The King of AI
By Crest Capital Advisors on May 24, 2024
Dow: (2.33%) to 39,069.59
S&P 500: 0.03% to 5,304.72
Nasdaq: 1.41% to 16,920.79
Russell 2000: (1.24%) to 2,069.67
10-Year Yield: 4.47%
Outperformers: Technology 3.44%, Communication Services 0.25%
Underperformers: Energy (3.82%), Real Estate (3.70%)
US stocks were mixed this week though the Nasdaq posted a fifth-straight weekly gain, closing the week at another all-time high on the back of more AI momentum. Absent this high-profile news and moves in the tech sector (more on this below), we’d have to describe this week’s move for stocks in general as fairly listless in a low volume week. The S&P 500 finished essentially unchanged.
On the economic front, the stronger than anticipated survey data from S&P Global released on Thursday played into the “good-news-is-bad-news dynamic” as traders sold stocks across the board on fears the Fed may not cut rates at all in 2024! Of course, we don’t agree with this point of view, but it does reflect the reality of the day-to-day stock market moves. For example, following the Thursday release showing the economy is stronger than thought, the odds of a September rate cut fell to around 50%, down from nearly 75% earlier this week.
More hawkish-leaning commentary (aka “Fed-speak”) via the May FOMC meeting minutes alongside additional comments from various Fed Governor’s continues to weigh on markets. Fed Governor Waller’s comments got a lot of attention with him saying he still needs to see “several more months” of good inflation data in order to be comfortable cutting.
Despite the macro and the near sole focus on ‘what the Fed might do’, the biggest event in terms of corporate earnings came on Wednesday evening with Nvidia’s earnings report. The King of Artificial Intelligence (AI), despite very high expectations, did not disappoint. The company grew revenue by 262% year-over-year to $26 billion, well ahead of estimates, including a 427% increase in data center segment revenues. As a result, the stock leaped to yet another all-time high and a whopping $2.66 trillion market capitalization as of the close on Friday! The AI boom is providing a significant tailwind to S&P earnings and helping drive markets higher despite the consternation of the bears and the challenging interest rate backdrop.
Looking ahead to next week, we want to acknowledge Memorial Day on Monday and pause to honor and remember the brave men and women who have made the ultimate sacrifice in service to our nation. Their courage, dedication, and selflessness have safeguarded our freedoms and ensured the continued prosperity of our country.
What to Expect When You’re Expecting…. Rate Cuts
In our view, the Fed continues to box itself in when it comes to addressing inflation and interest rates. The persistent high levels of super core inflation, driven primarily by auto insurance and hospital services, raise legitimate questions about whether the Fed’s strategy of maintaining higher interest rates for longer will effectively curb inflation in these specific areas. Furthermore, the overall inflation data is skewed by housing inflation, which remains stubbornly high and lags behind real-time data that indicates significant deflation. However, the Fed fears that lowering interest rates could reignite demand-driven components of CPI, including housing inflation, making them hesitant to act and repeatedly signaling they have ample time to make rate adjustments.
If the Fed adheres to its “higher for longer” stance, it risks exacerbating economic issues, as evidenced by last year’s regional banking crisis. Many small and medium-sized businesses are struggling under the weight of high interest rates, and cyclical sectors like housing and automotive continue to suffer. Conversely, deprioritizing concerns over housing inflation, auto insurance, and hospital services could trigger a resurgence of inflation in rate-sensitive sectors such as housing.
In striving for “more confidence that inflation is moving sustainably to target,” the Fed’s chances of achieving a balance between taming inflation and maintaining economic growth—a so-called ‘soft landing’—appear increasingly slim. While we remain hopeful that the data will improve sufficiently and swiftly to justify Fed rate cuts before significant damage occurs, the major risk to our outlook is that this does not happen. If the Fed becomes overly confident in its ability to maintain high rates for an extended period, it could lead to a more severe economic downturn, representing yet another policy misstep.
This brings us to the communication problem inherent in the Fed’s strategy of providing continual “forward guidance” through speeches by various Fed Presidents. The market’s extremely negative reaction to the release of the latest FOMC meeting minutes this week exemplifies the issue. The financial markets’ significant responses to the Fed’s apparent indecision underscore why Fed officials should perhaps limit their public commentary. Their efforts to manage expectations are creating unnecessary volatility and uncertainty, complicating an already challenging economic landscape.
Why Private Markets?
Most of the time and effort of investors is spent on discussing the most prominent names in the market (e.g. Nvidia, Apple, Tesla, etc) but these firms and the rest of the S&P 500 companies only make up a very small part of the US economy.
Consider the following facts, courtesy of Apollo Global Management
- 87% of firms with revenues greater than $100 million are private.
- Privately owned firms account for almost 80% of job openings.
- Employment in the S&P 500 companies is only 18% of total US employment.
- Employment in firms with more than 500 employees is 23.8 million, and total US employment is 158 million!
- Less than half of all corporate debt outstanding is from S&P 500 companies.
- S&P 500 profits make up half of economy-wide corporate profits.
- Capex by S&P 500 companies is 15% of total capex in the US economy.
In short, allocating capital with premier private markets managers substantially expands the available investment opportunities.
Earnings Optimism
S&P 500 revenue growth is estimated to accelerate over the next four quarters (see chart below) to north of 5%, and while earnings have been dragged down by Health Care and Energy in the most recent quarter, the revenue growth profile is largely driven by +10% expected out of the Technology sector. This increased revenue outlook is helping expand profits and a big reason why markets continue to grind higher.
Turning to profit margins for a moment, we note that Historically when operating margins are expanding for the overall index, the market does not usually get into too much trouble. Despite all of the macro and political headwinds the market faces, companies continue to show their resiliency. Fundamentals remain supportive of a higher market for now and if companies continue to invest in “AI”, it likely can continue for longer. Remember, one firm’s capex spending is another firm’s revenue and the largest companies continue to be flush with cash. The chart below shows how profit margins are once again expanding upward.
Economic Funnies
We’ve always found the old “Sell in May and Go Away” cliché to be rather ridiculous. This encapsulates why we’ve always rejected it. And yet, it gets trotted out every year by the financial media. Perhaps because it rhymes? Total nonsense.
It also illustrates one of the big problems with market timing. One has to not only accurately predict when to exit, but also when to get back in. Chances are you may get one of these correct, but it only works if you can successfully navigate both decisions.
Crazy Stat of the Week
Here are this week(s) crazy stats!
- File under the it’s never too late category…98% of Warrant Buffett’s current net worth came after he turned 65. “My life has been a product of compound interest.” – Warren Buffett
- The benchmark 10-year Japanese Government Bond (JGB) yield rose above 1% for the first time in over a decade! This marks the highest level since March 2012.
Quote of the Week
“People want to deploy these data centers right now. They want to put our [graphics processing units] to work right now and start making money and start saving money. And so that demand is just so strong.”
– Jensen Huang, Nvidia CEO
Calendar of Events to Watch for the Week of May 28th:
Next week will be holiday shortened with markets closed on Monday for the Memorial Day Holiday. The early portion of the week will be fairly quiet in terms of economic events, but Friday’s Personal Consumption Expenditure (PCE) report will be critical in the (seemingly) never-ending quest to determine when the Fed may finally begin cutting interest rates. An in-line or cooler than expected reading may calm investor fears over “higher for longer” and catalyze stocks even higher into the summer months. On the other hand, a ‘hot’ reading would likely result in traders throwing a fit and interest rates heading higher over yet more delays to the rate cutting cycle. Our money is on the former, but the latter is what makes markets!
Monday 5/27 – US markets will be closed in observance of Memorial Day.
Tuesday 5/28 – Consumer Confidence for May is expected to come in at 95.3 vs. last month’s 97.0 reading. Excessive ‘higher for longer’ Fed-speak is starting to take its toll on consumer confidence. The Dallas Fed Index is expected to remain in contractionary territory at -12.0 vs. last month’s -14.5.
Wednesday 5/29 – The Richmond Fed Index for May is expected to contract again at -7.0, which is in line with last month’s -7.0 reading.
Thursday 5/30 – The second preliminary reading into Q1 GDP is expected to remain consistent with the initial release. Economists are projecting a 3.1% quarter-over-quarter rate and a 2.5% year-over-year rate. Wholesale Inventories are expected roughly unchanged (technically at -0.05%) v. last month’s -04% contraction. And finally, Pending Home Sales are expected to increase by a very modest 0.4%.
Friday 5/31 – The main event of the week will be the release of the April Personal Consumption Expenditure (PCE) report. Economists are expecting a headline rate unchanged at 2.7% year-over-year, up 0.3% month-over-month. The Core (Ex-Food/Energy) is expected to come in at 2.8%, up 0.26% month-over-month. When the Fed talks about its 2% target for inflation, they’re referencing this data series. Hence, why this is so important to markets. A cooler than expected report will bring forward expectations of a rate cut and reduce the fears that picked up in Q1 of the next move being yet another rate hike.
Source: MarketWatch
