by Franklin J. Parker, CFA
- The big news last week was the Fed’s decision to keep interest rates where they are. That was no surprise to markets (there was only about a 5% chance of a hike), but Fed officials continued to insist that they expect two more rate hikes before the end of the year. Of course markets cheered the pause but were negative on the “two more” part. There were two important things this Fed meeting demonstrated, however: (1) markets are becoming less sensitive to changes in Fed policy (other forces are taking over), and (2) the Fed is beginning to see negative developments in the economy that have them adjusting policy. The second point is important: once the Fed starts cutting rates, a recession is typically not far behind. Rate cuts, at this point, are bearish — not bullish — for markets.
- This week is a light data week. Though the Fed meeting took center stage last week, we did see other important data on inflation, retail sales, and industrial production. Headline inflation dropped from 4.9% to 4.0%, but core inflation (which factors out food and energy prices) remained high at 5.3%. Retail sales continued its strong showing, with a surprise 0.3% increase over last month (a drop of 0.1% was expected). In short, consumers are still keeping everything afloat, despite inflation.
- The next couple of weeks should be pretty quiet. I am reiterating my view that this is a good time for investors to hedge portfolios and/or reduce risk. This market rally does have me scratching my head a bit, but a rally into a recession is not unusual behavior for markets. As always, your goals will determine the types of risk you can afford to take, and the types of risk you cannot afford to take. Understanding that should be central to managing your portfolio.
Let’s talk about the AI hype, but specifically the market’s reaction to it. Have you seen Nvidia lately?!?
Artificial Intelligence (AI) is all the rage these days, and, to be fair, there is good reason. Recent developments promise to change the way business is done in a way not seen since the internet revolution in the 1990s. And the internet revolution offers some valuable historical lessons we can apply here.
During the 1990s, especially the late 1990s, the hype surrounding the internet reached a fever pitch — any business associated with this new way of doing business was seeing massive increases in stock price. As we learned quickly, however, those increases were not always justified. In fact, hype is often the enemy of reasonable behavior.
Take Nvidia as an example. They are currently trading at multiple of about 225… this means that investors are willing to pay $225 for every $1 they have earned in profit. It doesn’t take a finance genius to wonder how that makes sense. If you do run the math, however, you will find that, at its current price, Nvidia would need to grow earnings by 62% every year for the next 10 years for an investor to just break even!
The basic question is, then: do you think developments AI will give Nvidia the ability to do that? I am no expert in AI, but I would struggle to believe that were possible.
None of that is to say that Nvidia stock won’t continue to climb (and I’m not picking on Nvidia here, they are just an example). If we have learned anything from market behavior in a bubble it is that extreme valuations can persist for quite some time. Investors can make money in these moments, but the key is to not be left holding the bag when the music stops.
In that vein, I will close with a quote from Scott McNealy, former CEO of Sun Microsystems, that sums up these ideas:
“[In the year 2000, Sun Microsystems was] selling at ten times revenues…
At ten times revenues, to give you a ten-year payback, I have to pay you 100% of revenues for ten straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes that, with zero R&D for the next ten years, I can maintain the current revenue run rate….
Do you realize how ridiculous those basic assumptions are? You don’t need transparency. You don’t need footnotes. What were you thinking?”Bloomberg Businessweek, emphasis added.
Nvidia is currently trading at 11 times revenue, so be careful out there.
Chart of the Week
One of the recession indicators that I watch is business inventories. Usually (but not always), you see inventories peak just before a recession. Since this happens concurrent with a recession, we have to use this as more of a confirmatory signal rather than a predictive one.
As this week’s chart shows, inventories do appear to be peaking. When combined with the other data on my recession dashboard, this adds some confidence to my view that a recession is likely to form within the next six months. At this point, however, the key figure to watch (as I mentioned in my last note) is employment.
This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.