The AI Honeymoon is Over… Welcome to the AI Marriage

It was a roller coaster week and the first market indication that the hard part of AI is beginning now. We stole our title from Open Field Capital’s most recent memo on AI, signaling that the easy money has been made, and the hard work must now follow. If you would like to read their most recent memo, let us know, we would be happy to send you a copy.

Bubbles and Technological Revolutions

It is difficult these days to have a conversation about the stock market without somehow addressing whether this is a bubble. I believe that is the wrong question. Bubbles are emotional events. Tulipmania in the 1630’s was a bubble because it was massive speculative event based on the rarity of certain tulip bulbs. Tulips were not at the center of some major technological advance. Paying ever increasing amounts for tulip bulbs was pure speculation with no fundamental backdrop. THAT’s a bubble.

All bubbles have high valuations, but not all high valuation events are bubbles. Valuations are an important part of any investment decision not because they indicate a bubble, but rather because valuation is an indicator of future returns. The higher the valuation at any given point in time, the lower the expected return becomes. The lesson here is that piling into securities with extreme valuations is always a risky business. If you buy at extreme valuations, you are relying on the greater fool theory to produce returns. Sometimes that works, but other times that is a recipe for disaster. While valuations have been high recently, they have not been extreme.

The AI frenzy is based on something very real – a technology breakthrough that will alter most everything we do and the way the world works. That has a unique sound to it, but it isn’t unique. Railroads, and later automobiles, would be huge economic game changers. Likewise, the internet has also changed the world. AI appears to be another easy bet to become a revolutionary change as well. The point is that this has happened before, so there should be some important lessons to learn from the past.

Technological breakthroughs tend to follow similar stages of development, beginning with some breakthrough that establishes the large economic opportunity. The transcontinental railroad (1869) was the catalyst for the enormous growth of railroads in the late 1800’s. Henry Ford’s assembly line (1913) reduced costs to make cars affordable to the masses, transforming individual transportation. The introduction of web browsers, particularly Netscape in 1995, launched the internet era. For AI, the introduction of ChatGPT (2022) was the critical event.

Once the catalyst is established, the race to be the first/benefit the most begins, creating a speculative build out. Railroads were built without regard to what others were doing, Henry Ford’s assembly line lower costs dramatically, forcing competitors to change their operations to stay competitive while meeting surging deamnd. The browser wars began in 1995 and chatbots have proliferated since ChatGPT was introduced. In all cases, multiple competitors emerged because everyone saw (or thought they saw) the opportunity to capture more than their share of the pie and they risked it all to get it. At first AI appeared to be a ‘gentlemen’s war’ among the mega-cap tech companies, but when Oracle (ORCL) jumped into the pool, it appeared to start the typical open warfare for domination. We can only assume that Oracle saw its core business about to be disrupted by AI, and decided that it is better to take a swing than to give in.

This week, Alphabet (GOOG/GOOGL) introduced their latest AI iteration, called Gemini 3, to rave reviews. That places pressure on Meta, Amazon, etc. to up their game. The NVIDIA (NVDA) earnings report this week tells us that the acceleration of AI development continues as each player attempts to one up the others.

As the capacity buildout progresses, no one is thinking about total capacity. All of the focus is on why ‘my’ technology is better than everybody else’s. Obviously, not everyone can be right. In fact, more will likely be wrong than right.

Set aside who the winner(s) will be, that is yet to be decided. However, when viewed in total, far too much capacity is likely to be built, which will eventually drive down profitability for chips. It isn’t logical that NVIDIA will be able to maintain their very high margins indefinitely. That doesn’t mean it ends soon, but at some point, demand will be satiated. While things are getting harder for the AI developers, it will also get hard for Nvidia. This is the hard part. The dream of the new technology collides with the reality of development. This is where winning strategies and losing strategies are eventually determined. The natural result of that is some turmoil in financial markets. We saw some of that this week, but we view it more as a normal rhythm of markets. When stocks get expensive, corrections are normal.

Japan Doesn’t Help

All the attention this week was on the technology stocks, but the fact is that events in Japan didn’t make this week any easier. Interest rates in Japan reached highs not seen in several decades. That may not sound like a big deal, but it is.

The Bank of Japan first lowered its interest rates to something approximating zero back in 1999. As a result, for many years, there has been the Yen carry trade – which is simply borrowing money very cheaply in Japan, converting it to dollars and buying U.S. Treasuries to earn a yield. As long as the dollar stays strong (or there is a large enough speread to pay for a currency hedge) this is easy money. This has created a natural background of consistent demand for U.S. Treasuries from Japan. With Japanese rates now higher, the motivation for the carry trade has essentially disappeared potentially lessening Treasury demand and putting upward pressure on Treasury rates. High rates and high valuations do not make good partners.

Can’t wait to see what next week brings… Have a great week!

 

What We’re Reading

 

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The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.

The views expressed in this commentary are subject to change based on the market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

Past performance is no guarantee of future returns.

 

 

 

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By: Adam