Stocks soared yesterday on the heels of a strong earnings report from Nvidia#. Over the previous several sessions apprehensive traders sold Nvidia stock and options expecting the company to tone down its future guidance when it reported. But that didn’t happen. AI is going to be for real, and companies that expect to provide AI solutions need to spend massively to both increase and modify existing capacity. The strength of AI-related demand has an impact on overall economic growth helping to push bond yields higher.
Let’s start with Nvidia. Sales roughly tripled in its January quarter versus a year earlier. Key customers, mostly those operating data centers and cloud platforms, must spend massively to ensure that they have both the capacity and the software tools to meet future demand. Here’s just a small example. Most of us today have opted to use electronic greeting cards. They are cheaper and easier to buy and send than traditional cards you mail. Greeting cards can be customized with both names and individual greetings. Some use sound employing the recipient’s names. Over time they have gotten more personalized. Then along comes AI. You now can tell the card site details about the recipient (age, hobbies, names of family members, etc.) and suddenly the card becomes more personalized, more special. The card company doesn’t have the massive computing power needed to execute an AI-generated card. It uses the power of a cloud provider. And, because the card is more personal and special, it can charge more. This is just one tiny example of how AI is going to change our world. No doubt people much smarter than I will be creating new applications almost daily. And they will be improving them constantly.
All this helps to explain why Nvidia’s sales tripled year over year. But any elementary student of math can figure that tripling sales is not going to happen forever. If sales tripled each year for just three years, third year sales would be 27x the starting number. For Nvidia, the questions become (a) how large might the total addressable market be 3-5 years from now, (b) how fast will it be able to get there, and (c) since growth of that magnitude will undoubtedly attract competition, what might normalized margins and profits look like a few years from now?
The answers at the moment can’t be determined precisely. Right now, demand exceeds supply, and that situation is going to last for several more months or even a couple of years. With that said, it isn’t likely that growth will suddenly stop. As more and more applications develop and more and more users employ AI, overall growth will continue for many years, albeit not at a 300% compounded rate. What we can conclude is that Nvidia and other leading companies that are leaders in AI development have very bright futures as far as one can see. Of course, that isn’t a profound statement. Much of the optimism is already priced into the stocks. As I note often, the stock market’s performance is related to a matching of future expectations and future realities. The one truism that one can count on is that today’s projections are wrong. They are either too optimistic or too pessimistic. As investors, we have to decide. All we can say is, looking backwards, projections to date have been far too pessimistic.
Given the excitement about AI and the resurgence of the retail investor, you have a more speculative environment. Retail speculators are back buying sub-$1 NASDAQ stocks in droves. Bitcoin is back above $50,000. At least for now, it remains the defining instrument of speculation. There are now at least nine bitcoin ETFs. Speculation has never been easier. So, with markets at or near all-time highs, values once again are being inflated by speculative fever. We are not back to 2021 levels yet. There is no IPO boom, no SPACs, no private equity unicorns. But short-term technical indicators suggest that one should at least be aware of the increase in speculation.
Against this backdrop, the economy continues to show its strength. Manufacturing activity is starting to pick up again as inventory liquidation runs its course. Consumers are still spending although there are signs they are stretching themselves a bit. But as long as 96%+ of working Americans have jobs, that’s not a big problem. The world isn’t perfect. Commercial real estate problems still exist, politics is messy and inflation still hurts.
Speaking of inflation, if you haven’t noticed, bond yields are creeping up again. The all-important 10-year Treasury yield is now near 4.35%. Just a few weeks ago it was close to 4.10%. The jump in shorter term Treasuries is even more pronounced. The 2-year Treasury yield has risen 50 basis points to 4.7%. Just a few months ago, Fed Funds futures were predicting 6-7 rate cuts this year starting in March. They now predict just three starting in September. The Fed all along talked of three. Based on January inflation data we have seen so far, there may not even be three. The Fed wants to stay out of politics, but can it? If there are no rate cuts through the summer, how can it start in September without having the media and traders associate the timing with the Presidential race? That’s a rhetorical question for which I have no answer. At any rate, rates rising 25-50 basis points while stocks march to new highs only makes sense if earnings expectations grow commensurately, offsetting the negative impact of higher rates. While that may be true for Nvidia and its AI compadres, I doubt that can be said for the overall economy.
I noted Wednesday, before Nvidia reported, that its earnings release would set the near-term tone for equity markets. It certainly did yesterday. But now that the report is behind us, we enter that intra-quarter period where news flow contracts, leaving small data points to have an outsized impact. Markets shouldn’t discount the same thing twice. Efficient markets adjusted Nvidia expectations quickly. Futures this morning suggest a further rise at the open but nowhere near yesterday’s huge gains. The market needs a breather. It would be great to see some reduction in speculative fever. While I have no crystal ball that tells me what stocks will do today or over the next month, there aren’t a lot of bargains out there. This isn’t the moment to chase. If bond yields keep rising, amid a vacuum of data, they could be the trigger for a modest correction just as they were last fall when 10-year Treasury yields touched 5%.
Today, Emily Blunt is 41. Josh Gad turns 43. A special shout out to my granddaughter Ivy, who turns 13 today.
James M. Meyer, CFA 610-260-2220