There has been growing adoption of new weight-loss drugs throughout this year, driving enthusiasm for the two manufacturers of these drugs, Eli Lilly and Novo Nordisk. After a year of strong gains, these two companies are now the first- and third-largest healthcare companies in the world as measured by market capitalization. Novo Nordisk’s success is so significant that it has single-handedly raised the economic outlook for the entire country of Denmark, which is where Novo is based.

The success of the weight loss drugs has set in motion a counter-trend for many other medical companies. On July 20th of this year, a seemingly innocuous comment from Intuitive Surgical, the leading manufacturer of robotic surgical equipment, triggered a widespread move in dozens of leading medical companies when the company announced it had seen a slight softening in demand for bariatric surgeries. The language was measured, but the stock market was swift in its reaction. Shares of Intuitive Surgical, and many medical equipment peers, began to fall in July.

Investors have now started to map out a new megatrend within the economy and stock market. Their assumption is that the world is going to be reshaped by widespread adoption of weight-loss drugs. Eli Lilly and Novo Nordisk have continued to gain momentum since the summer, while the list of medical companies losing value has grown longer and longer. Shares of medical companies treating sleep apnea, diabetes, heart disease, and kidney failure have all plummeted, some by as much as 50% in just a few months. Makers of knee and hip replacements have lost a quarter of their value, as investors contemplate a population putting less wear and tear on their joints. The entire medical equipment sector within the S&P 500 has declined by roughly 30% since the end of July. More recently, makers of packaged foods and restaurants have joined the decline. Shake Shack, Pepsi, Utz Brands, and Kellogg are just a small sampling of food companies that have lost nearly a quarter of their value or more in recent months. Food packaging companies are declining, as are companies that sell equipment to restaurants.

Much like the enthusiasm around artificial intelligence (AI) that we wrote about in the summer, the excitement over weight-loss drugs has a legitimate foundation. The clinical effects of these drugs are significant. A follow-up trial by Novo has shown that Wegovy, its leading weight loss drug, can reduce heart attacks and strokes in certain populations. Widespread adoption certainly has the potential to alter medical care and, to a smaller degree, food consumption. But as with AI, the impact within the stock market seems overly swift and exaggerated. Is society on the brink of seismic change that will alter everything? Or is there a reason why investors might be too willing to buy into that narrative and overextend themselves?

In our view, the macroeconomic backdrop matters tremendously in helping explain the emergence of two market megatrends in the same year. At the moment, the average stock is beset by two problems. First, interest rates continue to climb, which then pressures valuations for most companies. With investors able to get 5% in a money market fund or Treasury Bonds, many stocks simply have to get cheaper to remain mathematically compelling. And second, the economic outlook is atypically cloudy, with conflicting signs of strength and weakness throughout many pockets of the economy. The average stock in the market is on pace for another negative year at the moment, given the interest rate headwind and economic uncertainty.

Faced with these inferior returns, it’s understandable that investors would latch onto any narrative that seems simple and compelling. Whether that narrative concerns AI or weight-loss drugs, at a minimum an investor can say confidently that these trends will have some impact in the future. Of course, “impactful” is not the same thing as “transformative,” but in an environment where it has become quite hard to build confidence around most investment themes, it is not surprising to see investors potentially overplaying their hands when it comes to these two trends.

Current Strategy

The third quarter was challenging for stocks. The enthusiasm for AI stocks began to fade; most medical stocks were weak; and consumer staples companies fell sharply. The slide in most stocks has continued into October, as rising interest rates have exerted more pressure on stock valuations. Economic data continues to offer a mixed view on the economy, with the labor market remaining healthy even as consumer spending is under some pressure from rising interest rates. To illustrate the conundrum presented in the data, it seems most people are still able to find a good job, but more of their salary may be going towards 8% mortgages, higher rents or burdensome auto loans.

The set-up for many stocks and industries has not felt very compelling through the summer and early fall. For most clients, we were selling stocks in equal measure with any new buys. That is beginning to change, as the stock market churns lower and approaches a modest correction. More companies are showing the economic impact of higher rates, and earnings are starting to suffer, with share prices following them lower. In our view, the table is being set for a more prolonged, durable and widespread recovery in stocks in the future. For many clients, we have a lot of cash on hand, setting us up to begin stepping back into the stock market. But as always, we will invest in stocks judiciously, especially recognizing the current value of cash that yields above 5%.

The bond market may be nearer an inflection point. The shorter-term end of the bond market has not moved materially now for several months. There are growing expectations that the Federal Reserve is near the end of its rate hiking cycle, and the primary question now is how long they may keep rates at current levels. Inflation is declining, although the Federal Reserve would like to see it decline more significantly. The long-term end of the yield curve (typically bonds that mature in 10-30 years) is struggling, and yields are rising. Investors can now get reasonably good rates of interest for the next decade. Committing money for that long can be scary, and cash, at the moment, is just as rewarding. But it is not likely that cash yields will stay this high forever, and fixed income investors must plot years into the future. With some bonds maturing very soon, we are looking to extend the maturity of the fixed income portfolio for clients to ensure that we can earn a good rate of interest for years to come.

Through much of last year, technology stocks dragged the market lower. There were many
reasons for this underperformance, but put simply, investor expectations and optimism for the industry had run well ahead of reality during the pandemic. In light of these heavy corrections, it is not surprising that they have rebounded this year. What is surprising is the extent to which the technology sector has recovered – to the exclusion of most other industries – making for a very narrow, but powerful rally in the stock market. This recovery, sensible at first, is now looking more like a flood of momentum buyers hoping to cash in on a singular theme: artificial intelligence.

In January of this year, Microsoft announced a $10 billion investment in a new company called
OpenAI, which had released a trial version of its product, ChatGPT, late in 2022. This trial served as an introduction for many to the potential of artificial intelligence (AI), and Microsoft’s large investment signaled to the stock market that this relatively unknown company and their new product should be taken seriously.

Six months later, nearly every major technology company has framed their business and long-
term outlook within the context of AI. Many companies have come to market with competing or complementary offerings, and the stock market overall has added trillions of dollars of market
capitalization that can be traced back to this singular theme. The seven largest companies in
the S&P 500 Index, all technology companies (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, Meta), have spent considerable time and money this year connecting themselves to AI. In the first half of 2023, the shares of these companies increased collectively by 60%, at a time when most companies in other industries barely budged. Put another way, in an index of five hundred companies, the return from these seven companies made up three quarters of the return of the entire index, such was the enormous impact of their price rise.

To help understand the enthusiasm (and criticism) around AI, it may be useful to attempt a
rudimentary explanation of the technology. ChatGPT is a piece of software constructed around
a massive repository of language, i.e. digitized libraries and Wikipedia entries. A user will ask a
question or give a prompt, ChatGPT will analyze its library, and, in an extreme simplification, it
will deliver the response it deems most likely or probable based on the prompt. This approach and sometimes the result – can be at odds with the attachment most of us have to there being a “right” answer to a question. ChatGPT and other products like it are not searching for any right answer. They have been exposed as giving a “wrong” answer to somewhat simple questions, and at the same time giving incredibly interesting responses to equally complicated prompts, almost feeling “creative” in the process. Despite their faults, these are impressive feats of technological innovation – although the last decade has shown that not every technological feat necessarily produces social good or meaningful economic output.

Still, the stock market has added trillions of dollars of value this year. Companies providing the
computing infrastructure to build these powerful tools have soared in value; companies that
are building competing models to ChatGPT have generated excitement; and any technology company that can argue for a compelling end-use case has also attracted investors. From a personal assistant that can draft emails, to a well informed AI-driven “travel agent” that can create an itinerary, to a program that can potentially write the lyrics to the next hit pop song, the economic possibilities are compelling.

And yet, as with most big and compelling investment stories, there comes a point when
enthusiasm exceeds reality, and momentum buyers looking for a quick profit start to enter
the fray. We need only look back two years to see the last time this happened. In a world of
pandemics, it was thought, we would only shop online and we would all check in with our doctor via Zoom, in between numerous other virtual experiences. Undoubtedly, our lives post-pandemic are a bit different, and a bit more dependent on technology. Yet the shares of many pandemic-themed companies surged in a buying frenzy that collapsed even more quickly.

There will certainly be durable winners from the deployment of ChatGPT and its competitors.
It will change how we use existing technology. It will be valuable when used for good, and
dangerous when used poorly or to devious ends. But it is also likely generating too much enthusiasm within the stock market at present, driving the technology sector to massive short-term gains that may be difficult to sustain.

Current Strategy

The stock market has felt broadly split between the winners within the technology space and
everything else, with shares of many companies only inching forward this year. Although
our existing investment portfolio and new investments made in 2023 mostly fell outside the
technology sector, we managed many good successes to start the year in a variety of other
industries. We added investments in the healthcare and industrial sectors along the way,
although in each case the ideas were the result of unique opportunities we saw, rather than an
embrace of any broad thematic or economic outlook. Hopefully, we have structured a portfolio
of investments that stands to benefit under a broad range of economic outcomes or market
shifts. Today the S&P 500 Index has increasingly become exposed to the technology sector, and we are concerned that the largest companies are becoming overcrowded by investors buying shares directly – activity which is then amplified by the ETFs and other funds that match the Index in its composition.

As the stock market rally has gone on, we have found opportunities to take some gains and shift
funds to cash or bonds. With yields on cash and short-term bonds nearing 5%, the bar is set
higher for stocks to exceed that return. We view the math as challenging for stocks, at a time when the economic outlook is still cloudy and the largest sector within the market is showing signs of stretched valuations. While some investors continue to pull cash from the sidelines and pile into the most popular stocks of this market, we feel it is increasingly important to lean the other way. We have sold a few positions that feel most economically exposed, and have either built up some defensive positions (in healthcare, for example), or left the proceeds in cash.

This chapter of economic history is not yet finished, and it remains to be seen whether it will
finish like all past episodes of inflation-fighting via interest rate increases – with a recession – or if there is a different and better end in store. The current data is mixed, in our view. Economic forecasting is always guesswork, and sometimes even a proper view of the present is left to the eye of the beholder. We see an economy where employment is generally strong and inflation is still high, but clearly headed in the right direction. We also see an economy where many consumers are underwater on car loans, bank lending is tightening and consumer spending is constrained. Until we have a slightly clearer view on where we are and where we may be headed economically, the safety and income provided by cash and bonds is compelling, especially as the stock market approaches its old highs.

The month of March began with a quiet announcement from a relatively unknown bank called
Silvergate Bank. The “bank” was as much a cryptocurrency exchange as it was a conventional
bank, and their troubles had been evident since the collapse of various cryptocurrencies in
2022. On March 1st, Silvergate announced they might not have sufficient capital to continue.
The share price collapsed, depositors started to flee, and a week later the bank was insolvent.

The pace of that first decline felt glacial compared to what happened next. The same day
Silvergate officially went bankrupt, Silicon Valley Bank, the country’s most prominent lender to
the private equity and venture capital world, announced it would raise money by selling new
shares of its stock. The need to raise money set off alarm bells, and its depositors started to
withdraw money. The next day, $42 billion left the bank, with $100 billion lined up to leave the day after. Before that could happen, the bank was seized and put under the control of the FDIC.

In the span of just thirty-six hours, the U.S. had suffered its second-largest bank collapse in
history. Within the banking world, a weekend of panic ensued, capped off by Signature Bank,
another prominent lender to the cryptocurrency world, becoming insolvent. In the span of just a few days, three banks had closed, representing the most significant bank panic since 2008.

In the weeks since, the shares of a handful of banks have suffered tremendously, while the entire sector has struggled to regain investor confidence. First Republic Bank, most notably, has
required assistance from other banks and, at times, has seemed on the brink of becoming the
next insolvency. But even as First Republic Bank suffers, the contagion that swept through the bank sector for a week in March seems to have run its course. Many banks have reported their
results for the first quarter of the year that show resilience and allay the worst fears harbored in
March. Yet, with the height of the panic now likely behind us, bank shares have recovered little
meaningful ground, and investors remain skittish. To understand why, one needs to understand
the underlying causes of the bank panic. Given the specific banks that failed, it would be easy
to link the panic to the cryptocurrency collapse, or to the larger decline of the venture capital
industry in 2022. But this analysis misses much of the nuance, and too easily relegates the
problems to a few unique banks.

To fully see the larger problems affecting the entire banking sector, we return to the dominant
economic narrative of the last eighteen months: high inflation and rising interest rates. For banks, rising rates are proving to be a double-edged sword. Higher rates make it increasingly
productive for customers to move their money from checking and savings accounts into
higher-interest Money Market Funds, or short-term Treasury Bonds. This movement, in turn, is
beginning to drain bank deposits. The shift is occurring slowly at most banks, but as highlighted
above, at a few institutions it was cripplingly fast. And all banks now must suffer through
continued outflows or raise rates for their depositors, which hurts profitability.

Rising rates have also exposed poor investment decisions made by some banks in 2020 and
2021. During those years, a number of banks decided to invest some deposits into longer-dated
Treasury Bonds. This decision presumed that interest rates would remain low for a prolonged
period of time, but within a year these bonds sat at a significant loss. Now, as deposits leave,
the most pinched banks are forced to sell these bonds to generate the necessary funds for their
departing customers.

The bank panic may be over, but these larger issues, especially that of declining deposits, will
continue to exact a toll for months to come. And a critical byproduct of this episode will almost
certainly be increased conservatism on the part of most banks. If a bank is worried about
slipping deposits, it will naturally not lend out quite so much money. This will in turn act as
another brake on the economy, since bank lending is one of the key cogs in the machinery of
economic growth. Recessionary expectations have increased through the month of March; this
can be attributed almost entirely to the problems exposed by the bank panic, and the problems
it continues to create. An economy that was already fragile, as a result of rising interest rates,
will now have to contend with a cautious banking sector as well.

Current Strategy

The stock market staged a recovery in January and February, as it appeared that inflation was
more convincingly on the decline. Inflation served as the primary headwind for the market
during a tough year for investors in 2022. Any fresh signs that inflation was moderating
would naturally be received enthusiastically. Then the bank turmoil hit in March, temporarily
wiping out all progress the broader market had made on the year. We saw the beginnings
of an opportunity and made some new stock investments, while increasing the size of some
existing investments. While our investment actions in March do reflect a little risk-taking and
opportunism amidst a panic, we continue to balance our stock exposure with considerable
reserves in money market funds for most clients. This seems prudent given the heightened
chances of a recession some time this year.

Stock prices have recovered since the lows in March, as has our investment portfolio. Yet it
is telling that since the lows of the banking panic, among the best performing sectors in the market are healthcare companies, consumer staples and utilities. Meanwhile, the financial
and industrial sectors are almost unchanged, and shares of many banks and manufacturing
companies are setting new lows daily. The market is being lifted higher by the shares of
companies that are resilient during recessions, to the exclusion of many other companies.
This is not a rally in stocks that speaks to investor confidence in an improving economic
outlook.

The recovery in the bond market this year has felt more convincing and durable than the
recovery in stocks. Inflation is falling, although not quite as fast as the Federal Reserve might have hoped. But the banking panic and growing economic weakness provide a compelling
argument that central bankers have pushed far enough on interest rates. The Federal Reserve
must now seriously balance the health of the economy and the financial sector against the risk
posed by inflation. Bond investors think the Fed will pivot towards lower interest rates soon, as
economic risks force a more cautious approach. As these expectations of a pivot grow stronger,
longer-dated bonds are rising in price, continuing a rally that began late last year.

Against a backdrop of dour headlines, the stock market rallied through the second quarter. It is hard to recall a time when enthusiasm reflected in the stock market contrasted so sharply with news about the economy and the state of the country. Fear turned to optimism, and in some sectors outright euphoria, in a matter of months. An alarming number of current investment anecdotes recall the spring of 2000 and the technology investment bubble. What started as fairly rational buying of the largest tech names has morphed into rampant speculation in companies that mirror or mimic the leading tech companies. Some of the hottest stocks in the current market were not even publicly traded last year, have never produced a product, and perhaps never will.

To better explain the performance of the major market indices, we can divide the stock market, and the economy overall, in two. Companies perceived to be “new economy,” technology-driven enterprises are strongly in favor with investors. Most others, thousands of companies that represent much of the U.S. economy, are either falling in value or gaining very little. Through the second week of July, the Russell 2000 Index, a list of 2000 smaller to medium size companies that typify the U.S. economy, was down 14% on the year. This is not surprising, given that the country is suffering through a recession with tens of millions unemployed. On the other hand, the NASDAQ 100, a much smaller selection of predominantly technology companies, was up 25% on the year. This is in part because its member companies are designed for a stay-at-home and work-at-home world.

The dichotomy in the market has reached extreme proportions. Amazon’s valuation has grown to $1.6 trillion, and is now larger than all other publicly-traded retailers in the country combined (a list that includes Walmart, Target, Best Buy, and dozens of other retailers). While Amazon is thought of as a technology company, the others are seen as simply retailers. Another example is Tesla, which is estimated to produce one half of one percent of cars globally, yet is now the most highly valued car company in the world. Its valuation exceeds the combined value of GM, Ford, Honda, Subaru, VW, Nissan, BMW, and Mercedes. Investors have decided that Tesla is in the “new economy” tech group, while all other auto companies are simply boring auto makers. We admire the technology that has gone into producing Tesla cars, the best electric cars on the market. But we do take issue with the valuation of Tesla stock, which seems to know no bounds. Elon Musk himself said that Tesla stock was overvalued at $750 per share, but that has not stopped traders from pushing the stock to twice that price.

Amazon and Tesla are examples of substantive companies whose valuations have potentially reached an extreme point. Below their ranks are many companies whose shares exhibit an even greater degree of euphoria. Nikola, a company with only a prototype and a stock that began trading in June, reminded investors enough of Tesla that its shares doubled in a few weeks. Another company, Tiziana Life Sciences, has seen its shares rise nearly 600% since March. In the absence of significant news, one might speculate that the reason for this climb is the fortunate ticker symbol TLSA, which is quite similar to Tesla’s TSLA. Perhaps some traders are just entering the wrong symbol in their haste to buy Tesla.

Investors who were fearful just a few months ago have decided to vastly increase risky stock market bets. There is one simple cause that is most likely at the root of the buying. In an attempt to bolster the economy, the U.S. Government and the Federal Reserve have injected massive amounts of money into the financial system. The money supply in the United States has grown by $3 trillion in just two months. Any stimulus that is not spent becomes savings, and savings in turn become investments of one form or another, whether deposited at a local bank or used to day-trade in the stock market. In a twisted irony, the complete bungling of the Covid-19 pandemic response in the U.S. has led to an increased need for massive financial stimulus, which in turn has fueled the stock market rebound. Pushed into a corner by near-zero interest rates and a recession that is crippling many businesses, investors decided the biggest tech stocks were the safest haven for funds. It was a reasonable idea, and through April and May it was one that we shared. However, good investment ideas can quickly become crowded trades, with many investors piling into the same small number of companies. And with too many investors pursuing the same stocks, these good ideas ultimately turn into dangerous investment holdings.

Current Strategy

Many of our share purchases in the second quarter consisted of technology and consumer staples companies. In both cases we sought to invest in companies we thought would be relatively immune or insulated from the effects of a more lasting economic shutdown. We also selectively sold shares in companies we thought would have more pronounced difficulties in a recession. Given the spate of economic problems companies are facing, however, and how stretched valuations have become on technology companies, we think it is important to remain cautious. While negligible yields make it wholly unrewarding to sit on any cash, we believe that is the correct thing to do in this market. We are shifting our focus from pursuing potential gains in a low stock market to preserving gains in a market that feels elevated.

The corporate bond market collapsed in March, alongside most other asset classes. Since that point nearly all bonds have rallied ferociously, with investors emboldened by the full support of Central Banks around the world. Our existing bond holdings have rallied, and the corporate bonds we bought in the depths of the market decline in March have since risen in value. The problem now is that yields are negligible wherever one looks, and few bonds offer a rate of return that even exceeds inflation. The gyrations in March are a reminder that conditions can change unexpectedly. Rather than commit to long-term bonds with what we view as poor yields, we think it best to stay on the sidelines for now and wait for better opportunities.