The Dividend Cafe - The Recipe for Innovation

Episode Date: July 12, 2024

Today's Post - https://bahnsen.co/3S4efVq Market Dynamics and Economic Growth: Analyzing Cap-Weighted vs. Even-Weighted Indices In this episode of Dividend Cafe, David delves into recent market phenomena, specifically comparing cap-weighted and even-weighted S&P 500 indices. The discussion highlights an unprecedented 11% year-to-date difference between the two, exploring implications for market concentration and economic growth. The episode covers daily market fluctuations, Fed rate cut expectations, and offers insights into global economic indicators, contrasting Germany and Switzerland's market values to Apple. Key factors for productivity and economic growth such as education, rule of law, military capacity, entrepreneurial culture, ecosystems, and capital formation are emphasized. The host concludes by stressing the importance of understanding market and economic dynamics for better investment perspectives. 00:00 Introduction to This Week's Market Insights 01:50 Understanding Market Top Heaviness 03:34 Analyzing the S&P 500 Performance 07:04 Impact of Fed Rate Cuts on the Market 09:20 Global Market Comparisons: Germany and Switzerland 11:51 The Importance of Economic Growth 13:46 Key Factors for Productivity Growth 16:29 Conclusion and Final Thoughts Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to the Dividend Cafe.term story with a little bit more medium-term story and then expand it into a very, very long-term story. And so there's a little bit of something for everybody this week. It's very, very rare that I care at all to talk about in the Dividend Cafe something that happened in markets on a given day or even really a given week. Sometimes I might anecdotally mention some drama in markets on the week we just had, but it's generally not really all that relevant to what we're doing and the way we manage money for our clients at the

Bonson Group. And it's not generally relevant to the types of things I want to teach in the Dividend Cafe in terms of sharing our perspective on how investment markets ought to be managed and thought about. And we just generally have a much longer than one day or five day perspective. That hasn't changed this week, but there's a kind of opportunity to mention something as well as then dive into a few other stories. So I'm going to go all over the map of this week here. And I will say what I like to say quite often, for those of you listening to the podcast or watching the video, this week's Written Dividend Cafe has how many? One, it's just two, I believe. Yeah, two charts, but I think it will be impossible, impossible for me to capture what I want to say without you viewing those charts. So hopefully

you'll have a chance to jump in at DividendCafe.com as well, but we'll get into it. You tell me what you make of this. I've talked over and over and over again about the top heaviness in markets and the ahistorical reality of what's taking place right now with the concentration in return from one company, three companies, five companies, seven, ten, et cetera, and then one particular sector, two sectors. There's just been a consistent theme of a lot of top heaviness in markets for some time. where all 500 companies have the same weighting. You can hopefully do the math of what that would be to just in terms of divided by 100 for an even weighting company by company. And then also, of course, the cap weighted, which is almost entirely how people own an index, not universally, but by a large move, the cap weightedweighted indices have a lot more assets than even-weighted. And what I mean by cap-weighted is that the market capitalization indicates how big of a company or small of a company it will represent in the index. And so if you take the total capitalization of the S&P 500 and one company is $3 trillion divided by

capitalization, they're going to be a lot bigger in the index in this particular case, six or 7%, then a company that their capitalization is, let's say only 0.1% of the index. And so we have a lot of that right now in cap weighted where those larger capitalizations are moving the needle a lot more. Okay. Why do I bring this up? The even weighted index year to date versus the S&P cap weighted has an 11% Delta between the two. Okay. Oh, they have the exact same stocks in them, but one is up 11% more than the other in six months. We have never had that kind of a delta. And the last time we had a delta this close in a quarter. So you know, with the quarter two

of 2024 was the highest outperformance of a cap weighted index versus an even weighted index. That again, two indexes that hold the exact same stocks. It was the largest outperformance of a cap weighted index versus an even weighted index. Again, two indexes that hold the exact same stocks. It was the largest outperformance since Q1 of the year 2000. I think most of you know what happened in March of 2000 and why I'm bringing that up. It is not predictive to the extent that history has to exactly repeat that way. But the dynamics and the math and the economics that are at play are most certainly similar. And it's worth pointing out. Now, I had talked about that and set it up in Dividend Cafe before Thursday of this week. And then on Thursday, we had another individual event.

And that's why I bring up the year to date issue with the market first six months. And then on Thursday, we had another individual event. And that's why I bring up the year-to-date issue with the market for six months. And then now a ultra short-term thing of just one day. And one day is one day. I don't have any idea, nor do I care to have any idea as to whether or not it's predictive of something to come. But I do want to point out that the small cap index, the Russell 2000 on Thursday was up 3.6% in one day. The NASDAQ was down 2.2%. That's the largest single day delta ever in history by a wide margin. There's never been a day where those two were 5% apart. And a 5.8% delta between the Russell 2000 and the NASDAQ in one day is absolutely stunning. But all of the things that have been laggards this year, maybe they've been up, most cases they have been, but just up a little. The regional banks, the Russell 2000, REITs, the yen, long duration bonds, treasuries, they were all up huge on Thursday.

And then the winners of 2024, semiconductors were down three and a half percent in one day. Tesla was down eight percent in one day. It's been all over the map. NVIDIA was down almost six percent. Big cap growth was down big, over two percent. Big tech was down almost 6%. Big cap growth was down big over 2%. Big tech was down about 3%. So you just had one of these days where the big winners fell a lot. The big losers went up a lot. Is this predictive? No, I couldn't care less about that. The reason I'm explaining it

is because I think that there are theories about whether or not big cap growth just runs on forever. That would not be my view. Whether or not everything tanks together, that's certainly possible. Not my view, but it's possible. or a rotation takes place, a shift of leadership. And that has historically been very common and given valuations what we might expect this year. Now, some are saying, hey, maybe things are about to rock and roll because the Fed's about to cut rates. And so this is where a chart comes in that I put together myself, by the way, which is never a very good idea on the design side. But nevertheless, I took two charts from original sources and blended them together myself with our design team out today. But here's the thing. You started the year with an expectation of six rate cuts.

And in the actual chart of the Fed funds market, you go down, down, down, down, down. Well, right now we're expecting two cuts. We were planning on 175 basis points of rates coming out from six cuts at the beginning of the year. It's now down to 50. And yet inversely, the S&P going higher and higher. As rate cut expectations came down, S&P went up. Now, do I think that means that the market wants rates to go higher? Of course not. But there is no basis for believing that there are some big, huge hedge funds out there that are thinking, whoa, the Fed just cut rates. We better get going on this.

We were not expecting that. Let's check out this NVIDIA thing. I've heard it's doing well. It's just not true. Markets are discounting mechanisms. Is it possible that the big market action was in anticipation of something and that when the thing happens, markets respond differently? Of course it's possible. Happens all the time. Check out the chart. Okay. Quick update on the Fed now after the very benign CPI report this week. 94% chance

priced into Fed funds futures about a September rate cut. I think I'm going to end up being wrong on that one that they wouldn't cut till after the election. It certainly appears, although there are still two months to go, that they will end up cutting once before the election. It's a 96% is it? Let me look at it. No, 99% chance by November and 100% by December in the futures market. So these rate cuts by all indications are coming and apparently very likely to be starting even a little earlier than expected. Okay, there's some information on China that I want you to get out of DivingCafe.com that I got to skip through here. And then I want to quickly say I used Germany and Switzerland to make an analogy about growth. Because you have the German stock market, the MSCI index of Germany, which is 57 companies that is trading right now at half of the value of Apple. That is trading right now at half of the value of Apple. And it's generating an aggregate, all 57 companies, 10% more free cash flow than Apple, but is worth 50% that of Apple.

Then you have Switzerland, which is maybe about 60% of Apple, a little bit more than Germany, and yet is 10% less than free cash flow than Apple. So you have 90% of the free cash flow of Apple worth 60% of Apple in Switzerland. That's 45 companies, by the way. But you have 57 companies in the German index that are trading at half of the value of Apple with 110% of the free cash flow. But this is not totally irrational. It's a little irrational, but it's not totally irrational. At the end of the day, the more interesting factor to me than why Germany and Switzerland trade the way they do versus Apple, which is clearly part of just the cult stock reality of Apple, part of it, and again, I hat tip to Alexander Einheiken, one of my very favorite economist analysts in the world who I've

been reading now for almost 25 years. This has everything to do with the delta between Germany and Switzerland. How does Germany trade at 11 or 12 times earnings and Switzerland trades at 17 times earnings? Well, very simply put, Switzerland is number six in the world in GDP per capita, economic growth per citizen. Germany is barely in the top 30. Switzerland has a 38% debt to GDP ratio. Germany's is almost double that. And that's better than most of Germany's European neighboring countries, by the way. Debt represents a drain on future economic activity. And so all of these things come together for a purpose that marked into expectation is some growth expectation. And the way that Germany can trade to Apple or Switzerland trades to Apple or Germany and Switzerland trade

to one another, there's a big takeaway there. So then let me get to the bottom line thing I want to conclude with today, which does have everything to do with this economic growth. At the end of the day, I've talked over and over about the tautology of economic growth. We care about economic growth to the extent that it is a condition for a better quality of life, that you are creating the necessary soil for people to have a higher standard of living with better economic growth. And that economic growth is effectively, and this is tautologically true, the combination of population growth and productivity growth. And so when I think about productivity growth, a lot of it is because population growth right

now is impeded in the West by a pretty low view of fertility and a pretty low view of immigration. And as long as most Western countries, if not all Western countries, have essentially zero population growth or even negative population growth, it puts a far bigger burden on productivity growth to drive economic growth if we are to create a higher standard of living across Western nations, including our very own U.S. of A. And so my friend Louis Gove had written a piece a few weeks ago that I got around to reading this week that was very interesting to me in talking about what we know about countries that do take on this burden of greater innovation.

I write a lot about the impediments to productivity growth, the excessive government indebtedness being the secular, structural, systemic impediment that it is across any nation that gets into a position of excessive indebtedness, how that necessarily, and again, not to be fancy, algebraically, excuse me, takes away from economic growth. But, and then there's causation around this, high marginal tax rates, excessive regulation that go even above and beyond what the role of excessive indebtedness plays in putting downward pressure on productivity growth.

But what are the conditions for productivity growth that are positive? What is it we want to see to generate more besides not having some of the negatives? What are some of the positives? And Louis talks about education, and I think he's really onto something there. But the caveat, and one he acknowledges, is very important. Necessary but not sufficient. There are no countries that have dynamic economic growth that don't have a top tier education system. But there are plenty of countries that have a top tier university system

that don't have dynamic economic growth. Number two, again, the rule of law. This one is also necessary, but not sufficient. And even what it means to rule a law is often graded on a curve. Number three, a strong military capacity. And again, people can debate what's correlation and causation, but you look at the great innovative countries and you look at the highest military budgets per capita, the United States, Israel, South Korea, Taiwan, spending a lot in defense and having a lot of innovation relative to where the rest of the world is. Number four, entrepreneurialism. That's the term I'm using. Louis referred to it as an acceptance of failure. And I think he'd agree that this is what I mean by entrepreneurialism. Acceptance of failure, meaning a culture of risk, of risk-taking. And where there is not risk-taking, taking. And where there is not risk taking, Japan over the last 30 years, and where there is risk taking, United States, Silicon Valley, these things that have gone on, you can get significant.

And it's not, by the way, just the risk taking of big tech and Silicon Valley, and that's more exciting and venture capital plays in. But just the entrepreneurial culture that permeates the U.S. with small business, family business, private business, et cetera. And then number five, we talked about ecosystems. And I think this is essentially describing the network effect. And he's just completely spot on here that countries that have the conditions of innovation have strong ecosystems for innovation. Silicon Valley, by the way, being a great example of one. And then the final one I'm going to add that wasn't in Louis' list is capital formation. I don't think societies can innovate without robust capital markets.

And this essentially means where there's innovation in capital markets, there's innovation possible in the economy. The United States has done this very, very well. And when people sit around talking negatively about capital markets, they are talking negatively about free enterprise. They are talking negatively about innovation across the economy. Capital formation is a wildly important element. Check out the chart of the week at Dividend Cafe, where you will see in very visual form, the top heaviness of the S&P. I started off our discussion today talking about the equal weight versus cap weighted index. And I will tell you, 78% of the stocks in the S&P 500 are performing less than the S&P 500, highest in history. Do with that what you will. Thank you, as always, for listening,

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