Burning Down the House

”I hope that people don’t panic.”

                                                                                                --Time Bomb Y2K

It’s official: NVIDIA is more popular than Taylor Swift.

Key takeaway: Two throwbacks to 2000, and neither of them are comforting. Fed Governor Waller may have revealed a flaw in the Fed’s thinking. China’s liquidity trap. Move the line in the sand for the early warning of a market top up to the 4946 S&P low hit right before NVDA’s earnings.

One Score and Four Years Ago Dept: Berkshire Hathaway’s 1999 annual report was published on March 11, 2000, at the height of the tech bubble. In it, Warren Buffett warned of his “expectation—indeed, in our minds, the virtual certainty—that the S&P will do far less well in the next decade or two than it has done since 1982…equity investors seem wildly optimistic in their expectations about future returns.” However, then as now, he said he has not scaled back his portfolio dramatically.

In his letter for Berkshire’s 2023 annual report, the Chairman outlined that he feels better about the businesses in Berkshire’s portfolio than their stocks (to steal a phrase from his 1999 letter) and that there are no companies that could be purchased in the U.S. or globally that are attractively priced. Normally when he is not adding, you should be subtracting.

He included a macro analysis in 1999 that is relevant today. He explained that profits should grow over time at the same rate as nominal GDP, which was 5% back then. He wrote that if profits do grow at that expected rate, “the valuation placed on American business is unlikely to climb by much more than that. Add in something for dividends, and you emerge with returns from equities that are dramatically less than most investors have either experienced in the past or expect in the future. If investor expectations become more realistic — and they almost certainly will — the market adjustment is apt to be severe, particularly in sectors in which speculation has been concentrated” (emphasis added).

Mr. Buffett wrote he was using a 2% TIPS yield and a 3% real GDP rate to arrive at his 5% nominal GDP that he expected earnings growth to track. At the time, 30-year TIPS traded at 2.25% versus a current level of 2.11%. Recently, economists ranging from the Fed to the Conference Board to the IMF are forecasting a 2% annualized real GDP growth rate. Therefore, it is safe to assume that Warren is expecting a lower forecasted earnings growth rate than his 5% forecast in 1999.

Assuming profit growth now stands at a 4% nominal GDP rate plus roughly the same incremental adjustment for dividends (March 2000 S&P dividend yield was 1.10% vs. 1.35% currently) that Warren Buffett discussed in 2000, then I assume he is thinking the same now as then: it is likely that we “emerge with returns from equities that are dramatically less than most investors have either experienced in the past or expect in the future.”

That is depressing, although not surprising.

Now comes the scary part of his new letter.

Whereas in 2000 he talked about a “market adjustment that is likely to be severe” that follows investor disappointment upon realizing that future profit growth will not match their expectations, now he is speaking in more somber tones. Buffett mentioned that there are times when markets unpredictably “seize up or even vanish as they did for four months in 1914 and for a few days in 2001. If you believe that American investors are now more stable than in the past, think back to September 2008.”

He added that “Such instant panics won’t happen often – but they will happen.”

He is confident that a market shutdown could happen despite the liquidity depth of today’s stock market, basically because “active participants are neither more emotionally stable nor better taught than when I was in school. For whatever reasons, markets now exhibit far more casino-like behavior than they did when I was young. The casino now resides in many homes and daily tempts the occupants.”

He has a cash position of $163 billion, holding Treasury bills that are ”far in excess of what conventional wisdom deems necessary.” He said that in 2008 Berkshire “did not rely in any manner on commercial paper, bank lines or debt markets. We did not predict the time of an economic paralysis, but we were always prepared for one.”

Two weeks ago, we displayed a chart showing how quickly the semiconductor sector can collapse after it becomes overvalued. We wrote “The lesson from this chart is…the fallout that occurs when you are last to reach the exit as in 2017 and 2021. Being prudent will begin to win out over FOMO.”

Being prudent will begin to win out over FOMO. That is what I was thinking when I read this next sentence from Warren Buffett this weekend:

“We also operate with minimal requirements for cash, even if the country encounters a prolonged period of global economic weakness, fear and near-paralysis...I believe Berkshire can handle financial disasters of a magnitude beyond any heretofore experienced.”

Prudence over FOMO. I think I am sitting in pretty good company.

NVIDIA and Cisco: It’s More than Price

NVIDIA rocked the investment world when it released its expectation-busting earnings, and CEO Jenson Huang added the fuel with his proclamations. He stated that we are experiencing a radical transition from general to accelerated computing and stand at the outset of a new era “where AI-dedicated data centers generate digital intelligence…and NVIDIA AI supercomputers are essentially AI-generation factories of this Industrial Revolution.” The stock’s $277 billion market cap gain for the day following the earnings call was over 8 times the total market cap of ON Semiconductor, a stock that represents the median size of an S&P 500 company.

NVIDIAs gain on Thursday alone exceeds by more than 50% the enormous $163 billion cash hoard that Warren Buffett has amassed to take advantage of any major stock decline. These outsized one-day gains by mega cap tech stocks lately probably contributed to Buffett’s concerns regarding a potential market seizure once this ever-present euphoria eventually evaporates.

I am not sure which is more feverish—the stock’s price action or the rush to compare the price action between NVDA stock and CSCO’s action in 2000:

CSCO (in red) went from 10.3 in October 1998 to 81.8 in March 2000 for a 593% gain. NVDA, meanwhile, rose 563% from 108 on October 22 to 824 in roughly the same amount of time as CSCO’s rally. If it were to match CSCO’s 1998-2000 run, NVDA would reach a price of 850.

Bulls can argue that:

·         The popularity of the comparison will probably render the analog incorrect. They can also point to;

·         At CSCO’s 2000 high, its P/E ratio based on last 12-month earnings was 220x, while NVDA’s is “only” 65x.

At a 220 P/E ratio, NVDA’s equivalent price would be 2700...Let’s Go! The more conservative bulls will mention that Cisco briefly pushed above Microsoft in 2000 to become the world’s highest market cap stock. The parallel situation would point to a mere 1200 stock price target and $3+ trillion market cap for NVDA if it relegated Microsoft to the number 2 position once again, as happened in 2000.

Focus: Analogous Narrative between Cisco then versus NVIDIA now

In 2000, The New York Times wrote that “The love fest between Wall Street and Cisco Systems reached a new level of ardor today as the company surpassed earnings estimates…sending its shares to a 52-week high.” The LA Times made the following comments from the opposite coast:

“Showing again how the company has parlayed its dominance providing the backbone of Internet and telecommunications networks into astonishing profit and revenue growth.”

The story mentioned that the Dow’s P/E ratio at the time was 25x (it is at a 27x valuation now) and quoted CEO John Chambers as saying:

“It also shows you there’s no substitute for being in the right industry at the right time.”

These lines from 24 years ago could have been written last week, just substituting NVIDIA for Cisco, and Huang for Chambers.

If you look back to his comments during the 2000 Cisco earnings call, CEO John Chambers said:

“The momentum of the Internet revolution continues to accelerate across both business and government sectors on a worldwide basis…This continued economic growth together with Cisco’s recognized expertise in the Internet positions us to lead in the Internet Economy…The resulting increase in productivity, agility, and competitive advantage will define the winners in the Internet revolution”

Compare that to Jensen Huang’s comments on last week’s call, “Accelerated computing and generative AI have hit the tipping point. Demand is surging worldwide across companies, industries, and nations…and so we carry everybody with us on the one hand. We make giant breakthroughs on the other hand…every enterprise in the world…will run on NVIDIA AI Enterprise.” Sounds pretty similar; Perhaps Jensen hired Melania Trump’s speechwriter…

I won’t belabor the point, but I will end with one last statement made by Ajay Diwan, the Goldman Sachs analyst who covered Cisco back in the day. He suggested the narrow-breadth market leadership of mega cap tech internet companies in March 2000 would continue:

“This is the Information Age. Companies that provide communication technology or computing technology should exceed the market cap of a company that dominated the Industrial Age.”

Am I hearing an echo?

There is an important passage in Buffett’s 1999 annual report letter to which NVDA enthusiasts should consider “Our problem — which we can’t solve by studying up — is that we have no insights into which participants in the tech field possess a truly durable competitive advantage (Mr. Buffet’s emphasis). He happened to find one tech company that does, and that is Apple. Cisco did not meet their criteria. The question is, does NVIDIA?

Turning to one other analog, I wrote last week that the CNN Greed and Fear Index was coincident with the July 2023 top “The interesting facet of this analog is it signals a top coinciding with the NVDA earnings release Wednesday.” As an update, while the S&P made a slight new high Friday, the Nasdaq Composite and the Nasdaq 100 failed to do so. AAPL GOOG, META, MSFT, TSLA, and NFLX were down Friday. Of that group, only META made a new high this week (AMZN was up Friday, making new all-time highs).

Theme from two Fed Speakers last week: What’s the Rush?

Virginia Fed President Thomas Barkin, a Federal Open Market Committee (FOMC) voter for the remainder of 2024 said it all last week: “You do worry that when the goods deflation cycle ends, you are going to be left with shelter and services higher than you like.” Before CPI, in a February 8 speech titled “Inflation: Handle with Care” Barkin noted that while the U.S. could return “seamlessly” to the pre-pandemic economy, “it’s also possible that the landing might be somewhat bumpier with continued inflation pressure…that we will need to counteract.” He added “at the end of the Volker era, inflation seemed to settle in mid-1986. The Fed reduced rates. But inflation then escalated again the following year, causing the Fed to reverse course.”

In a speech ominously titled “What’s the Rush?” Fed Governor and permanent FOMC voter Christopher Waller said that due to the strength in the latest releases of GDP, Employment, and CPI where “all three reports came in hotter than expected.” He concluded that “I see predominately upside risks to my general expectation that inflation will continue to move toward the FOMC’s 2% goal.” However, overall, he is still dovish, stating “the risk of waiting a little longer to ease policy is lower than the risk of acting too soon and possibly halting or reversing the progress we made on inflation.”

However, I have a problem with the following:

Waller said he does not understand why people are concerned that a Fed delay in rate cuts could cause a recession this year. “When rates are rising, most of the discussion is on the long and variable lags of monetary policy with rate hikes not having a serious impact on the economy for 18 months or more. But when it comes to delaying rate cuts for a short period of time, we supposedly risk suddenly driving the economy into a recession  This supposed asymmetry in the lagged effects of rate hikes versus rate cuts is puzzling and not supported by any economic model that I am aware of.”

While I understand Governor Waller’s logic, it lacks common sense. Just because rates have a long and variable lag, does that mean it justifies holding back on rate cuts until we are on the verge of a recession? His thought process implies that because the impact of last July’s final hike 7 months ago may still be felt in Q4 2024, then what does matter if the FOMC cuts in May or June versus September, since the lags won’t kick in until late 2025 anyway?

Well, it matters quite a bit—the existence of lags is the reason the Fed must be proactive and not reactive. This type of reasoning is what could lead the central bank straight into a major policy error.

He strikes a note of caution due to Retail Sales: “It may indicate that consumer spending, which ran higher than I expected in the second half of 2023 is finally showing the effects of higher interest rates and a depletion of excess savings.” That is why his focus is on wages and compensation—if worker pay drops, it could warn of an economic slowdown; also, because payroll is the largest expense for most businesses, any renewed increase would be inflationary.

This Thursday night, NY Fed President John Williams, another permanent FOMC voter speaks, and I will be following his remarks closely to see if his speech will be titled “What, Me Worry?” William’s comments normally reflect the current FOMC mindset.

China: Fighting the Wrong War

China cut their 5-year mortgage rate by a record margin in an attempt to bolster the property sector. The 1-year loan prime rate was unchanged, but the benchmark was cut 25 basis points to 3.95%.

Here we have a classic instance of pushing on a string as Chinese property buyers need to put up the entire purchase price up front, therefore they need further reassurance that what they buy, they will receive. The risk of buying something that never gets completed is prohibitive currently. The problem for China equity bulls is that the Chinese property markets are highly correlated with the general indices, as shown in the following chart from Jefferies:

Depending on the asset, Chinese equities have steadily underperformed the U.S. since 2008. Incentives without structural change are not the solution. As of now, the best chance for a significant China outperformance is a sharp drop in global equities, where short China positions would be unwound as gross books are sharply reduced due to VaR risk management liquidations.

Markets:

 Equity Market: BTD update

Weekly Trend: Bullish

I published an hourly S&P 500 Index chart last week and I pointed out when an oscillator became oversold, there appeared to be a mechanical buy-the-dip reaction. I wrote: “I will be watching to see that when the next time that the BTD level is hit.”

Here is an updated chart:

The vertical black line marks the beginning action for last week. Note that Wednesday afternoon just before the last hour of trading, the market hit the BTD trigger. An oversold rally occurred in the last hour of trading before NVIDIAs earnings announcement. Then, there was a massive gap up Thursday morning, and the market remained bid into Friday’s close.

I wrote that if the move up after the BTD signal “results in a corrective, overlapping move up rather than an impulsive 5-wave rally…that will be a bearish outcome.” We need more data this week before having some visibility.

As I wrote two weeks ago, “this is not a market where it has paid to sell into strength. It is more prudent to look for failed support levels.”  The first level will come on a break below last Wednesday’s low at 4946. I have marked a rectangle on the chart above, showing a support zone between 4925-4945.

 What is critical about that rectangle of support is that a lot of shorts were forced to cover above it, and many new long positions have been entered above that area. Any breakdown will mean longs will incur losses and will start a liquidation. Staying above the rectangle is bullish and can lead to new highs.

Remember that after Warren Buffett penned his prescient March 2000 investor letter, the market still revisited its highs in Q3 2000 before falling. It is true that topping is a process, and patience and prudence are key.

Fixed Income: Big Volume

Weekly Trend: Bond Bearish

Weekly volume for the 10-year treasury note was largest since March 2022 at $60 bln. The 2-year note, which will have an auction on Monday (the results of which should be monitored) rose in yield as the 10-year fell, resulting in an interesting breakdown in the yield curve:

We will see how the curve reacts to PCE inflation data on the 29th, and the potential for a (partial) government shutdown that could occur as early as this weekend.

 The 10-year still has an upward trend in yields, and should see selling come in if the yield falls toward 4.12% this week:

Crude Oil:

 Weekly Trend: Bullish

The combined assets of the four largest long-oil ETFs hit the lowest level since September 2022. In September 2022, WTI crude had fallen almost 40% from over $120 in June 2022 toward $75, which generated those major oil outflows as longs were closed. In comparison, oil has risen about 15% over the last two months from its $67 December 2023 in WTI crude futures low. Investors are doubtful there will be more upside.

That dynamic makes for a clean long trade if crude can move to slight new highs. The following chart is a weekly UCO levered crude oil ETF.

Oil traders can establish a clean long trade above the cloud (see black arrow on the right above). A close above the cloud would be the first such move since August 2022, near the time when crude ETFs were as unloved as they are now. The WTI futures equivalent level is $80—that is the key pivot.

Peter Corey

PavePro Team

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