Waiting is the Hardest Part

It’s December!  Not long now before we close out yet another year.  For investors, it might be tempting to begin to tally up the year’s results.  But it’s a bit early yet – a lot can happen in a couple of weeks.

Not very much seems to have happened in the last month or so, but dig beneath the surface and some interesting things are beginning to unfold.  Let’s dig into a few topics worthy of some attention.

To begin, let’s recap where we sit in terms of valuations.  Now, I’m humble and self-aware enough to realise there’s a lot of finance-guys (and girls) that are much smarter than me.  I’ll therefore work “smarter, not harder” and lean on the excellent work of others rather than trying to be original.

In relation to U.S. shares, I frequently cite valuation models created and maintained by Dr John Hussman and his team.  The below model is the most “accurate” of all the ones they’ve tested – meaning a very high correlation to actual subsequent market returns.

Here’s the same model but expressed differently.  Each dot plots the modelled expected return against the 12-year actual return.

In the context of this, it is worth remembering how current valuations have “distorted” actual returns experienced over the recent years. 

In terms of investing, what sort of timeframe would you consider “long term”?  10 years?  15 years?  Does that sound reasonably “long term”? 

Valuations are extremely informative about prospective long-term returns.  And a “good” valuation model will display a high correlation between “expected returns” and “actual returns”.

Look at how beautiful that graph is.  Most of the dots clustered around the line – actual subsequent returns consistently coming in (roughly) as predicted. 

Now, look at that point highlighted there.  12-year average annual returns of around 14%.  It’s been a great period for investors.  But before you conclude that the market has simply produced “normal” long-term returns, realise that those excellent returns have taken us to our current valuation point – the point where valuations are higher than they have ever been.

A few people have asked me over recent months why the market can’t continue to rise.  These have been “intelligent laypeople”.  They don’t really know investing.  They don’t have conviction that the markets will continue to rise.  They are just curious to know why it can’t continue to rise. 

My answer of course is the markets could absolutely continue to rise.  There’s no hard ceiling.  No limit.

What it ultimately comes down to is what you believe.  Do you believe in history?  Do you believe that the market (and economy) still has cycles?  Do you believe that valuations matter?

Or do you believe we’re in a new world?  Valuations no longer matter.  Valuation models that have a commendable track record in over a century of market data will no longer prove of any use.  Markets instead driven by the will of politicians and central bankers that will defend the bubble at all costs.  Investors all “vibe-trading” as opposed to making informed decisions grounded in proper analysis.  “AI” somehow going to turbocharge growth and bail everyone out of extreme valuations.

Investors dearly want to hope that the market delivers another significantly positive “outlier” in the coming 12 year period.  Notice what the current modelled forecast return is over that period?  Average annual return around: minus 6%

An average annual return of zero over the coming 12 years would be another significant positive outlier.  That’s quite sobering to think about. 

Howard Marks, David Einhornn, Jeremy Grantham, Cliff Assness, Jim Chanos, Michael Burry…

These are just a few “household names” that have recently expressed varying degrees of concern about current valuations and – by extension – the market outlook.  But hey, who knows…  Perhaps we’re all misplaced in our pessimism. 

Turning to Australia, here’s the market “price to earnings” (PE) courtesy of Martin Conlon and the team at Schroders. 

Around 30% above the long-term average.  Not too bad.  “Expensive”, but not on the same scale as the US.

But of course once again, you shouldn’t expect a “historically average” return in the years to come when your starting point is 30% above “historically average”. 

Growing scepticism

We’ve discussed in recent months how there’s a growing realisation among sophisticated investors that the current wave of AI investment makes little economic sense.  The sums being invested are staggering… the expected revenues staggeringly small. 

Greenlight Capital’s David Einhorn made this observation in a recent note:

“Here is how we see it (these numbers are illustrative):

• The consumer or business user spends $1 on a ChatGPT subscription (OpenAI revenue).

• OpenAI provides the service by spending $2 on Microsoft AI infrastructure (Microsoft revenue).

• Microsoft spends $0.60 on leasing GPUs from CoreWeave to handle the compute load (CoreWeave revenue).

• CoreWeave spends $2.40 on chips from NVIDIA (NVIDIA revenue) and $2.40 on other Capex (revenue to a variety of companies).

“So altogether, $1 of loss-making customer revenue cascades into more than $8 of aggregate AI revenue across the supply chain.  Microsoft and NVIDIA show excellent margins that are subsidized by the losses of OpenAI and CoreWeave.”

Companies like OpenAI can only continue to operate at a loss with the support of investors.  When the bank balance runs dry, they need enough investors believing in their future to stump up further money. 

With that in mind, you may have heard that OpenAI’s CEO Sam Altman made somewhat of a blunder during a recent investor presentation.  He was asked a rather innocuous question; 

“how can a company with $13 billion in revenue make $1.4 trillion in spending commitments?”

Instead of laying out the grand vision of how great their future is, Sam got very defensive – telling the investor that if he wanted to sell his shares in the company, he will find him a buyer.  It didn’t go down too well with the audience…

Of course, Sam himself is one of many to have publicly expressed in recent months that he thinks AI is in a bubble. 

It’s all getting rather eerie.  Grandiose plans.  A circular flow of money aggregating to massive losses that need to be funded by investors as far as the eye can see.

For those of us that were around for the dotcom bubble, this statement from David Einhorn will resonate:

“Let’s back up for a moment.  Reflecting upon the internet bubble with the benefit of hindsight, whoever was the most bullish about the internet in the year 2000 was still not bullish enough.  At the turn of the century, we had no smart phones, no tablets, no Wi-Fi, no Google, no Facebook, no TikTok, no cloud, and no video streaming.  The internet has become much more important than even the biggest optimists believed.  There is a good chance that 25 years from now, AI will turn out to be even more important than we currently imagine.  Whether that is a good thing or not is an open question.  But, the path from here to there is likely to be very bumpy for investors.”

It is an incredibly challenging time to be an investor.  U.S. equity valuations are extreme.  U.S. economic growth is tied to two unsustainable forces – loss-making AI investment and extreme government deficits.  It’s clear how much of this ends, but the more pressing question is “when”…

Meanwhile, much of the world remains in somewhat of an economic quagmire with low growth, moderate (and possibly accelerating) inflation and valuations that are quite unappealing.

Better opportunities lie ahead… but waiting is the hardest part…

This document contains information which is the copyright of Aviator Capital Pty Ltd (AFSL 432803) or relevant third party. Any views expressed in this transmission are those of the individual, except where the individual specifically states them to be the views of Aviator Capital Pty Ltd. Except as required by law, Aviator Capital Pty Ltd does not represent, warrant and/or guarantee that the integrity of this document has been maintained nor is free of errors, interception or interference. You should not copy, disclose or distribute this document without the authority of Aviator Capital Pty Ltd. Aviator Capital Pty Ltd does not accept any liability for any investment decisions made on the basis of this information. This information is intended to provide general information only, without taking into account any particular person’s objectives, financial situation, taxation or needs. It does not constitute financial advice and should not be taken as such. Aviator Capital Pty Ltd urges you to obtain professional advice before proceeding with any financial investment.