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What’s Next for Tech, Green Stock Prophets or Profits and CAT Bonds

The early bird gets all the worms. Usually, a week or two into the calendar quarter, I start receiving the investment newsletters of peers and investment professionals I follow. This time, they got to talk about how a resilient economy continues to propel the markets upward and how big tech continues to exceed expectations as the AI trend unlocks ever greater opportunities. Now I finally get around to writing my letter and things look decidedly less rosy. Nvidia – the company that aims to meet the insatiable demand for chips that can power AI – had a 10% down day last week, seemingly out of the blue. Meta Platforms spooked investors this week on its massive AI spending plans – on Nvidia chips incidentally – and its stock dropped 10% too, for good measure.

Markets Will Be Up or Down in 2024

Now 2024 looks decidedly less impressive year-to-date than it did a few weeks ago. Bonds are down a few percentage points, and the stock market is up 1-5% depending on your choice of broad market index. Last Friday the market closed in “pull back” territory – 5% below a recent high – though it has come back some. To be sure, market pullbacks are not unusual and most investors “welcome them” to cool down a market that risks overheating. But more importantly, the fact remains that a week from now things could look decidedly different, seeding new narratives that will ignore the randomness of short-term market movements.

In my view, the bigger picture has not changed too much: 2024 is still an election year, high interest rates and inflation have shown staying power, and the economy is doing better than it feels. My optimism for investment returns is rooted in the prospect of lower rates in the not-too-distant future.  I still think we will get there, but the longer it takes and the longer inflation stays elevated, the greater the chance that we have a recession or at least an environment more hostile to financial assets.

For those who can afford to be in a low-risk portfolio, these are good times with high rates on short-term instruments like CDs, T-Bills, and Money Funds.  For those investing for growth, things look riskier, but that is often the case and should not preclude one from investing. If you only invested in risky assets when it felt “safe,” chances are you would leave most of the returns the market can offer on the table.

Tech Stocks: Will the Turtle Catch the Hare?

We live in an age of unbelievable technological progress. It is a phrase I am pretty sure I have heard throughout my entire life. However, somehow it always feels like only the last couple years have been truly disruptive. Is AI an invention or a discovery, as Jeff Bezos recently described large language models? I don’t know. However, I am fairly sure of three things as it relates to technology: tech stocks have carried the stock market for the better part of a decade but won’t do so forever, today’s technology will look quaint 10 years from now, and not all technology is progress, case in point: social media.

So if technological change is more or less a constant, then the tech sector’s outperformance doesn’t come from a burst of innovation, but from earnings growth, profitability, and investor sentiment as it pertains to the sector. That makes the tech sector susceptible to being lapped by another sector, if the fundamentals of that sector become comparatively more attractive. Perhaps now we are at such a moment, where non-tech stocks are so much cheaper than tech stocks that the math just becomes too hard for continued Magnificent Seven dominance.

Anecdotally, the best performing stock going back to January 1999 is that of a company that sells over-caffeinated sugar water: Monster Beverage Co. Now the point is not to go out and buy Monster – let alone drink it – but rather that the market prices stocks based on fundamentals and popularity. Or put differently, if a stock has strong fundamentals – growth, earnings, dividends, etc. – but is not that popular, the market offers you an opportunity to earn a return that is potentially higher than what it has on offer for the most innovative and revered companies. I think we are at a point in time where the grab bag of 493 of the 500 biggest US stocks has some true gems for the picking, because everyone wants the other 7.

After 25 years: Nvidia almost caught Monster

Green Stocks: Curb your Enthusiasm and Serve your Financial Goals

In the last newsletter I wrote about clean energy stocks that were in the sweet spot because they paid high dividends at a time when rates might be peaking – and subsequently receding. The public market is not ready to buy this thesis, but the private market is. There have been a number of transactions recently, where renewable energy producers have been taken private. The latest example is Avangrid, which saw its stock price jump 15% in March on a take-private offer from Iberdrola. If the market continues to underappreciate clean energy and our holdings would just get taken private, that would work out fine for our investors.  But it also touches on a bigger reality that has been something I have had to contend with for a decade: the market doesn’t really care for green stocks most of the time. Thankfully, sometimes it does. In 2020, “pure play” green stock funds were up in the range of 60%-230%. Averaging out such years over the morose periods, still leaves you with a decent return. But that is not ideal and it looks less attractive if you factor in the wild swings you would have to endure to earn that return.

By virtue of operating in this space of green stocks, I have met some well-intentioned folks over the years who invest in it because they want to solve the climate crisis and safeguard the planet’s biodiversity, ecosystems, and clean air & water. From that perspective, one might hold the view that it is always a good time to invest in green stocks. It is not the approach I take, however. My clients need to meet their financial goals. The essence of my role, thus, is to be a good steward of their capital so that they may attain their goals. That is not inconsistent with investing in green stocks, but it is inconsistent with investing in auto-pilot fashion, broad brush in hand, across the green stock- and fund universe without consideration for profitability, survivability, and volatility. And to the extent that you really want your capital deployed for a healthier planet, it still pays to discriminate with your money, as capital is scarce and burning it doesn’t serve one’s values or the planet.

$10,000 invested in 2005 became $60,000 in the S&P 500 vs $3,500 in the Wilderhill Clean Energy ETF

A better approach is to find the intersection of green stocks and stocks that screen well from a profitability (potential), growth, and valuation perspective. Think Venn diagram, though at times it will look more like 2 adjacent circles.  Though it sounds so obvious it is not as straightforward. It will force you to mostly exclude the more interesting and groundbreaking technologies in clean tech and clean energy, most EV companies, most battery storage companies, charging companies, and so on. And chances are you might exclude the next Tesla too. But the alternative to this “curb your enthusiasm” approach is to lean too far into the green sector theme and burn your capital. This Larry David mindset has allowed us to invest in the space and not get burned, though at times it has produced frustratingly few “pure play” investments you can’t wait to talk to your clients and friends about.

CAT Bonds – Investing in Natural Disasters Avoided

Catastrophe bonds – or CAT bonds – are high yield debt instruments that raise money for insurance companies when they need to pay out policyholders as a result of a natural disaster. When disaster strikes, coupon payments and principal due to bondholders are suspended, reduced, or possibly even eliminated, thus creating capital for the insurance company in their time of need. Essentially, insurers and reinsurers spread their risk to financial markets, in what I think could be construed, at least in theory, as a win-win. It reduces pressure on insurance premiums, as it mitigates risk to the insurance company. It allows insurance companies to continue to operate in geographies that they might otherwise abandon, and it provides an uncorrelated risk with high income for investors. Incidentally, you might also become a more verdant advocate for urgently addressing climate change, so as to protect your investment. Ok, that last point might be a stretch.

I think I would buy this CAT bond.

Now why would you buy a CAT bond in a world of ever more extreme weather events? Well, think like an insurance company. Why do they keep writing homeowners policies in states like CA? – I was going to say Florida, but that’s increasingly a bridge too far for private insurance. They will keep writing these policies, as long as the price is right. The price, in this instance, is the yield you receive on your investment. And of course, you would need to diversify your CAT bonds. For example, you can buy them inside a fund, where you are exposed to many different geographies and insured assets. Perhaps each year you experience some loss, but as long as it is offset by the juicy CAT bonds that did not have an adverse event, you are coming out ahead. Often financial innovation is – rightly – considered a dirty word. Think of some recent vintage: crypto (agree to disagree), securitized subprime mortgages, social media-inspired mobile stock trading (Robinhood), non-fungible tokens (NFT), and Special Purpose Acquisition Vehicles (SPACs). CAT bonds, however, seem to have a legitimate, non-speculative use case and I am researching them with interest.

Springtime is here and in my neck of the woods one swallow has not made a summer. The weather has been nice at times, rainy and cold at times, and mostly it can’t make up its mind. Much like financial markets, but we can be patient in both instances and excited about what might be in store.

Kindly,

Jan P. Schalkwijk, CFA

JPS Global Investments

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