Stephen: Welcome back to another episode of “The Smart Money Show.” I’m your host Stephen Rischall, and with me today is my partner and CFA, David Jacobs. Wow, I really can’t believe that we’re more than halfway through the year so far. And 2023 has been pretty good for markets and the economy. On this episode, we’ll be discussing the rise of AI, receding inflation, higher interest rates and the recent US credit rating downgrade by Fitch. David, it’s always great having you on the show.

David: Thanks, Stephen. And certainly it has been a whirlwind year, hasn’t it? Not really what most of us have expected. A lot of us expected there to be a recession towards the second half of this year. Doesn’t look like that’s gonna happen. As we sit here, the economy’s humming. The market is strong, as you noted, particularly in a few AI-led tech stocks which has really caused the tech sector recover from what was the dismal 2022. And more broadly in non-tech sectors, we’ve seen decent performance as well in particular overseas stocks have shown strength. And I’m happy to report that bonds, which came off their worst year ever last year, are also doing quite well through the first half of this year.

Stephen: Absolutely. And the concentration of returns in just a handful of stocks, primarily due to AI, I think it’s quite shocking when you break it down. But look, with every surge there’s always this looming question, right? Are we in a bubble?

David: Yeah, it kind of feels that way ’cause it feels similar to kind of when the internet boom happened. And this was a revolutionary new tool, which it was. So definitely feels similar back in the internet bubble, which I guess is 20 years ago. So I’m kind of dating myself. But you know, a handful of companies, you know, AOL, et cetera, really led the market. And now is noted about 10 stocks in the S&P accounted for roughly 80% of the return of the S&P in the first half, and all are really fueled by AI. So AI actually isn’t new for a lot of our viewers. You may not know it’s been around for a couple decades, it’s just new to us. Consumers now have it at their fingertips, which is exciting and scary at the same time. But with like with any major shift in technology or anything else, you really wanna focus on fundamentals. Long-term AI is likely to be transformative, but once the hype dies down, I expect a lot of these stocks will come back to earth.

Stephen: Yeah, that’s a great point. It seems like every couple of years there’s a new trend luring investors, right? A few years ago it was blockchain and crypto. Before that it was the green rush with cannabis stocks. And here we are today with AI. But David, let’s talk a little bit more broadly about what we’re seeing, what you’re seeing on the horizon for markets and how we’re positioning our clients for this dynamic landscape.

David: Well, it’s evolving. Like I said, we did expect a recession this year. It’s likely not to happen, but now we do expect it next year. Even though fewer economists are calling for it now, it’s probably good ’cause the more people that think one way usually the opposite happens. But we think there likely will be a recession in 2024, maybe 2025. Higher interest rates are here to stay. The Fed just raised the rates another quarter basis point, or a quarter percent at their last meeting. And they may do it again later in the year. Our belief is the Fed’s already overshot, meaning they’ve already raised rates too high and haven’t given the economy time to really react. And so because of that, the impact is likely to be worse than they intend, hence a recession. Keep in mind that consumers, you and me, spending our money is two thirds of our economy. And the personal savings rate, our percentage as a population that’s saving our income is down to the lowest level since 2007, somewhere around 4% personal savings rate. And we all know what happened after 2007. It wasn’t good.

So even though recession is starting to recede, recession was most recently under 4%, which sounds good, but it still remains above the Fed target, which is why they may continue to raise rates. And it also means that the prices we’re paying for goods and services remain high. You know, it was 9% a year ago, it’s three or 4% now. It’s still very high, so larger percentage of our pocketbooks are gonna be going to our regular expenses. In terms of the business spending, we’ve already seen tech companies start to lay off their employees which is usually the first sign of a slowdown. Banks are being more cautious because of this challenging credit environment. All of this is likely to lead to decelerating corporate profits. And lastly, in real estate, in particular commercial real estate, the post-COVID vacant office space, you know, retail space, it’s likely to reduce construction costs, also reduce real estate valuation. So definitely some challenges ahead.

Stephen: Yeah, and let’s not forget about payments on student loans which are set to resume very soon. But David, I think it’s time for us to address the elephant in the room here, and that is the Fitch downgrade of the US government’s credit rating. It’s been making headlines. Our clients are definitely keen to understand its implications.

David: Yeah, that was a big surprise. You know, things have been pretty good. Market’s been very strong, and Fitch kind of drops this bomb on us a few days ago. It’s a reflection of a few concerns they have and really we share as well, long-term fiscal challenges in our US national debt. A lot of it represented by entitlement, social security and Medicare, how we’re gonna deal with that? And politically, it’s our politics are so dysfunctional that not only can they not agree on how to handle those challenges, but also they hold the debt ceiling over us every year or two. And Fitch acknowledges all of those things as reasons they downgraded our debt from AAA to AA+. It did cause a couple bad days in the market, but most of us believe that it really won’t have a meaningful long-term effect on either the economy or the stock market over time.

Stephen: I think that’s a very valuable perspective. And speaking of evolving futures, how do you see the equity markets shaping up, especially with the dominance of just a handful of stocks?

David: Yeah, well look, a slowing economy with higher interest rates, it’s gonna put pressure on valuations and lower valuations means lower returns in stocks. So we do believe in general that the stock market will do worse than its historical average for the next year or two. It has shown strength this year, as we’ve already noted, but really in those 10 stocks. And traditionally, when we have a market concentration like that in a handful of stocks, it does pose some risks.

Stephen: Right, and with current valuations after this year’s gain so far, how should investors be approaching this market?

David: Yeah, well you wanna approach it certainly more broadly. And in fact, when you exclude those top 10 stocks, the market P/E ratio is actually somewhat reasonable. It does offer some earnings potential. Interest rates have turned real interest rates, which is interest rates minus inflation. So for the last couple years, even though rates were higher over the last year, inflation was 9% with interest rates at 4%, that’s not a positive return. Now that interest rates are five and inflation’s under four, we see real interest rates being positive, which just traditionally will cause P/E ratios to fall. So what we’re doing is we’re positioning in certain stocks that are gonna be more resilient in what we believe to be a pretty challenging environment.

Stephen: That’s super insightful, David. Really appreciate you sharing that today with our viewers. So look, as we forge ahead into the second half of 2023, what should our viewers, what should our clients really be keeping in mind about their portfolios?

David: Well, I mean, I’ve probably said it a thousand times, but diversification remains the golden rule. We all know it’s prudent. We all know it’s the right thing to do, but in particular in this challenging environment that we expect, diversification’s very, very important. We’re embracing international markets, specifically dividend-paying stocks and alternative investments, like oil and gas, et cetera.

Bonds, including treasuries, corporate bonds, muni bonds are very, very attractive. Their yields are the highest they’ve been in over a decade, and their valuations are very attractive. So we do expect higher-than-average returns in bonds, lower-than-average returns in stocks. So with this in mind, we’ve begun to rebalance our portfolios by trimming growth, trimming high tech in favor of both stocks with reasonable valuations and bonds that we expect to do better in the coming year.

Stephen: Very well said. Thanks, David. Well, to our viewers, to our clients, look, if you found today’s discussion as helpful, if you learn something new, please share this episode with your friends and with your family because they might learn something new too. Knowledge is power, and in the financial world, it is your most valuable asset. So until next time, I’m Stephen. That’s David. And thanks for tuning in to “The Smart Money Show.”