2%, which is what they spent most of the last decade worried about. I think that's where we're going to be, be again. And I think some people think that inflation is here to stay or that we're in a permanently high level of inflation. I just do not see that.

The topic of inflation can get dense. When you're talking slinky, you're speaking my language and the language of a lot of people listening. Thank you very much for taking the time to speak with me. Anytime, Jack. Thank you, David, and thank all of you for listening. If you have a question, send it along. We'll answer it on the podcast. You can tape it using the voice memo app on your phone and send it to jack.hough@barons.com. Meta Lootsoft is our producer. She does voice effects too. Darn good ones if you ask me. Meta? The Simpsons will be calling at any moment. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. And if you listen on Apple, please write us a review. See you next week.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.