Mid-Summer Market Update, Bernhard Koepp, C.J. Lawrence Commentary, 7/21/23

In this video, Bernhard Koepp gives a mid-Summer update on the markets, and a brief macro outlook. He also covers opportunities in Technology stocks driven by generative AI and highlights healthcare stocks benefitting from the next medical device cycle.

Hi there. This is Bernhard Koepp at CJ Lawrence. It is July 21st, and I wanted to give you a midsummer update on what we’re seeing in the markets. Our second quarter letter has gone out to clients. It’s been quite a year. The second quarter was another positive quarter. There is a saying in Wall Street that says sell in May and go away. Well, if you did that this year, you would’ve missed out on about a 10% return. Let’s look at the indices. The S&P 500 hit 20% plus just the other day. Many of the other indices, like the tech heavy Nasdaq, are up twice as much. Even if you look at the international markets in Europe, many of them are up double digits as well. It’s been quite a year already. What is driving this macro better is obviously one of the parts of this.

I’ll talk a little bit about that later. But more importantly, it’s a new product cycle. And look, we’ve already published on this. Our strategist, Terry Gardner has been talking about it, and it’s really the phenomena of generative AI. All of you, or many of you, have heard about ChatGPT by now. This is something that was launched back in November of last year by a company called Open AI. Generative AI, in simple terms, is a system capable of generating text, images or other media in response to prompts. It’s a new form of artificial intelligence, which really responds to human beings. You can basically talk to it, and it will respond to you and give you responses. This is very different from, or the next phase of AI, from basically running algorithms and learning from using algorithms or mathematical formulas, to solve problems.

This is now an interactive software that allows the user, through prompts, to get responses. And this is very powerful if you think about it, because the system scrapes data from the internet. So basically, anything that’s floating around in the web is fair game. Today there was a meeting at the White House where the president summoned some of the leaders in this space to discuss the boundaries for this scraping of data on the internet. There will be lots of regulation, I’m sure, and guidelines coming out to this, but this is a very exciting and scary development at the same time. So why are we excited about it?

There was a Goldman Sachs report that just came out that basically says, within the next decade, corporate earnings should be driven 30% higher in most cases, or in some cases through this new software or this new application. We are seeing this play out already amongst the large tech companies. You’ve heard of the company Alphabet. They invented Google or Googling as a search. The whole search business or the way search that was done in the past will be completely transformed through this generative AI. You won’t be putting in a sentence asking where can I find this or that. It will be an interactive dialogue, if you will, between the search engine which will have generative AI functionality. It will give you complete sentences back and curate the responses for you in an almost human-like kind of response.

There is this battle galore happening right now between Microsoft and Google. Google is obviously the market share leader in search, but you know, Microsoft also has a search engine where they’re incorporating these generative AI functionality. It’s going to be very interesting who will dominate the search space in the end. We’ve seen companies like meta platforms. Meta is the old Facebook. They launched a new version of Twitter. All the issues surrounding Twitter have opened the door to a second competitor. It is amazing that within a couple of days, this new Twitter, which is called Threads, garnered a hundred million users. This is an incredible effect. Meta already controlled 2 billion users, so you could say that this is not surprising.

But for a new application to attract this many subscribers and users in that short period of time is quite remarkable. And what Meta is doing is using these new generative AI technologies to create a better user experience. If you think of the generative AI software experiences that we will see in the future, they’re all centered around better user experiences. Think of things like call centers. How many of you have been on, on the phone for hours and hours, and then you get some call center in the middle of nowhere telling you things that you already knew or not being able to help you. Generative AI will probably replace very simple functionality within large companies that are service oriented, whether it’s in the travel industry or in the healthcare services in your society.

Basically answering questions in a more succinct way, and probably even more informed way, because it can scrape data much more efficiently than a human being can. That will be very transformative for many sectors that we’re following. We’re seeing it also in images. Adobe, which we’ve had in the portfolio for many years, just launched Firefly. It’s an amazing new generative AI driven software where you can prompt it to say:I want an image to depict this or that. You no longer need to be a professional web designer to navigate through complicated software. You can really ask it something like: I want to show an elephant you know swimming through a lake, and it will generate that image for you.

And if you want to pair that with text, you can also ask it to do that without being a professional web designer or a curator of photographs. The experience that’s being transformed here through generative AI. Another company that we just added to the portfolio called Oracle.Oracle has been in the database business for decades. They are the gold standard when it comes to databases. They acquired a company in the healthcare space last year called Cerner. Think of all the functionality that’s incredibly inefficient within the healthcare services space in user interface when it comes to patients that will be transformed through generative AI. We’re very excited about this new technology. There will certainly be very scary headlines relating to generative AI as well, which we’re watching with interest.

It will be interesting to see how regulators catch up with this technology as it’s being rolled out. Looking beyond technology, there’s also healthcare that we find very interesting on the medical device side. We had this period during the pandemic where elective surgery was very difficult just because beds weren’t open at the time. Anything that was elective, whether you needed a new knee, new hip, stent, pacemakers, or things that are less urgent in some cases was hard to schedule. Tese operations were put off. Currently, we’re seeing a new growth wave in the medical device side. We’re very excited about this space in the healthcare space. Those include firms like Medtronic, Zimmer Biomet, and Stryker. These are the bulldogs as we call them in that space.

We’re also still very excited about what’s going on with the big pharma companies like Eli Lilly in the innovation and new treatments for everything from Alzheimer’s to obesity. There are varied, exciting developments that are happening in these companies, and we’re seeing that play out in the stock prices of companies like Eli Lil. Turning to the macro picture, we were cautiously positioned going into 2023. The inflation dragon hadn’t been slain yet and many reputable economists were forecasting an imminent recession. Europe seemed to be heading for a severe energy crisis. China had not reemerged from its zero Covid policies and lockdown, and J. Powell was going to put us into a severe recession with his interest rate policy.

Well, guess what? None of that happened. The good news today is inflation is now, at the latest reading for inflation for June, is 3%. That is remarkable, especially if you think about where we were just last year at 9.1%. We are at 3%. The Fed’s target for interest for inflation is 2% and we are at 3%. I would not be surprised if we didn’t have a handle on inflation sometime soon. That has basically put the pressure off when it comes to yields. We saw yields peak in March, and that was because of the banking crisis. We saw three banks back in March basically go under, starting with Silicon Valley Bank and followed by Signature Bank and First Republic. These were not unremarkable events. We’ve seen banking crises before.

I am old enough to remember the savings and loans crisis from the late eighties and early nineties where a thousand savings and loan banks, or thrifts as they were called at the time, went under. The next banking crisis we went through was in the great recession. That was the 2008 and 2009 period. We lost about 25 banks in that initial period, and then another 400 after that. So, two things to remember from those events was each one of those banking crisis actually set up a very nice equity bull market following those banking crisis. We saw three banks go bust this cycle, interest rates are still quite high, and there’s still a lot of pain when it comes to the pressures from severely restrictive interest rate policies.

I would not be surprised if something breaks in the second half of the year. But it was also interesting to see in March when these banks went bankrupt, or were taken over by the larger banks, like JP Morgan, for instance took over First Republic. It was interesting to see that yields peaked. So basically the read through was, okay, we have an event and the Fed is going to factor in the effects of this banking crisis, which is basically a pullback or banks becoming less willing to lend money, which is something which dampens the economy and is deflationary. We saw a peak in yields in 2 years and 10 years already in March. And the stock market sold off at first and then rallied off that bottom. So we saw an interim bottom again.

In that period, yields went back up again in the May period. Then we got the inflation data for June at 3%, and the market said, okay, I think the inflation dragon has been slain. We don’t need to worry too much about inflation anymore going forward, given the data that we’ve seen. We still have an inverted yield curve. Inverted yield curves are usually a predictor of recessions. We are also predicting a recession, but I think it’s fair to say at this point, the recession that we’re expecting is going to be quite shallow. And the reason for this is that we have very strong employment. If we are near full employment, that is going to slow for sure, and wages are still quite elevated, although the growth rates are coming down and now we’re gonna see quite a slowdown.

We don’t expect to see a recession, and this is really leaning on our favorite economists. We don’t think we will see a recession till the fourth quarter of this year. We would expect negative GDP growth in the fourth quarter of this year and the first quarter of next year. The market is kind of looking through this because the market is trying to gauge the level of earnings per share. There are some doomsday estimates for S&P earnings at like 180. Well, we are at 210 or 215 still in terms of the estimates. We are a long way from the most pessimistic views on earnings, and we get more data every day on earnings, but the key is what is next year going to look like?

If we can hold earnings at this level and then make it through the shallow recession, then we are going to see a relief in earnings in 2024. So what is that kind of set up for next year? Again, leaning on our favorite economists out there, we are looking at a scenario where we could be at a low growth environment for GDP between 2% and 3% in 2024, combined with an inflation rate of about the same. So that means nominal growth, that is GDP growth minus the inflation rate nominal or plus the inflation rate. The nominal rate then is quite low. What does that mean for stock picking? It means that you must be tilted back to more growth type companies, companies that have secular growth drivers, because we are going back to an environment that is quite slow growth.

In a slow growth environment, companies that have sustainable longer term growth will get premium valuations. That is the kind of thing we are focused on going into next year. One thing to end the macro or round out the macro piece is our view on the dollar. Typically when interest rates peak, you also get a peak in the currency. We are already seeing that in the US dollar, which is weakening, and that is actually good for our companies who have revenues abroad. There will be a good tailwind for S&P earnings going forward because of the weaker dollar, and that’s because almost half of the revenues of the S&P 500 are coming from abroad, and many of the companies in our portfolios are even more skewed to international earnings.

To sum it all up, we are still seeing plenty of interesting opportunities to invest in. Many are saying this is an expensive market. For investors like us, who tend to be more growth investors, it’s not. If we look at next year’s multiple, it’s about 18 and a half times. We’ve seen a lot higher in the past. We continue to add interesting stock positions to our portfolio. And also on the fixed income side, it’s quite interesting. We are getting to the point where we can start thinking about extending maturities or duration on the fixed income side. That is a lot in midyear. We feel like we are well positioned in the portfolio and continue to be optimistic about the second half of the year.

Thank you very much for listening.


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