The Federal Reserve and the Mag 7 – How Long Can Two Irresistible Forces Co-exist?

It was two years ago that the Federal Reserve began raising interest rates. They did so with alacrity. That was understandable, given that inflation had been roused from somnolence over 40 years’ time. The Fed’s task was formidable, not only because inflation had been falling for so long, but also because interest rates had declined essentially to zero, with little precedent in financial history. As a result, their task was in some ways even more formidable than that of Jay Powell’s predecessor Paul Volcker, who at least started from a point of much higher rates that avoided the potential distortions of near-zero rates. The history is striking:

Notwithstanding widespread media coverage that the Fed’s moves have had little effect on the economy, there are tangible signs that they are. The leading indicator index from the Conference Board shows a visible downward movement when they began their tightening:

It shouldn’t be a surprise that the data was already in decline given the scale of the massive government response to Covid; with the passage of time some amount of normalization was to be expected. However, the decline was not negative until after the first Fed rate hike. The deceleration has continued, which could be expected given the Fed’s ardent pursuit of their 2% inflation target. Which brings us to the next chart:

While it is always dangerous to rely on signals from the financial markets, since they are the most mercurial of indicators, the inflection in 2023 led the economic series. The turnaround has been a bit stunning, in fact, when we consider the leadership. That has been, of course, the technology stocks, led by the redoubtable “Magnificent Seven” (in case you have taken a break from the financial news, they are Amazon, Apple, Google (Alphabet), Meta, Microsoft, Nvidia and Tesla). Their performance is reflected in Chart 4; it should be noted that those seven stocks are included in all three series, but the composition of the series is the source of the differences:

The competitive advantages of these firms, in general, are large. When we (and everybody else) add the open-sky nature of the AI opportunity, their valuations may appear justified. But those valuations are not low:

It is true that these are not the most outrageous multiples ever seen. Leadership valuations of some firms in the Dot.com episode a quarter-century ago were even higher. The “Mag 7” in fact offer an interesting historical commentary on just how high those valuations were. We have re-based the current NASDAQ performance and its Dot.com episode in Chart 5 to compare them:

So when the mood strikes, valuation discipline can be tossed to the wind. The valuation of ARM holdings, a company that serves some of the same markets as Mag 7 companies, trades today at about 100 times earnings. And while the valuations reflect favorable growth opportunities, there are annoying caveats. One, for example, is that the large data centers that do the work use so much electricity that they are receiving regulatory scrutiny. From a recent article in the Financial Times:

So there are, perhaps, some limits to the growth expectations.

It remains the case, however, that the performance of these stocks has happened late in the sharpest Fed tightening in 40 years. That is testament to the strength of their businesses, which puts the burden of truth on their skeptics. But it is possible that the actions of the Fed have yet to be fully felt. It is axiomatic that their behavior acts with “long and variable lags”, as Prof. Milton Friedman said years ago. Their balance sheet has been contracting for a year and a half, and the money supply followed at the beginning of 2023. These are decidedly contractionary policies. If one were prescient (or lucky) enough to own the market leaders, it might be wise to at least take some off the table.