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Speaking on CNBC on December 6, 2022, Jamie Dimon said that U.S. spending is still 401/3T above pre-pandemic levels. American consumers are still burning through the stimulus money injected in 2020 and 2021. In other words, the U.S. economy is still overheating.
It seems to me that China and Europe have already experienced a spending recession in 2022. Now, it appears the US is heading for the same eventuality in 2023. In the same CNBC interview, Jamie Dimon estimated that Americans will burn through the rest of their excess liquidity by mid-2023. He has 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 that there will be good years and bad years, perhaps even a drought every now and then. This should be factored into the farm's purchase price. The same goes 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 companies. These companies have experienced an exceptional boom over the past five years. But legendary macro investor Stanley Druckenmiller warned that the U.S. economy could face some dark years after this tremendous boom.
The last time a major stock bubble occurred in the United States was in 2000. Unfortunately, the stock market's exuberance didn't bode well for the future. Earnings declined for three consecutive years from 2000 to 2003. It took 13 years for the S&P 500 to surpass its 2000 peak. Now, you might say, "That won't happen again, right?" Well, it can.
Below are the earnings per share of the S&P 500 over the past 30 years (in orange):
S&P 500 Earnings Per Share (Macro Trend)
Are Rocky's earnings included in the price of this farm? Not yet. Over the next decade, I expect returns of 4% per year for the Vanguard S&P 500 ETF (VOO) and the Invesco QQQ ETF (QQQ).
The growth trap
There's a lot of talk in investorland about "value traps," and they certainly exist. But there's little talk about "growth traps." You may have never heard of them. A growth trap, as I define it, is a company that has experienced dramatic growth in revenue, cash flow, and earnings over the past three, five, or ten years. But there's a problem. This company's financials are about to fall off a cliff, and its high multiple is about to plummet with it.
There have been thousands of growth traps over the decades. Legendary value investor Benjamin Graham wrote about several of them in his book "The Intelligent Investor," dating back to the 1950s, 60s, and 70s. For the sake of time, I'll only talk about 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 that, but it held the key to the Internet in its Internet Explorer web browser, released in 1995. One could easily argue that Microsoft was a "wonderful business." With profit margins of 40%, you'd say, "Wow, what a moat this company must have." Then came 2001.
A 2001 New York Times article stated, "Microsoft Profits Fall 42%," citing lost investments and falling PC sales as the reason. Microsoft's net income didn't decline until 2002 and took years to recover. Microsoft's profit margins and return on assets also plummeted:
Data for Y-charts: After trading at as much as 60 times earnings in 2000, Microsoft's stock plummeted. And, along with the S&P 500 and the Nasdaq, Microsoft's stock hasn't been moving in 13 years:
Data for YO charts: Microsoft's "Internet Explorer" is now an afterthought. What will be an afterthought in 15 years? Will it be Google Search (GOOG), Amazon's AWS (AMZN), Meta's Instagram (META), or Apple's iPhone (AAPL)? The reality is, we don't know. However, these companies represent trillions of dollars in market capitalization within the underlying VOO and QQQ indices.
Microsoft finally turned things around, albeit a decade and a half later. But others like Nokia (NOK), Yahoo, and General Electric (GE) never did.
Information Technology was the best performing sector in the last 5 and 10 years:
Industry Performance (Loyalty)
The information technology sector grew 395% in the last 10 years, followed by healthcare at 219%. But, as you've seen, trees don't grow to the sky.
The evaluation
The biggest problem for these ETFs is the cyclicality of earnings. Let's look at the cyclically adjusted PE (CAPE report). This uses average (inflation-adjusted) earnings over the past ten years. The ratio is still around 1929 levels:
Shiller PE Report (Multipl.com)
If you visit multipl.com, you'll see that the S&P 500's price-to-book and price-to-sales ratios are also quite tense. As for the QQQ, at the end of 2021, the Nasdaq 100 reached a CAPE ratio of 60x.
Profit margins are also stretched:
S&P 500 Operating Margin (Charlie Bilello on Twitter)
Why will earnings decrease?
GMO's Jeremy Grantham once said:
“Profit margins are probably the most average series in finance.”
The US money supply is shrinking as the Fed engages in quantitative easing. Higher interest rates are bad for most companies' profit margins. The same goes for cost-driven inflation. The Fed could find itself caught 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 continue.
Another thing to watch is the global debt bubble. Consumers leveraged themselves with zero interest rates. When debt bubbles burst, consumers tend to hoard cash. There's a correlation between high levels of public debt and rising corporate tax rates. I wouldn't be surprised to see corporate tax rates rise in the US.
Long-term returns
My 2033 price targets for QQQ and VOO are $ 408 per share and $ 450 per share, implying returns of 4% per year with dividends reinvested.
- The Nasdaq 100 has a PE of 23.7, yielding QQQ earnings per share of $ 12.16. Meanwhile, the S&P 500 has a PE of 20.9, yielding VOO earnings per share of US$$ 17.60. I expect Nasdaq 100 and S&P 500 earnings to grow by 7% and 5.5% per year, respectively. This gives you 2033 EPS of $ 24 for QQQ and $ 30 for VOO. I applied terminal multiples of 17x and 15x.
where do I find alpha
Below are the returns by asset class over the past 10 years:
10-Year Annualized Returns by Asset Class (JP Morgan Market Guide)
When investing, the next decade is often completely different from the previous decade. To achieve outsized returns, you often have to go where others won't. The last decade was characterized by low interest rates, discretionary spending, and fiscal stimulus. Things that underperformed over the past 15 years should benefit from the changing environment.
Everyone wants to invest in wonderful businesses, but many forget that Warren Buffett increased his wealth much more by buying cigar butts. Today, it seems there are more opportunities in mediocre companies, especially companies that will benefit from a change in management or even the macro scenario. Some of these companies have thrived for 50 to 150 years. Time is the true test of an antifragile company, according to Nassim Taleb's book "Antifragile: Things That Gain From Disorder."
I'm actively avoiding beloved big companies trading at high valuations, not because I want to, but because I don't know what the next growth trap will be. Sir John Templeton and Ben Graham outperformed the market for decades by buying low and selling high. As Howard Marks, who watched the Nifty Fifty bubble implode, likes to say:
“Successful investing doesn't come from buying nice things, but from buying good things.”
So, where do I find opportunities? In high-value international stocks. There are antifragile companies out there, printing cash flows and trading below tangible book value. If you're just an ETF investor, I like the long-term tailwinds in emerging markets. There may also be some very valuable funds out there. Let me know what you find. Until next time, happy investing.
This article was written by
A natural contrarian, business student, and value investor, I look for market opportunities that offer outsized returns. I constantly analyze financial statements, stress test my opinions, and study the principles of great investors.
Disclosure: We do not currently hold stock, options, or similar derivative positions in any of the companies mentioned, and we do not expect to open any such positions within the next 72 hours. I wrote this article myself, and it expresses my opinions. I receive no compensation for it (except from Seeking Alpha). I do not do business with any company whose stock is mentioned in this article.
Additional information: This article includes baseline estimates, using known facts and economic projections. The future is uncertain, and investors should draw their own conclusions.
