Invert, always invert
CAT
ESP
FRA
Artificial intelligence, persistent inflation, and a re-acceleration of growth are the dominant themes in today's financial markets, where the strength of the United States economy continues to surprise in contrast to the increased weakness in the Chinese and major European economies. February has been a good month for global stock markets (MSCI World +4.6%), with emerging markets and North American exchanges leading the advances amid a satisfactory corporate earnings season. Two-thirds of S&P 500 companies have surpassed analysts' expectations. The momentum of names associated with artificial intelligence continues to gain traction, with Nvidia standing out as the flagship of this dynamic (the day after its earnings presentation, its market capitalization increased by over $277 billion, the largest single-day move in history).
Nvidia: The largest single-day market capitalization change in history
A euphoria that contrasts with the rough start to the year, not only for companies more closely tied to the value factor but also for fixed income, despite the optimism that existed in this asset class at the beginning of the year. Forecasts for 2024 of up to seven interest rate cuts by the Federal Reserve are now a distant memory, as a combination of less favorable inflation readings and economic strength has prompted an adjustment in interest rate curves. The global bond index has declined by -1.14% year-to-date. Consequently, considering Alkimia's portfolio positioning, one must ask: What eludes us in a world where what is expensive keeps getting more so? Can we overlook the old mantra of investing at reasonable valuations?
Returns main markets: 31/12/23-31/01/24
To answer this, we will apply Charlie Munger's mental model for investing: "Invert, always invert". The principle is simple. Instead of asking how to make an investment successful, Munger advises reflecting on ways it could fail first. By considering negative scenarios and potential pitfalls, it becomes easier to identify factors that could lead to an unfavorable outcome, improving the investment process and decision-making. Translated to our case, the question we could ask is: "Is there any structural change in the composition of financial markets, such that investing based on fundamentals has ceased to be a successful formula?"
If we take a historical perspective, this has been a recurring question throughout time. Whenever the market has been expensive, narratives have never been lacking to justify overpaying for the trendy equities. From the railway bubble of the 1840s to the Dotcom crisis in 2001, each new emerging technology has been used to rationalize any excess in the stock market under the mantra that "this time is different." So far, history has been stubborn: it has rarely been different. Instead, the key factor for superior equity returns has been not overpaying during moments of excess. As an example, the following chart analyzes the price-to-earnings ratio compared to returns over the next ten years, with a correlation exceeding 80%.
Valuations explain more than 80% of the return in the subsequent 10 years
The intellectual conclusion drawn from observing this chart is frustrating in a market dominated by current euphoria: valuation is irrelevant when trying to predict the next year, but it is all one needs to know to predict the next decade. However, the message is not particularly hopeful either because history tells us that with a P/E ratio of 25x, returns on the U.S. stock market for the next ten years are not likely to be very good. The next question then becomes: "Has the market structure changed enough to justify a permanently higher ratio?" As mentioned in previous letters, there are factors that can justify a higher valuation premium for the U.S. stock market, as the technological supremacy of the United States and the quasi-monopoly features of large tech companies do indeed warrant a higher valuation premium.
The Top 10 companies reach an unprecedented level of valuation extremity
In conclusion, we believe that the future remains uncertain, and the valuations currently paid in the U.S. stock market are based on assumptions that may or may not materialize. History, however, demonstrates that the best way to achieve superior results has been to avoid overpaying. Once again, as has recurrently happened in other instances, euphoria and short-term perspectives make it challenging to adhere to a disciplined and rigorous valuation process. Nevertheless, we cannot waver. Frequently questioning whether anything has changed is a useful exercise, but the price paid will always be a determinant of long-term returns.