The Elephant in the Room

We have long held that the Fed has been the dominant force in both the stock and bond markets. Rates going down? Then markets are moving up, and vice versa. That has generally been true since the recovery started in 2009. More recently, the Fed has taken a back seat. As far as the stock market is concerned, we can no longer ignore the elephant in the room, otherwise known as AI (artificial intelligence). Bond prices will predictably react to interest rate movements, but stocks have again de-coupled from the Fed and interest rates and are reacting to the possibilities created by AI.

The transition from one dominant factor to another has not been smooth. The intro of Chat GPT in late 2022 created a stir and a strong market rally, but that faded the second half of ’23 as the Fed refused to cooperate with rate cuts, leading to bottoms in the stock and bond market in late October. At that point, anticipation of rate cuts began to grow and both bonds and stocks began to rally again.

In December, in another misguided attempt at transparency, the Fed appeared to acquiesce to markets and spoke of rate cuts for the first time. The stock and bond markets shot higher still. The bond market quickly priced in 6 to 7 rate cuts in 2024 (each cut being 0.25%) and the stock market followed suit moving to new all-time highs. The assumption was that, like the bond market, the stock market was reacting to interest rates, in other words, the Fed remained the dominant influencer. As we look back now, that was not necessarily the case.

Bonds Correct/Stocks Don’t

The interest rate euphoria didn’t last very long as the Fed walked back rate cut comments. And when the minutes of the January Fed meeting were released this week, it became very clear that markets had jumped the gun. Since the low at the end of 2023, the 10-year yield has spiked 0.5%; yet another very large move in a very short period of time.

If history held, both stocks and bonds should have had a correction as rates rose. But that is only half-right. The bond market did correct sharply and the 10-year yield is back to 4.3% and now fewer than 4 rate cuts are priced in for 2024 (which may still be too many). Yet the stock market has continued to run. Changing interest rates may have been the trigger to get stocks going late last year, but the fuel now is clearly related to AI. For now, the AI bubble is ruling the roost and the poster child is NVIDIA (NVDA).

NVIDIA reported blow out earnings numbers again this week and the whole market is rocketing as a result. We can’t help but believe that the continuing market overreactions to every piece of news, good or bad, is not healthy. Markets have become far too quick to speculate and far too quick to extrapolate. Market narratives are not only shifting quickly, they are shifting radically. In the last 4 month span, we began with rates spiking higher (5%, 10-year yield), triggering fears of even higher rates and very weak markets to the 10-year yield back down to 3.8% with stocks and bonds having significant rallies, back to the 10 year yield of 4.3%, but stocks heading even higher based on AI. The S&P 500 is now up about 25% from the October lows! We never argue with a rising stock market, but the big question is will it last?

We say, yes!

We affirmatively acknowledge the onset of a digital revolution, which currently unfolds in its nascent phase. To grasp the essence of this burgeoning shift, consider the following insights:

    • Prominent financial institutions on Wall Street forecast a staggering investment ranging from $8 to $10 trillion in the digital economy’s expansion.
    • Global expenditure on the digital revolution is anticipated to reach an astonishing $20 trillion by the year 2030.
    • Presently, the expenditure rate barely touches the $500 billion mark.

Contemplating the sheer magnitude of these projections, it becomes evident that leading enterprises spearheading this revolution, such as NVIDIA, are poised for sustained success. Despite the inevitability of NVIDIA’s market share fluctuation, the vast potential for profit, underscored by these expenditure forecasts, remains robust.

Hence, the trajectory of Artificial Intelligence (AI) is marked by significant potential, albeit punctuated by inevitable fluctuations. The journey towards AI’s development and its adoption carries tremendous promise alongside formidable challenges. Navigating through this complex landscape presents a considerable challenge. A chart sourced from The Market Ear, illustrating NVIDIA’s revenue trends since 2017, vividly demonstrates the surging demand for NVIDIA’s AI-centric chips, underscoring the critical role AI plays in driving demand within this sector.

AI has actually been around for a while. You may recall IBM Watson playing, and winning, at Jeopardy back in 2011, but the AI race really started in earnest when ChatGPT was introduced in late 2022. It was a huge leap forward and now both companies and governments are concerned about the global AI race and the geopolitical repercussions of who wins that race. We should have every expectation that development will continue expeditiously. The tools of that trade, for the time being, are NVIDIA chips and they are being produced and purchased at a record pace.

There’s no doubt that NVIDIA will sell a lot more of these chips in the future, but we also need to be cognizant that the demand NVDA is seeing is like ‘pandemic demand’. At the moment, every participant is buying as many chips as possible, which not only meets their own needs, but might also prevent competitors from buying those chips. We have to assume that these AI companies are double and triple ordering, just to make sure they get what they need.

To put it briefly, what we’re experiencing with digital technology now mirrors the early days of e-commerce around 2000, when Amazon led the way. Back then, it was hard for many to grasp why Amazon’s multiple was so high. Now, we see that e-commerce has expanded massively, with Amazon reaping significant benefits among others. The current digital trend is akin to that, but with NVIDIA already achieving substantial profits. We’re just at the start of this journey, and it’s thrilling to anticipate how it will revolutionize our economy.


What We’re Reading

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By: thinkhouse