Taking Stock 19 December 2024

James Lee is joining Chris Lee & Partners as chairman after a 23-year career with Jarden, culminating in six years as its chief executive. Chris Lee & Partners is delighted to have James join the company. He writes the last Taking Stock for 2024.

“This will be the defining learning opportunity in your lifetime, James.”

Those words still sit with me today. At the time, it was the GFC, and the words seemed far from the truth. Markets were tumbling, the Bank of England had just announced its first rescue package, and all investors were under significant strain.

My daily ritual at Jarden in 2008 started with a conversation with three people. The late Lloyd Morrison was generally in competition to be first, and the then Head of Alliance Bernstein was another contender.

What Lloyd meant was that, in times of intense strain, you are forced to learn and innovate. If you embrace the lessons - not the fear of a situation - when environments turn, you will be materially better off. This lesson, coupled with sharing my father’s love of writing, means I end each year with a reflective mindset, which prepares me for the standard Saturday afternoon bbq question: “What does the year ahead hold in store for us?” 

Taking Stock today is my response.

This time last year, we were faced with some significant challenges: two global wars, record debt-to-GDP ratios, stubborn inflation, record heat, and increasing unemployment. None of that should have been good for markets, but the impact was hidden behind the veil of record markets, driven largely by the promise of an AI revolution, leading most markets to rise between 10% and 25% in 2024.

When we look to the year ahead, we see one with lower interest rates, hopes of ceasefires in the Ukraine and Gaza conflicts, inflation closer to acceptable levels, and large investment into new technology. This has led many professionals and non-professionals taking to social media to talk about the expected recovery in 2025. I would venture that when the new year rolls in, the local papers will be full of views suggesting equity returns will be around 10% next year.

In my mind, this is at best an educated wish (at worst, self-serving sales propaganda), as it ignores the reality of what makes us human - our emotions, which for most of us are driven by our confidence. After five challenging years, the average person’s resilience and confidence are low. Fear lurks.

When I think about the year ahead, I look back and remind myself of the biases and learnings from my own experiences. I then consider what is useful to colour my view of the future.

I started my career at the peak of the dot-com boom, 25 years ago. At the time, the markets were soaring, fuelled by the idea that the internet would change our lives. So everyone started an online store. This demand for the internet meant telecommunication infrastructure players, which made this possible, were seen as a sure-fire bet.

The problem at the time was that everyone needed either venture capital (VC) or public money via an IPO to fund their losses as they tried to create the new world order.

The two material stories at the time were Amazon and CISCO. Amazon was a bright star, using the technology to change how we shopped, while CISCO was the global leader in the infrastructure required to service this demand (these were the historical equivalents of OpenAI and NVIDIA).

CISCO's revenue went from $4 billion in 1996 to nearly $20 billion in 2000, while its market cap grew from $30 billion to nearly $700 billion, meaning its revenue multiple went from around 7x to nearly 35x. Amazon grew revenue from $15 million to $1.6 billion. Its market cap went from $500 million to $25 billion. Everyone was trying to copy these two market darlings - either by creating new online stores, like Pets.com, or infrastructure, like Nortel Networks.

The reality was that the technology was so new that the business models of users like Amazon and Pets.com just weren’t profitable. So, VC and public markets stopped funding their growth. This meant the unrelenting demand for new infrastructure ceased, leaving a material oversupply, too much debt, failed dreams, and badly stung investors.

From the peak of 1999, Amazon and CISCO lost more than 80% of their value, while many others just went broke.

While the history books focus on the wipeout of value and effectively make fun of what were preposterous ideas (such as Pets.com), what can’t be forgotten is the advancements this period brought. Today, internet shopping and the infrastructure that supports the internet have changed the way we live our lives. Amazon is a $2 trillion company, while CISCO generates over $50 billion in revenue.

Our lessons from that period were that the market correctly predicted that the internet and online sales would fundamentally change the world, but it had little ability to determine how long it would take and who would win. What it taught us, though, is that despite the constant comment of “a new paradigm”, rationality always returns. But as the adage goes, the market can stay irrational longer than an investor can stay liquid.

It is this bias that guides my view of 2025. It is likely the global economy will get easier, but it is very unlikely to snap back quickly. The protection we received last year in terms of investment into AI and AI-associated infrastructure is likely to continue for a while, but for how long, and how fast it falls, is completely unknown.

The similarities to 1999 are hard to ignore. There are few commercially viable uses for AI, given the extraordinary energy and infrastructure costs. Data centres and AI infrastructure are premised on demand continuing to grow for decades to come, but at what point will the $1.1 trillion going into AI be measured by its returns?

That isn’t to say there won’t be extraordinary winners from the ability to synthesise and comprehend large complex data in healthcare, pharmaceuticals, and energy. But not everyone will get it right, and progress will not be as fast as investors might hope.

Given so many of our returns last year were driven by AI-related stocks, it is a relatively aggressive bet to suggest markets will repeat the same performance next year. NVIDIA is valued at $3.5 trillion (up 172% this year) on revenues of $130 billion (up over 100%). That compares with a $360 billion market cap and $26 billion revenue three years ago. When revenue growth slows, what will the right valuation be?

If the funding for AI investment slows because people struggle to commercialise it, then will data centre growth stall? Will NVIDIA still be able to charge the same gross margin, or will it see competition? Will demand for power therefore stall? Will someone use AI to solve fusion, develop a battery that makes autonomous air travel possible, or create a pill form of the drugs that are so popular for weight loss?

My view on markets is that you should place a bet only when you feel better informed than the market. Today, the main global markets (which really means the US) are trading at expensive multiples by any standard, effectively factoring in full confidence in what is largely unknown.

Whenever that happens, in my mind it is the time to re-evaluate both our risk tolerance and ability to take risk.

Retired investors do not have to take risks with developing technology. They can revert to proven, stable sectors and companies.

While some would say that is why you invest passively - to avoid thinking about those risks - unfortunately today, 35% of the S&P 500 is weighted to just seven stocks. So passive investing effectively means you are taking a very clear and correlated risk related to the market's appetite to continue pouring capital into the unknown.

And this would be my response over the Christmas bbq period, when discussing investing in the S&P 500 next year. Is that a risk you understand well enough to take? Do you need to take that risk? If so, how much of your funds would be the right amount to embrace that risk?

Our advisers are skilled in matching both risk tolerance and risk capacity to your risk strategy.

My interest in financial markets began as a teenager filling in for Dad one summer, so I am both proud and pleased to take on the role of chairman of Chris Lee & Partners, to be a part of the conversation on understanding risk.

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We wish readers an enjoyable holiday period. Our office closes at 12pm on Friday 20 December and reopens on Wednesday 8 January. We will monitor emails over the break for anything urgent but will be unavailable via phone.

Chris Lee and Partners Limited