The debt ceiling deal was the biggest non-surprise of 2023. So why did the market rally on its completion?
The stock market (measured by the S&P500) jumped 2% on Friday to finish up 11.5% YTD. It’s only 1% shy of a 52-week high. Tech stocks are behaving like we are in a bull market. Given the persistent inflation, interest rates rising at the fastest pace history has ever seen, turmoil at regional banks, increased geo-political tensions, a housing market in recession and a weakening consumer, how can this be?
I’ll repeat one of the themes of my letters: do not confuse the stock market for the economy. Over the long-term stock prices will be determined largely by the cash flow and earnings produced by companies. On a short-term basis, the connection between prices and earnings (or value) is elastic. Investor psychology is one of the largest sources of this elasticity. The positive stock market reaction to the debt deal contains significantly more information about investor psychology than it does about either the state of the nation’s finances or its economic outlook. The takeaway, in my opinion, is that many or most investors are still very bearish. It also suggests stocks are going higher.
There was another data point on Friday worth mentioning. The May employment data also came out Friday morning. It was stronger than expected. Other recent data, including the job openings figure (JOLTS) also shows that demand for labor remains robust. The bears haven’t put a fine point on when they expected the job market to crack, but the ongoing resilience does not appear to be consistent with an imminent recession. I think this was a contributing factor in the jump in many stocks.
That said, since my last letter, I have seen more signs of weakness in consumer spending, which is a concern. In the consumer arena, my area of focus, I normally start with a review of employment and wages, and these still look very good. However, several retailers I follow closely recently reported that consumers have changed their behavior unfavorably. This is not a good sign. Target (TGT), Dollar General (DG), and Foot Locker (FL) each have thousands of stores and millions of customers and can segment their stores and products by income cohort and by discretionary (economically-sensitive) and non-discretionary products. They are all saying the same thing. Consumers are spending less and shifting spending to “needs” vs. “wants”. Higher living expenses (inflation) eating into spending ability and smaller tax refunds were cited. Increased borrowing costs due to interest rates aren’t helping. Another explanation is that the long tail of financial security created by stimulus payments and reduced spending during the pandemic is finally running its course. Looking forward I am watching the resumption of student loan payments starting in August, which are estimated by various sources between $400 and $500 per month per borrower. Those payments are going to come directly out of consumer budgets for bars, restaurants, entertainment, travel, clothing, etc.
The bears have been on the wrong side of the market so far in 2023, as have those who shifted assets to “value” stocks from growth and technology at the start of the year. What about from here? I admit that things are getting worse with the consumer, interest rates are still going up and some of this impact is still in front of us. Maybe the bears are going to be right? Unfortunately, I really have little ability to answer this question. My view is that using macro as a prism to craft an investment strategy is fraught with potential for error. The economy is complex and has dozens of relevant inputs, any number of which could combine in unanticipated ways to alter the outcome. Thus far 2023 has been something of a case-in-point. Further, intuitively, the idea of using an examination of past conditions to predict the future seems fundamentally misguided.
The strategy I am using starts by admitting that we can’t forecast the rate of economic growth or where we are in economic cycle with precision. On other hand, I think it is somewhat possible to assess what stocks are reflecting. Last week’s move, for example, gives us a tool to gauge the state of investor psychology. But at the end of the day our investments will be successful if the companies we own grow earnings and cash flows beyond what is reflected in their current stock prices. I therefore try to filter out the macro noise coming from the media and focus my efforts on understanding the companies we own and their prospects.
Selection From our Investment Portfolio: Upwork, Inc. (UPWK)*
The most talked about innovation in the market in 2023 is surely generative artificial intelligence (AI). I’ve tested out ChatGPT like most of you and I agree it seems pretty amazing. That said, some of the discussion on its potential impact has veered into the crazy realm. It reminds me of the Forrester Research reports about the internet from 1999-2000 era. Forrester just took whatever trends were going on and then projected them growing exponentially into the future. I think they were at least half responsible for the Internet bubble. Anyway, I have no idea if Forrester is still around and weighing in on generative AI, but I recently read an amusing headline that some professor somewhere said it would eliminate the need for all lawyers in relatively short order.
Could that happen? I am not holding my breath. On the other hand, generative AI will probably make some job functions redundant. This brings us to our investment in Upwork (UPWK) which is an online platform connecting skilled workers to enterprises. This has not been a successful holding for us. We overpaid and have suffered losses. However, the promise of the business which is to scale to much higher levels profitability while connecting greater numbers of skilled temporary and remote workers to companies has remained intact, in my opinion. More recently, the company changed CFOs and has pivoted from a strategy to grow as fast as possible at break-even to better balance of profitability and growth. UPWK is currently forecasting a material inflection to profitability and positive free cash flow by the fourth quarter of 2023. Seems great to me.
Enter the discussion of generative AI, the job-destroyer. It has gotten into the heads of short-sellers that UPWK’s job sharing platform will be hurt by generative AI. The number of UPWK shares sold short (meaning investors are expecting the stock to decline) recently doubled to 11 million shares, representing 8% of shares outstanding. I think the market has gotten this backwards. Generative AI will likely put some jobs into the dustbin of history, but my guess is that it will also create many new kinds of jobs. Further, these jobs will be just the knowledge-based jobs that can be filled on UPWK’s platform. A quick look at the site shows 10K workers already advertising their services in AI. That may be a fraction of the job seekers in other functions, but it certainly casts doubt on ChatGPT putting the platform out of business.
*This is not a recommendation to buy or sell any security. Please consult with your investment advisor for advice tailored to your investment objectives and risk tolerance.
Feedback and commentary welcome. Would you like to learn more about how we invest in the markets? Please click here to get in touch.
John Zolidis
President & Founder
Quo Vadis Capital, Inc.
John.zolidis@quovadiscapital.com
Mr. Zolidis founded Quo Vadis Capital, Inc., a Registered Investment Advisor (RIA) and research consultancy, in 2017. He started his career in finance in 1996 following degree studies in Philosophy at Kenyon College and the University of Oxford. He has followed U.S. consumer companies as a senior analyst since 1999, mostly on the sell-side, writing research for institutional investor clients. He also managed money in a buy-side role at a long-short equity fund over 2013-2014. He was named in the Wall Street Journal’s Best on the Street list in 2005. Mr. Zolidis and works from New York, NY and Paris, France or wherever he has his laptop.
Travel update: June will be busy. I am traveling the entire month. Tomorrow I am leaving for Olympia, Greece, where my wife is attending a meeting related to the Olympics. I’ll be working when I am not making clumsy attempts to translate Greek into French or kicking around the ruins and taking photos. Subsequently, we are packing up the family and heading to Long Island for the balance of the month. I also have two trips planned inside the U.S. First, I am heading down to Bentonville, Arkansas for a meeting with Walmart’s investor relations team and potentially some top management. Secondly, I am attending a value investing conference in Vail, CO. At ValueX Vail (https://valuexvail.com/) I will be presenting an investment idea and meeting with other investors. I believe this will be my sixth or seventh ValueX Vail and it is definitely a highlight of the calendar year. Separately, last week I recorded a podcast on Business Breakdowns on Lululemon (LULU). You can keep an eye out for that on Spotify and I’ll include a link in my next letter. If you’re going to be “out East” during June please reach out so we can meet up. Thanks!
