February showed the underlying challenges in the global economy despite the excitement around artificial intelligence.

The UK and Japan entered recessions, with Japan falling to the fourth-largest economy globally. The eurozone showed signs of slowing growth, cutting its GDP expectations for 2024.

These regions, along with China’s economic difficulties, suggest that over 40% of the world’s GDP is facing economic pressures.

Despite these challenges, U.S. investor optimism remains high, driven largely by gains in the “Magnificent Seven” tech stocks, which significantly impact the S&P 500 Index’s valuation.

However, economic indicators like rising U.S. corporate bankruptcies and commercial real estate struggles point to unresolved economic pressures.

Investors seem overly optimistic, ignoring potential risks and focusing mainly on the successes in AI and tech, potentially overlooking the broader economic challenges.

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February was a reminder of what lies under the surface of the artificial intelligence (“AI”) mania…

Last month, news broke that both the U.K. and Japan had officially entered into recessions. Japan even lost its spot as the world’s third-largest economy… now the fourth-largest behind Germany.

The eurozone economy – while not quite in recession territory yet – also signaled slowing growth… It slashed its 2024 gross domestic product (“GDP”) expectations from 1.2% growth to just 0.8%.

Altogether, Japan, the U.K., and the eurozone account for roughly 24% of the world’s GDP. In other words, roughly a quarter of global GDP may be at or near recession.

There’s also the constant stream of headlines coming out of China about its weak economic growth, government bailouts, and serious real estate issues. China accounts for another 18% of the world’s GDP.

So, in all, more than 40% of global GDP is under pressure. And yet, U.S. investors remain optimistic…

The S&P 500 Index has climbed 7% so far this year. As we’ve covered, most of the gains stem from the red-hot “Magnificent Seven” tech stocks. Currently, they account for 30% of the index’s total valuation. Nvidia (NVDA) alone accounts for 15% of the gains since 2023.

The AI mania is driving this market optimism.

While AI has contributed to some economic growth over the past year, it’s not enough to justify the market’s overall bullish outlook…

U.S. corporate bankruptcies are piling up. The number hit a 13-year high in 2023 and is expected to keep climbing through 2024. There’s also the struggling commercial real estate sector… which is set to be a major source of bank losses.

U.S. office vacancy rates rose to a record 19.6% in the fourth quarter of 2023 after reaching a 30-year high of 18.4% the quarter prior.

The market, however, remains bullish today….

We can see this through our aggregate Embedded Expectations Analysis (“EEA”) framework.

The EEA starts by looking at average stock prices for U.S. companies. From there, we can calculate what the market expects from future cash flows. We then compare that with our own cash-flow projections.

In short, it tells us how well U.S. companies have to perform in the future to be worth what the market is paying for them today.

As you can see, 2022 was a record year for U.S. profitability. The aggregate Uniform return on assets (“ROA”) reached a high of 13%. While the numbers for 2023 aren’t yet finalized, it looks like last year’s profits will take a bit of a hit… with Uniform ROA expected to fall to about 11%.

And yet, investors are already pricing in a rebound, even though the worst is likely still to come.

Take a look…

Investors don’t see the coming risk from today’s economic pressures.

They’re too focused on what’s going right in the economy, particularly with AI-driven tech. And they’re completely ignoring the warning signs coming out of almost every other industry, particularly with debt-laden areas like commercial real estate.

While tech may carry our economy over the long term, it’s not strong enough to shield us from waves of default elsewhere.

Investors who get too comfortable in this tech-focused market might end up regretting it.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research