The US stock market has recently recorded a series of all-time highs driven by the prospect of imminent interest rate cuts which have added fuel to a market increasingly enraptured by the potential of artificial intelligence (AI). Huge share price gains have come alongside breathless forecasts of the scale of opportunity and the profits that will follow. Understandably, some on the sidelines are wondering what they are missing and questioning whether they ought not to delay their participation any longer for fear of forgoing potential profits. We are wary of getting caught up in the exuberance especially as, in our view, the macroeconomic outlook remains challenging.
In this update we discuss the narrow subset of stocks that have driven markets higher, such as those at the centre of the AI story, which appear to promise strong growth regardless of the economic backdrop. We follow this by taking a look at Nvidia, the flagship of the AI hysteria, to highlight the risk that such growth may not be as enduring as current valuations demand. We begin, however, with a brief update on economic developments.
Economic Developments
Our understanding – that high interest rates suppress inflation by bearing down on economic activity – is entirely orthodox and causes us to attach a low probability to the fabled ‘soft economic landing’ scenario where inflation returns obediently to target while growth trundles on. In our previous investment update, Walking a Narrow Path, we highlighted the challenge that central bankers face in returning inflation to target while the economy remains resilient and near full capacity. Indeed, recent data has confirmed that short-term annualised measures of US inflation have been trending higher. At the same time, however, leading indicators of the labour market, such as a survey of US small companies’ hiring intentions, have deteriorated and are pointing to potential weakness ahead.
This presents a double-pronged challenge to investors; on the one hand, a resurgence in inflation would jeopardise the rate cuts that markets are expecting – likely undermining the ‘soft landing’ outcome baked into equity market valuations. While on the other hand, a deterioration in the labour market would likely put paid to inflation, but at the expense of a marked economic slowdown. We don’t believe markets are appropriately discounting either of these risks.
At this point, we turn to the Magnificent Seven – the group of stocks that have propelled markets higher – and the latest investment phenomenon: artificial intelligence.
How Magnificent?
As has been widely reported, seven US technology names have become enormously influential in global stock markets. Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla. Together they make up close to 30% of the US stock market and almost 20% of the Fidelity Index World fund that we recommend within portfolios. Collectively, these seven stocks are worth more than five times the hundred largest companies listed on the London stock exchange. Indeed, two of them – Microsoft and Apple – are each individually worth more than those one hundred “large” UK companies.
It is worthwhile reflecting on the development of the Magnificent Seven. Initially, investor interest was focused on the FANGs – Facebook, Amazon, Netflix and Google. Apple was subsequently added to make the FAANGs, before Microsoft’s introduction at the expense of Netflix laid that acronym to rest. The Magnificent Seven were then identified following some spectacular share price gains from late 2022 onwards. Our point is that such groupings are artificial and short lived. It therefore comes as no surprise that the Magnificent Seven has recently started to splinter. Tesla is facing stiff competition from Chinese manufacturers and is no longer among the ten largest US stocks. Meanwhile, Apple shares are c9% lower over the year-to-date, even as the wider US market is up c10%, thanks to a significant regulatory threat to the income it derives from forcing transactions to take place within its App Store.
Inevitably, another trend has come to the fore: the artificial intelligence goldrush, with Nvidia as its posterchild enjoying a near 700% gain in its share price over the past 18 months. We believe Nvidia presents a good example of the risks currently embedded in global equity markets.
A Bubble in Earnings?
In contrast to the tech bubble of the 1990s (which otherwise bears strong comparison), investor exuberance is not obviously apparent in high valuations. Following a 586% jump in earnings per share over its last financial year, and with a further 114% increase expected over 2024, Nvidia ‘only’ trades at 36x this year’s expected earnings. Factor in forecasts of 25% annual earnings growth over the following three years, and Nvidia’s valuation arguably appears palatable at close to twice the US market’s valuation.
Investors should instead be questioning whether the earnings forecasts that underpin these valuations are themselves reasonable. In our view, they appear to incorporate some heroic assumptions.
Nvidia, which designs high powered, market leading microchips, operates in a highly cyclical industry – one in which the earnings of its peers have historically been highly volatile. Yet consensus expectations appear to extrapolate recent earnings growth into a long-term structural trend with no cyclical downturns. Given the excitement over AI, perhaps it is reasonable to expect an ever-increasing demand for the powerful processors necessary for building and training large language models? We doubt it, but even if this were the case, is it reasonable to expect Nvidia to maintain its c80% market share? Nvidia’s customer base is concentrated, and heavily incentivised to unpick Nvidia’s near monopoly. Several of its biggest customers, including Apple, Meta and Amazon are developing rival chips designed specifically for their needs and therefore expected to be significantly more efficient than the general processors supplied by Nvidia. Meanwhile, Microsoft is working closely with AMD – one of Nvidia’s key competitors. And if it faces stiffer competition, can Nvidia really be expected to not only maintain its profit margin (which has grown from 59% to a staggering 74% over the past year alone) but to expand it further still, as demanded by the earnings forecasts? We wonder whether TSMC – the Taiwanese company that manufactures all of Nvidia’s chips and is itself the dominant player in its part of the industry – might, at some point, question how fair it is that Nvidia gets to keep such a large share of the profits.
We are open to the idea that AI may well exert a profound influence on the global economy and the corporate landscape. Nonetheless, we are staggered by the assumptions and extrapolations that are fuelling the stock market, with the shares of many of Nvidia’s competitors (Broadcom +114%, AMD +78%) and other AI-themed stocks (SoundHound AI +63%, ServiceNow +68%, Super Micro Computer +771%) rocketing over the past year. The recent earnings growth of Nvidia and its ilk is undeniable. However, in our view, it is also unsustainable. We believe investors buying into these stocks now are quite possibly being sucked into a bubble in earnings. Unsurprisingly, we believe this bubble presents a clear risk to investors, particularly when the economic backdrop remains precarious.
Though market pricing indicates investors are confident that the global economy can stay on the narrow path to a soft landing, the threats of recession on one side and stubborn inflation on the other have not been entirely put to bed. Investor enthusiasm for companies capable of growing earnings even in an economic downturn, and of raising prices to protect against inflation is therefore understandable. However, we think cyclical growth has in many cases been mistaken for structural growth. In these cases, investors risk finding themselves on the receiving end of a sharp one-two as earnings disappoint, simultaneously undermining the premium valuations awarded to these stocks in expectation of long, strong, uninterrupted growth.
Greed and the Fear of Missing Out
We strongly caution against the temptation to yield to the fear of missing out. The feeling that we are standing on the sidelines while riches are being amassed lends an interesting twist to Warren Buffet’s wise counsel to “be fearful when others are greedy, and greedy when others are fearful”. It is not missing out that we should be fearful of, but rather the risks building in markets as investors pile assumptions on top of extrapolations in an attempt to justify expectations of further stock market gains.
Interestingly, even the most optimistic Wall Street forecasts we have seen put the US stock market only 4-5% higher from current levels by the end of the year. Given the risk that the economic outlook proves less benign than currently assumed, or that stubborn inflation might curtail hopes of lower interest rates, or that disappointing earnings pull the rug from beneath the feet of the AI trend, we find these prospective returns unappetising. Encouragingly, we do not need to give in to greed to find more appealing fare elsewhere. High quality short-dated corporate bonds currently offer yields around 6% – enough to deliver a positive real return even after accounting for a possible resurgence in inflation, while presenting little risk of permanent capital impairment. In our view, this is a much more compelling balance of risk and return.
There will come a time to be greedy. This, we are sure, is not it.
