Stocks rose sharply Friday afternoon soon after Ukraine President Zelensky was escorted out of the White House. The two were unrelated. The dustup in the Oval Office made for great theatre and gave fodder for all the Sunday talk shows but was unlikely to alter the ultimate course for settlement of Ukraine’s conflict with Russia. On the surface, Friday’s rally can be viewed in one of two ways. It could be a combination of relief rally and short covering, a one-day wonder that won’t alter the equity correction in place other than to diminish a short-term oversold condition in the market. Or it could signal an end to the very brief correction that has taken place over the past few weeks. We will have a better idea which answer is more accurate today. If a robust follow through takes place, the recent correction is probably over. If markets resume their decline today, Friday’s rally was nothing more than a relief from an oversold condition.
To get a better idea, let’s look at fundamentals through two lenses. One lens is to examine market rotation. Clearly, the Magnificent 7, who have dominated market trading for the past two years have stopped dominating since this past summer. Yes, a few like Meta Platforms# have continued to move higher. But names like Microsoft#, Tesla, and Nvidia# are down 10% or more from recent highs. Last week, Nvidia reported its results and they were quite good, especially measured in an absolute sense. Data center sales, the core of its growth, rose 16% sequentially and 93% year-over-year. While that may not have beaten everyone’s expectations, which have risen sequentially quarter to quarter as Nvidia keeps outperforming, it’s hardly reasonable to denigrate revenue growth of nearly 100%. To be fair, there are some who believe all the large capital spending being done by the Mag 7 and others, will come to a screeching halt in the not too far distant future. However, there are few signs from any of the large tech companies that they are about to reduce spending anytime soon.
Without getting too deep into the weeds and tech jargon, there is an evolution in artificial intelligence from simply gathering and sifting through massive amounts of data to give a quick answer, to a level of reasoning that can be an efficient replacement for tasks done by humans today. Thus, AI models go from training to post-training to inference to reasoning, each time improving outcomes, and ultimately outperforming what we can do. Remember Watson, the IBM computer that could compete against chess grandmasters? Today, humans would have no chance of winning. But AI is about more than chess games. Early on, when ChatGPT first was introduced, reporters had a field day feeding weird questions to generate weird answers allowing them to write articles denigrating AI. It wasn’t ready for prime time. Each new iteration of a large language model is not only more robust and more accurate, but each iteration requires multiple times as much computing power as the previous version. New generations of chips to support AI are introduced annually, sometimes within a 12-month period. Even when we get to models that can reason as well as humans, there will be movement to make them even more efficient, more accurate, and lower cost. The AI boom is barely in its second inning, not the ninth.
To be fair, not all those chasing the pot of gold will succeed. Much of today’s spending will be wasted. That’s no different than in the first decade of the 1900s when over 3,000 companies were competing to become leadership companies within an emerging auto industry. In the 1960s, there were the BUNCH companies (Burroughs, Univac, NCR, Control Data and Honeywell) seeking to compete against IBM in the mainframe world. All failed. In the 1980s, names like Kaypro, Commodore, and Atari among dozens of others wanted to be the personal computer of choice. At the start of this century, Google obliterated Yahoo, Lycos, Alta Vista and Ask Jeeves in the race for search dominance. But don’t confuse the carnage of war with any lack of forward progress. Indeed, it’s the pace of progress that kills the weak. There is no doubt in my mind that a decade from now many AI leadership companies will be names not even public today and some of the Mag 7 will end up being left behind just as Intel and Cisco today are shadows of their former selves.
But let me get back to the market overall. Nvidia’s earnings report was greeted negatively, a repeat of the prior quarter performance. Indeed, many professional traders quickly shorted the stock after its early earnings bounce expecting such a repeat. But as I noted just now, this wasn’t a bad report. At its low post-earnings, the stock was down 20% from its fall peak while earnings were substantially higher. I haven’t seen an analyst report post-earnings that lowered future earnings expectations for Nvidia. Maybe, therefore, the near-term correction is over.
I spend so much time talking about Nvidia because it was the king of the mountain for the Mag 7 for much of the past two years. Its fortunes are tied to all companies engaged in the AI revolution. Its chips are the building blocks for everyone. When looking back over the past year or so, if one simply looks at our economy from 30,000 feet it appears it has grown at close to 3% with inflation moderating. But just as we have experienced a bifurcated stock market with the Mag 7 and acolytes surging leaving the rest of the market behind, the economy has been behaving in similar fashion. The Mag 7 grew capital spending last year by 40%, the rest of the country by a bit under 3%.
An interesting way to look at the economy and the stock market is to compare earnings growth with the performance of the equal weighted S&P 500. Last year, while the headlines said the S&P 500 grew by close to 25%, the equal weighted index rose by 12%. Corporate profits increased by a shade under 13%. In 2023, the equal weighted index rose by 10%, profits by 13%. In 2022 the equal weighted index fell by 10%; profits fell by 11%. Pretty tightly correlated if you ask me. Predictions this year are for equal weighted stocks to increase earnings by 12-15%. So far, through two months, the index is up just shy of 3%.
As we know, earnings alone don’t determine stock prices. Changing interest rates matter. So does the volatility of everyday headlines. Lately, bond yields have moderated. I wish I could attach that to softer inflation numbers, but the best correlation is to softer economic data. Why the softness early this year? There is no one definitive answer but some may be attributed to companies pre-buying in anticipation of tariffs, some can be attributed to a harsher winter in 2025, and some can be attributed to uncertainty related to the flurry of Trump’s initiatives. The DOGE-related firings and steps to reduce regulation have yet to show up in any of the economic data.
One measure of volatility is the VIX index which measures option premiums, the thought being higher premiums imply greater risk. The index over the past year has fluctuated between 14 and 23 most of the time. On Friday morning it once again approached the top end of the range. All the noise about tariffs, firings, and discontinued programs has consumers nervous and business leaders unsure. When managements are unsure, they defer decisions, bad for the economy. The uncertainties are heightened by a pattern of decisions on day one being modified, or even canceled by day three.
There is little reason to expect the volatility in Washington to suddenly stop. What we don’t know yet is the impact. Net interest payments for the U.S. next year are estimated to rise by more than $200 billion. Social Security cost of living adjustments alone will add close to $40 billion. Medicare payments will add billions more. The new budget framework passed by the House suggests Medicaid cuts of close to $800 billion. That’s a pipe dream as are most Presidential budget outlines. They are wish lists rather than predictions. One of the reasons that number is inflated is that reconciliation, a procedure that will allow the Senate to pass an economic-related bill by simple majority, needs significant savings offsets to allow for an extension of Trump’s tax cuts plus additional cuts such as tax-free tips. So far DOGE has eliminated less than 20,000 jobs that annualized can save about $30 billion. Not all its proposed cuts will stick thanks to court challenges. Medicaid will be a big source of savings but the idea of massive cuts in services isn’t going to fly. Nor will states simply accept more of the burden of costs without a fight. $400 billion in serious savings would be a miracle.
By far the biggest part of the Federal budget where money could be saved is in defense. That sounds ludicrous given all the cries for more defense spending, but the whole process of defense procurement is a bureaucratic mess. It can take close to a decade from conception to first delivery for a new fighter jet. Any procurement that can pass muster in less than two years is rare. Yet Ukraine regularly can swap out sensors, etc. to upgrade its drone fleet every six weeks. In many ways, built from necessity, Ukraine has by far the best and most sophisticated military infrastructure in Europe, all built on the fly over the past three years. Tearing apart our antiquated and bureaucratic procurement system isn’t likely to happen quickly. But rather than simply cut and slash without any foresight of the impact of cuts, DOGE might be better served to deconstruct and reconstitute procurement systems not only in the Defense Department, but throughout the Federal bureaucracy.
Most likely that’s a pipe dream. What we are left with therefore, is more of the slashing and burning we have witnessed over the past six weeks. Clearly, the political world is being turned upside down. The economic impact will be less extreme but there will be collateral impact.
In the meantime, the stock market will do what it always does; react to earnings and interest rates. If I had to sum up the last few weeks in a sentence or two, I would say that the economic outlook is a bit more pessimistic than a few weeks ago and that has led to a modest moderation in long-term interest rates. The two balance out and, therefore, stocks are basically unchanged. The Mag 7 have gone through a correction that appears to be running its course. It might be worth noting that today Wal-Mart’s p/e on next year’s earnings forecast is higher than any of the Mag 7 companies except Tesla.
Today’s market action has short-term importance either by validating Friday’s move or not. Tomorrow evening Trump delivers his State of the Union Address. It will provide more fodder for the media than the market. Fact checkers will have a glorious time dissecting his hyperbole.
Today, Jessica Biel is 43. Julie Bowen turns 55. The inventor of the telephone, Alexander Graham Bell, was born on this date is Scotland in 1847. The telephone became our dominant form of communication until the advent of text messaging.
James M. Meyer, CFA 610-260-2220