Q1 2024 Compass Review: Two Sides of a Coin

In Warren Buffet’s latest annual Berkshire Hathway letter, he wrote, “For whatever reasons, markets now exhibit far more casino-like behavior than they did when I was young. The casino now resides in many homes and daily tempts the occupants. One fact of financial life should never be forgotten. Wall Street – to use the term in its figurative sense – would like its customers to make money, but what truly causes its denizens’ juices to flow is feverish activity.”

It’s been two years since the Fed started raising interest rates to fight inflation. Few thought they could lower inflation without sending the economy into recession, the mythical soft landing, yet it appears they are close to pulling it off. Some economists believe the last mile of inflation will be the toughest to beat, and it may be, but so far, the economy keeps trucking along.

With both a Fed rate cut and a recession delayed, bond yields rose ~.5% in Q1. Ironically, economists are now worried that the economy is too strong, and the Fed will have to fight a reacceleration of growth and inflation. Which side of the coin are we to believe?

After a roaring 2023, the S&P 500 continued its ascent. While market leadership remains with a basket of AI related tech companies, market breadth increased. Healthy GDP growth and significant public and private investment buoyed financial and industrial stocks. Meanwhile, stronger demand and global conflict caused oil prices to jump from $70 to $85/barrel, allowing natural resource companies a respite after a terrible 2023.

In a return to sanity the Magnificent 7 started trading on fundamentals, resulting in extreme performance diversion. Nvidia still led the way (+82%), but Tesla’s star faded with falling global sales (-29%). Even Apple stalled, as the reality of slower growth finally set in (-10%). Still, the group’s average return of 17% led the S&P 500 to a 10% gain.

More conservative sectors like healthcare, consumer staples, and utilities were in the green, but could not keep up with the torrid pace elsewhere. Once again, mid-cap, small-cap, international, and emerging market stocks all lagged the mega-cap weighted S&P 500.

It begs the question Mr. Buffet; how can we be at the casino when the economy is in good shape and the most dominant companies in the world are driving the highest returns? Unfortunately, nobody has created an Artificial Intelligence model to provide the answer (yet).

We can certainly sympathize with Buffet. Meme stocks and crypto currencies are back and crazier than ever. Legal sports gambling has never been bigger. Last year alone, Americans spent over $100 billion on lottery tickets. In the stock market, putting it all on black is pervasive, and anything that touches “AI” looks black.    

Speaking of AI, the current level of market speculation creates a challenge for investors who must hold two seemingly contradictory ideas at the same time. On one side of the coin, machine learning and Artificial Intelligence will have a meaningful, perhaps transformational, impact on society over the long run. We can envision a day when our personal AI assistant books our travel, sets our work calendar, and helps with the dishes. On the other side, most people will lose a lot of money trying to pick the AI winners.

In her 2002 book, “Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages,” Carlota Perez introduced a framework for understanding technological revolutions. The cliff notes version is that we’ve had five cycles in the last 250 years: the Industrial Revolution; Steam and Rail; Steel and Electricity; the Automobile and Mass Production; and, most recently, Information and Telecommunications, which began in the 1970s with the development of the microprocessor. 

Each cycle progresses through five stages, beginning with the ‘irruption’ phase, where a groundbreaking technological emerges, and ending with the ‘maturity’ phase where the technology becomes fully embedded in society. A lot happens in between including frenzies and financial bubbles, but ultimately the old paradigm gets superseded by the new. It’s possible that we are about to embark on the next revolution, perhaps the “Age of Intelligence.”

The problem is that even the people building this technology don’t know where AI will take us, who will be the winners and losers, and how long the current cycle will last. That’s what makes investing at the leading edge of technology so difficult. Recall the late 90s, when the obvious telco winners were Lucent, Nokia, SBC, WorldCom, AOL, and Cisco. You lost a lot of money if you bought those companies. 

This time around, the obvious winner is Nvidia. They are leading the AI revolution and will remain out front for the foreseeable future, as reflected in the stock price. All seems well, but there’s a problem. Nvidia’s dominance creates a dilemma for the rest of big tech whose giant cloud businesses are built on cheap commoditized hardware. AI chips are anything but cheap!

If this were a Star Wars movie, Nvidia would be the evil empire. The rebels (other tech companies) must appease Nvidia in the short run because they need their chips, but their survival depends on finding an alternative. Otherwise, big tech’s growth in profitability over the last decade will end up in Nvidia’s pocket. Hence the giant spending war, which is good for Nvidia in the short run but could, in the long run, end up emptying the pockets of their best customers. It’s also possible the rebels will emerge from a totally new planet, with new ideas and new products, unshackled by the legacy business models of big tech.

The fact is we just don’t know where the coin is going to land on the economy or with AI, but we do know that owning a diversified portfolio of companies that remain grounded in fundamentals is how we’ve thrived for three decades, even when it seemed easier to just follow the crowd.

This is a special quarterly letter, as we are doing a first in Compass history by also releasing our latest newsletter concurrently . After this long stretch where it seems like the only smart investment to make is in these big tech companies, we’ve done some soul searching about the merits of our value-oriented investment philosophy. Is value investing dead? Punch line: we think not.

_{Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.}