This quarter, Jon Manchester, CFA, CFP® (Senior Vice President, Chief Strategist – Wealth Management, and Portfolio Manager – Sustainable, Responsible and Impact Investing) takes us on a thoughtful journey through the changing landscape of executive leadership, the ripple effects of Sarbanes-Oxley, and how the Fed’s latest moves could realign market dynamics.

 

The Beatles occupied the top spot on the Billboard Hot 100 list a record 20 times, all between 1964 and 1970.1 Their final #1 hit came in June 1970 for a melancholy tune called “The Long and Winding Road.” Its release occurred roughly a month after Paul McCartney announced he would take a break—which ultimately proved permanent—from the legendary Liverpudlian group. The song reflected the somber mood of a band searching for an off-ramp following a transformational stretch atop the global charts and consciousness. Their music helped create the zeitgeist of that era and remains relevant 60 years later, but Beatlemania was no more sustainable than any other mania. It weighed heavily on the Fab Four, ultimately fracturing their collective desire to soldier on. They faced shifting agendas and the daily pressure of trying to be The Beatles.

Although on a much different level, Chief Executive Officers (CEOs) have their own journeys down a long and winding road. McCartney said the song was “all about the unattainable; the door you never quite reach…the road that you never get to the end of.”2 Running a Fortune 500 company must feel somewhat the same: you are a temporary caretaker of a business designed to last in perpetuity. Not surprisingly, CEOs tend to have relatively short stays in the hot seat. Spencer Stuart is an executive search and leadership consulting firm based in Chicago, IL. According to its 2023 CEO Transitions report, the average CEO tenure at a Standard & Poor’s 500 (S&P 500) company was 8.9 years as of 2023.3 In part, tenure is limited by a long-term trend toward an older starting age, with Spencer Stuart noting that in 2023 the average S&P 500 CEO assumed the role at 56.4 years old, an all-time high. Although the vast majority of CEO departures are categorized as planned, so-called “resignations under pressure” jumped from 7% in 2022 to 16% in 2023. Per Spencer Stuart, CEO departures under pressure are more common at the larger S&P 500 companies due to elevated media and investor scrutiny.

To replace these sunsetting CEOs, corporations tend to look internally, and an increasingly popular choice is the Chief Financial Officer (CFO). Across the pond, around a third of FTSE 100 CEOs have previously served as CFOs, up from 21% in 2019.4 This may be a result of the more expansive role taken on by CFOs, including corporate strategy, plus the heightened importance of risk management. Some CFOs are even the face of the franchise, so to speak. Long-time Costco Wholesale CFO Richard Galanti recently retired after nearly 40 years on the job. Galanti was the one who met with Wall Street analysts each quarter to review Costco’s results, not (former) CEO Craig Jelinek. He also, importantly, spent essentially his entire career reassuring customers that Costco’s famous hot dog-and-soda combo meal would stay at $1.50. Beyond serving as an inflation fighter (at least for the revered combo meal), Galanti helped Costco generate a remarkable 17.7% annual return, including dividends, for shareholders over the 38 years spanning 1986-2023. His story is fairly unique, but the CFO as influencer and future CEO seems more common, particularly as the complexity of running multinational corporations only increases.

Mind the GAAP

Perhaps we can trace the rising prominence of the CFO back to the Sarbanes-Oxley Act of 2002. Crafted in response to a series of accounting scandals at Enron, Tyco, and other companies, the Act sought to strengthen accounting practices and oversight. It established the Public Company Accounting Oversight Board (PCAOB), whose charge is to regulate the auditors (that is, audit the auditors), ending a long history of self-regulation for accounting firms offering audit services. Sarbanes-Oxley also requires that the company’s principal officers—typically the CEO and CFO—certify and approve their company’s financial reports each quarter. Criminal penalties await those who certify falsified reports, including significant monetary fines and/or prison.

The driving purpose of the Act’s reforms was to restore investor confidence, especially in periods of economic uncertainty. Co-sponsor Michael Oxley, former U.S. House member from Ohio, later said: “We often think of money as the currency of a free market system, but in truth the system rises and falls on the confidence of its investors. Those who invest capital do so based on an understanding and knowledge of the risks and potential rewards involved.”5 That confidence would be greatly tested once again, of course, during the global financial crisis (GFC) of 2007-08. Unfortunately, these episodes of diminished trust are a seemingly unavoidable facet of being a long-term investor. On the plus side, reforms are made, lessons are learned (the hard way), and sharp drawdowns in asset values can provide attractive entry points for opportunistic and patient investors.

At a high level, one way we can monitor an uptick in strained corporate finances is to compare company earnings calculated using Generally Accepted Accounting Principles (GAAP) versus non-GAAP earnings. With non-GAAP earnings, companies have the latitude to exclude income statement items they consider to be one-time, or nonrecurring. These may include expense items such as restructuring costs or asset write-downs, or a sizeable gain from selling assets. Monitoring the relationship between GAAP and non-GAAP earnings helps us spot signs of financial strain. In periods of economic stress, these numbers tend to deviate, indicating that companies are recording more one-time losses and driving down GAAP earnings, while non-GAAP earnings benefit from excluding those items. In Chart 1 on the following page, the ratio of S&P 500 GAAP earnings per share (EPS) to non-GAAP EPS suffered sharp declines during both the Tech bubble’s pop (2000-02) and the credit crisis. Over the last 30 years, the median for this ratio has been roughly 89%. In 2023, the ratio was 90%. This metric appears to be more of a coincident than leading indicator, but it’s worth keeping tabs on to gauge whether CFOs, in aggregate, are busier than usual excluding items from the standardized GAAP earnings calculation. Through the first half of 2024, the ratio is inline with that trailing 30-year median number.

T-Bills and Chill

The highly-anticipated Federal Reserve (Fed) pivot finally arrived in mid-September. To the surprise of some Fed watchers, it was a 0.5% (or 50 basis point6) cut to the Fed Funds rate, taking the upper end of the target range to 5.0%. Fed Chairman Jerome Powell described it as a “recalibration of our policy…as we begin the process of moving toward a more neutral stance.”7 Members of the Federal Open Market Committee (FOMC) estimated the target rate would drop to 4.4% by year-end 2024, and 3.4% by the end of 2025. With inflation in much better shape—the Consumer Price Index rose 2.5% year-over-year in August—the Fed is now turning its attention to supporting the labor markets by lowering short-term rates. This ongoing tightrope walk by the Fed is an attempt to properly balance its dual mandates of stable prices and maximum employment. Thus far, Chairman Powell has successfully navigated these choppy waters, but we know it’s too early to declare victory. If the Fed ends up reducing the target rate by roughly two percentage points while avoiding an economic recession, it would be an outlier over the last few decades. That scale of monetary easing has always been in response to a significant negative shock to the economy.

Markets aren’t sure exactly what to make of all this. Risk assets have enjoyed a strongly-positive 2024 to this point, but at the same time, the price of gold has hit new highs and the 10-year U.S. Treasury note yield has fallen from nearly 5% in October 2023 to approximately 3.8% by third quarter-end. There is some logic to this considering the anticipated Fed easing cycle, yet it still feels like investors are hedging bets on both sides of the economic “soft landing” question. One clear repercussion of lower short-term interest rates is a decline in income from money market funds and ultrashort bonds. The short-lived era of 5%-plus yields will come to an end, and in fact rates have already moved significantly lower ahead of the Fed. The “T-Bills and Chill” approach—meaning parking cash in Treasury bills yielding 5% and then sitting back to relax—will need a new moniker. It may end up pushing investors into equities in search of higher returns. Stocks offering higher dividend yields fared well in the third quarter, suggesting the yield-focused crowd might already be moving on.

To complicate things further, the U.S. presidential election looms ahead. If you want to know the winner ahead of time, Comerica Wealth Management’s 2024 Election Chartbook points out that the S&P 500’s performance for the August through October timeframe has correctly predicted each presidential election since 1984.8 In years when the S&P 500 Index is positive over those three months, the incumbent party has won. Comerica reasons that equity performance reflects broader economic sentiment, so when voters are satisfied with the economy’s direction, they tend to support the status quo. From a bigger picture standpoint, Comerica reminds us to separate our investments and politics, saying elections have little impact on long-term investment returns and that markets tend to do well regardless of which party holds the Oval Office.

So, take a deep breath, we’ll get through this. It’s a long and winding road, after all. At least, for now, we are passing through an economic landscape of steady growth, tempered inflation, and supportive monetary policy.

1 “Artists With the Most No. 1 Songs on the Hot 100, From The Beatles to Rihanna & More,” www.billboard.com, 4/30/2024.
2 “The Long and Winding Road,” www.wikipedia.org.
3 “2023 CEO Transitions,” www.spencerstuart.com, January 2024.
4 “Why more CFOs are becoming CEOs,” www.ft.com, 3/13/2024.
5 “The Sarbanes-Oxley Act of 2002 – Restoring Investor Confidence,” www.publications.aaahq.org, 12/1/2007.
6 A basis point is 0.01%.
7 “Transcript of Chair Powell’s Press Conference,” www.federalreserve.org, 9/18/2024
8 “Election Chartbook 2024,” www.comerica.com, September 2024