The simple explanation is that for several prior quarters, when the company announced its earnings release date it also said that it would have good news to report. This time, no such commentary. The stock had already been in decline along with the rest of the market over the past several weeks. Thus, the non-comment spooked investors who ran for the hills.
Super Micro makes servers and storage devices that go into those racks that power all the AI stuff you hear about. For the past year, since ChatGPT and other AI software burst on the scene, big cloud providers and others have scrambled to add capacity to serve future AI needs. You can’t be a legitimate cloud provider and lack the capacity to serve your clients’ needs.
We have seen this movie before. At first, demand surges and suppliers struggle to catch up. Then, supply ends up racing ahead and has to wait for demand to catch up. During the Internet bubble a quarter of a century ago, as everyone got connected, this dynamic expressed itself via all the cable laid across the Atlantic set to meet future demand that never arrived for almost two decades! I have no fear that capacity the cloud providers are building will sit unused for two decades. But the 300% annual increase in sales of key hardware and chips we all witnessed in 2023 won’t be repeated.
This isn’t just a Super Micro event. We don’t even know what Super Micro will have to say next week. But there have been plenty of hints that the manic pace of physical expansion is going to slow, probably more quickly than the euphoric bulls thought just a few weeks ago. Taiwan Semiconductor, the company that manufactures most of the high-end chips that go into the AI servers, said growth this year would be less than previously expected and that it intends to moderate the pace of expansion. Granted, most of the slowdown is for non-AI related chips. Others, however, have hinted at similar moderation. It isn’t that growth will stop; it will simply moderate from the frantic pace of last year.
Life is often two steps forward, one step back. Forget Wall Street and the stock market for a moment. If you look at a company like Nvidia#, it has always been the case that growth seen in 2023 wouldn’t be replicated. Not only would it slow going forward, but at some point, it would normalize meaning chip demand would follow a typical path of all chips, most likely double-digit growth in units and something less in dollars. What you are seeing today isn’t the lack of excitement over AI. Rather it’s a collective moderation by AI users of the growth in capital they are willing to invest. Before investing more, they want to see the payback from money already spent. Every good company wants to be on the leading edge when it comes to AI deployment. AI is, unquestionably, revolutionary. It will enhance productivity and customer experiences. But all the early hype simply has gone too far. It isn’t much different than what we are witnessing with electric vehicles. They hype got ahead of reality. The value equation to buy EVs today versus traditional gas-powered cars isn’t quite there yet. It will get there, but it isn’t there today.
The same applies to AI. It’s coming. It will turn the computer business upside down just as the PC and the smartphone did. It just will take some time. Lots of companies make servers and storage devices that power AI. Super Micro was and is in the right place at the right time. But there is little to differentiate one server or one storage device from another. Super Micro rode the wave first and gained first mover advantage. But in the end, what it does is largely going to be commoditized. Can it pivot to something more value added? That’s their challenge. Super Micro isn’t alone. Chipmaker Nvidia plus others and all the companies that make the machinery to manufacture the chips have been hit hard on Wall Street this month and all suffered big losses Friday although not on the scale of Super Micro.
Has the hype been erased? Is the correction complete? No one really knows. Nvidia’s stock is down more than 20% from its peak of just a few weeks ago but is still up over 50% this year alone. It doesn’t report earnings until next month. It may be the most logical winner in the AI revolution. But it won’t have the high-end market to itself forever. Unit volume growth will slow and competition won’t allow margins to stay as elevated as they are now forever either. But as long as it retains leadership, and that could be for a very long time, it will remain a poster child for the future of the AI revolution. With that said, higher interest rates are resetting valuation. The biggest revaluation occurs within those companies that sport the highest P/E ratios. Many market corrections that encompass earnings season end as corporations start to repurchase stock. That suggests at least a temporary bottom within the next two weeks.
Other factors come into play. Six months ago, markets were expecting six or more Fed Funds rate cuts this year. Consensus is now two. None is quite possible. In 2022, the Fed labeled the inflation spike as “transient”. It wasn’t. The same Fed official sloughed off the CPI increases for January and February. After March was hot as well, they stopped talking. Inflation is moderating. But the pace of moderation is slowing. Most important, the 2% stated target may not be in sight if the Fed starts cutting rates. No better proof of change in mood than the rise in the yield on 10-year Treasuries from 3.8% late last year to 4.65% this morning. Simply put, a 4.65% 10-year Treasury yield does not equate with a long-term 2% inflation target. The market isn’t buying what the Fed is saying.
For high P/E stocks, that’s bad news. The S&P P/E this morning, based on 2024 expected earnings is 21.5. Too high. Even after a 5% correction to date. The market doesn’t have to normalize today or tomorrow. It can take many months. It could normalize via higher earnings although it is hard to understand how earnings growth accelerates alongside moderating GDP growth, a strong dollar, and rising unemployment.
The bottom line is that what we have today is a higher level of uncertainty. You see it within the so-called Magnificent 7. Tesla is a disaster this year with no signs of good news ahead. Apple# is getting clobbered in China. All except Nvidia will report within the next two weeks. It will be the future roadmap adjustments, if any, that will move the stock prices. Most saw big moves up after announcing fourth quarter earnings. How they react to Q1 results will likely change the tone for the market overall.
As for the other 493 S&P 5400 components, so far it has been a fairly positive quarter although few managements are pointing toward acceleration in growth. One group to watch is the automotive sector. It is an important component of GDP. Car buyers are facing sticker shock not only from higher prices but also from higher lease and financing rates. Car dealer lots are filling up. I suspect dealers will need to make further pricing actions to keep buyers coming. That will squeeze margins all the way down the food chain.
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You have all heard how low-income families are getting squeezed by higher rates. Now it appears higher end buyers are getting cautious. High end real estate prices are softening in many markets. Luxury goods manufacturers are experiencing slower growth in sales. Will the entire economy roll over just when the notion of a possible recession recedes into the back of our collective minds? Retailers don’t report for another month. Their numbers will be impacted by a late Easter this year. Department stores are doing terribly. Some of the more hip retailers, like Nike and Lululemon, are seeing moderation of growth. If the consumer stops spending with abandon, while home sales and auto sales slow, forecasters will have to moderate expectations. Thus, while some of the tech names most hurt last week may see a bounce this morning, don’t rush back in. Nibble a bit if you must. But stay level headed and listen to what managements tell us is happening today in real time, as we enter the heart of earnings season this week and next.
Today, Jack Nicholson turns 87.
James M. Meyer, CFA 610-260-2220