We just heard from Walgreens, H&M, and Levi’s and all reported weak retail results that suggest the consumer is pulling back. Pool Corp, a seller of new pool systems and supplies, issued a warning that it expects new pool builds and remodels to be down 15 to 20% this year as compared to their previous estimate of flat to down 10%. AGCO, a global player in the farm equipment industry, announced a plan to cut 6% of its salaried staff as it responds to weakening demand. And, even though FedEx reported a better-than-expected profit, it attributed the surprise beat to the effects of its aggressive cost cutting initiatives rather than strong demand. It sure seems like the lagged effects of the Fed’s restrictive monetary policy is starting to show up in the economy now.
A tale of two markets
Meanwhile, the S&P 500 remains near record highs, up +15% YTD, supported by the strength of the “Magnificent 7” (with the exception of Tesla), while the Dow Jones and equal-weighted S&P 500 are each up a more humbling 4%. It continues to be a tale of two markets. Over the next several weeks, we will get an update on the economy and corporate profits as we enter the second-quarter reporting season. Street analysts are expecting earnings growth of +9% Y/Y. Last quarter, five companies including Amazon, Alphabet, Meta, Microsoft, and Nvidia posted earnings growth of +64% while the remaining 495 constituents of the S&P 500 reported a decline in earnings of -6%.
This concentration in earnings growth, as well as in the valuation of these companies, presents some unique risks and choices for investors. Should I follow the index and concentrate my investments? Should I remain diversified while this AI investment cycle plays itself out? There is no right answer; it simply depends on an investor’s risk tolerance, time-horizon, investment objectives, and trading philosophy. The AI investment cycle will almost certainly go on for years and will change in nature and scope like other major transformative technology adoptive periods.
AI and the Olympics
Speaking of which, as I was watching the Olympic trials this past weekend, I couldn’t help but think about the similarities of the upcoming summer Olympic Games and artificial intelligence. While these two subjects seem unrelated, they share surprising parallels in their pursuit of excellence and pushing boundaries. Both represent the pinnacle of human achievement, albeit in vastly different domains. The Olympics showcase the remarkable physical and mental capabilities of athletes, who dedicate years of training to compete on the world stage. Similarly, AI is the culmination of decades of research and development, where scientists and engineers strive to create machines that can mimic and even surpass human intelligence.
Another point of convergence of AI and the Olympics lies in their impact on society. The Olympics inspire millions worldwide, fostering a sense of unity and promoting the values of sportsmanship, perseverance, and fair play. The Games have the power to transcend political and cultural divides, bringing people together in celebration of athleticism. AI, too, has the potential to revolutionize many sectors of our economy. By automating mundane tasks, augmenting human capabilities, and generating novel solutions, AI promises to improve efficiency, productivity, and quality of life for individuals and communities alike.
However, both AI and the Olympics also raise ethical concerns and societal challenges. In the Olympics, issues such as doping, cheating, and commercialization threaten the integrity of the games. Similarly, AI raises questions about job displacement, privacy, bias, and the potential for catastrophic misuse. It will be crucial to consider their broader implications and ensure that AI is used for the betterment of humanity, rather than for exploitation or harm. I suspect that we will be dealing with these challenges for years to come, regardless of the investment implications that we are so focused on today.
The economics of AI adoption
This quarter’s company earnings reports will be insightful as we track the spending patterns and trends of companies making investments in AI, as well as those companies selling AI infrastructure. The expectations around revenue growth and productivity from AI is a key driver in today’s valuation of stocks. Moreover, the mismatch of supply and demand right now is causing pricing to be astronomical for certain products, like Nvidia’s newest chips that can cost as much as $40,000 each, as compared to less capable competitors’ chips that may be priced between $10-15,000.
These investments are creating giant profits for the infrastructure sellers, while requiring massive investments for the buyers. Over time, it is logical to think that the price gaps of chips will shrink as more capacity is entered into service and the performance differential among competitors’ products is narrowed. More competition will normalize profits, but the question is: How long will this cycle take to play itself out?
The S&P 500 trades for 21 X forward 12-months earnings. The 10-year US Treasury yield is 4.3%, up from 3.9% at year-end. This seems reasonable absent any significant surprises. However, the coming election and continued uncertainty about the Fed’s next rate move will undoubtedly cause some ups and downs in the months ahead. As companies share their outlooks in the weeks ahead, we will get more clarity. In the meantime, have a safe and enjoyable holiday as we celebrate our nation’s 248th birthday next week.
Speaking of birthdays, fashion designer Vera Wang is 75 today, actor Tobey Maguire turns 49, and Film Director JJ Abrams is 58.
Christopher Gildea 610-260-2235