Investing takes some nerve. Capital markets can be volatile, and the risk of loss is real. But investment gains in the U.S. equity markets have been consistently strong, enabling tremendous wealth creation over time. Many view the stock market as capricious, moving up or down based solely on public opinion. Ultimately, however, investment returns are based on continued economic growth in sales and earnings, particularly driven by new innovations. Furthermore, the major stock indexes are continuously removing the failing companies and adding successful new enterprises. There is good reason the major indexes keep hitting new highs in most years.
As we move into summer, the U.S. equity fundamentals remain surprisingly positive – even after a consistent stream of major supply shocks over the last several years. Covid, the Russian invasion of Ukraine, tariffs, and the closing of the Strait of Hormuz have all threatened to disrupt supply chains, raise prices and push the economy into recession. Despite these events, the S&P 500 has gained more than 150% from January 2020 through May of this year. The ten-year annual return is greater than 15%.
Even so, fundamentals don’t always align with consumer sentiment. For most Americans, the economy appears weak. Higher prices, fewer job opportunities, high interest rates, and artificial intelligence anxiety have brought public confidence to new lows. The “affordability crisis” has become the number one political issue. While these concerns are real, the underlying economy remains in good shape.
For example, inflation spiked at more than 9% in the summer of 2022 as the Covid pandemic wound down. Since then, inflation has come largely under control. But it doesn’t feel that way for consumers. When inflation moderates that doesn’t mean prices return to the lower level. They just stop rising as quickly. Inflation has been under 3% annually since mid-2023 and yet we are still complaining about how expensive everything is. It’s hard to get those old prices out of your head. My grandparents would wistfully reminisce that “in their day” a cup of coffee cost a nickel.
Corporate earnings for the S&P 500 grew more than 25% in the March quarter versus the prior year. This is nearly triple the average earnings growth since 1990. This growth is principally driven by capital expenditures to build out artificial intelligence capabilities. The magnitude of that growth is hard to overstate. Earnings for the so-called Magnificent 7, which include Alphabet, Apple, Amazon, Meta, Microsoft, Nvidia and Tesla are up more than 60% last quarter from the year-ago period. Tremendous dollars are being spent to build out AI, but the leading companies doing the spending continue to grow their profits. If the promise of AI falls short of expectations, there will be a reckoning – valuations will be readjusted. But for now, opportunity remains.
The successful investment playbook has been to ignore the headlines and focus on sales and earnings growth. We expect technology and artificial intelligence to continue to drive investment gains this year, but there are risks. Be diversified. Balance tech with other sectors and other asset classes. With higher interest rates, municipal, government and corporate bonds pay solid yields with less volatility than stocks and provide a good counterbalance to a technology-focused portfolio.
