Nvidia vs. Everybody

We are halfway through the year and so I wanted to provide a quick school report on how we are doing. Overall, I think we can give the market an A- but like most scorecards, the devil is in the detail. The best subject has been the US stock market once again, delivering just under 15% return excluding dividends. Canada on the other hand is a solid B with just under 5% price return and quite a bit of volatility in June. More on that later.

The major theme that has lifted US stocks, well the largest technology stocks at least, is Artificial Intelligence (AI). It has become clear that investors are putting a lot of faith (& dollars) behind AI and its impact on the modern society. AI is being viewed as just as influential to society as the birth of internet back in the late 90’s. It isn’t just a few people hyping up the impact, the acknowledgment of its potential is growing by the day. In a recent study by PWC, they have estimated that AI could contribute up to $15.7 trillion to the global economy by 2030. They forecast there could be up to 26% boost in economic growth for local economies and have identified 300 use cases for AI across all sectors, ranging from Healthcare to Manufacturing.

Most of us haven’t experienced significant changes to our daily lives but that doesn’t mean that AI isn’t coming. After a quick search online, I came across this list of AI related apps & websites to help with all manner of projects an office worker might find themselves doing. Whether or not they take off, these are designed to make our lives easier and that is something to be optimistic about.

Is it any real surprise to see chipmakers, which are required to power AI, being the best performing sector this year? Nvidia has a market valuation of $3trillion at the time of writing and is being priced to capture a large chunk of the economic growth listed in the PWC report. There is an old phrase that when there is a gold rush you buy the picks & shovel businesses, and this is happening in troves with AI today.

Whenever a stock becomes a new market leader you often see a series of new charts and comparisons to put the size of the company into context. My favourites are highlighted below, even though the first is stale because the company has tacked on $500 billion of market cap since it was published at the end of May!

While the majority of the market is excited about the prospects of AI, there are a few pundits drawing comparison between the today and the dot-com bubble era. While I would agree that the market concentration doesn’t give me the warm & fuzzies, the market today is very different to the late 90s. For example, there was barely any revenue, let alone profit during the dot.com stock bubble. Today, the top 10 stocks in the S&P 500 index delivered 26.8% of the earnings over the last twelve months. The top 10 stocks in the S&P 500 index make up 37.3% of the index. Do I love those numbers? Not overly, but it shows us that these companies are delivering monster earnings. They have strong balance sheets too which means the current interest rate environment isn’t taking a chunk out of margins.

Not everyone is drinking the artificial intelligence Kool-Aid and the chief market strategist at JP Morgan believes that US equities will decline for the remainder of the year. Marko Kolanovic puts forward a slowing US economy and downward earnings revisions as the key reasons for the S&P 500 index dropping to 4,200 by year end, just over 20% decline from today. Kolanovic is at the lower end of the year-end S&P 500 target, as the chart below show.

Another market participant warned that despite the largest companies putting up blockbuster earnings, there are other similarities to the dotcom bubble that are not getting talked about. They note that: “The next leg of spending on AI will accrue to the leaders in the applications layer that implement the large language learning models that power AI. This is not unlike how we expected the software and web service companies in 2000 to take over the next phase of growth once the internet infrastructure was built out. Companies such as Microsoft and Oracle took those roles and grew throughout that entire post 2000 era. But it took both of those stocks 15 years to get back to the levels seen in 2000, so valuations did matter.”

As the adage goes…it takes two opinions to make a market!

My second Nvidia chart looks fake but sadly it isn’t. Nvidia’s market value is now larger than all Canadian companies in the TSX combined. To help us feel a little better about it, there are many comparisons where Nvidia would win in a game of top trumps. For example, Nvidia would be in 8th place if it were a country and you ranked its market capitalization versus the size of other countries (by GDP). It would be ahead of Italy and Brazil, just behind France & the UK.

Is Nvidia priced for perfection and unsustainable growth? Yes, I think so. Does that mean the stock is going to crash 75% to 90%, definitely not. Like anything investment related, you need to understand the rules of engagement and the probabilities of success. I personally don’t particularly like the long-term odds as an Nvidia shareholder at these valuations but that doesn’t mean it’s not a good trade. Then again, as I have said many times in this newsletter, trading is not investing. They have very different objectives and timeframes, and I will always stay in the investing lane.

Back to Canada, the stock market wasn’t given much help from the federal government in June as they voted through the change in capital gains tax. Individuals, corporations & trusts were sent into a tailspin, reviewing portfolios and if necessary, making changes before the June 25 deadline. There aren’t many occasions where you see tax tail wag the dog but this was one of them and the overhang was visible for a couple weeks. This newsletter is definitely not a political one but it sure would be nice for the Canadian government to design policies focused on growth, competitiveness, and leaning into what Canada does best. A stable and business friendly government is what corporations & investors appreciate. Otherwise, the expected growth rate that investors believe can be achieved drops, and equity in a company becomes a less attractive proposition. I will leave that there for now.

It wouldn’t be a monthly memo if I didn’t mention interest rates. The Bank of Canada decreased the policy rate from 5% down to 4.75% in June, a moment that was largely expected and another 1.5 cuts are priced in for the rest of the year. We still haven’t seen a cut from the Federal Reserve although there are close to 2 cuts priced in by the end of the year. I will give fixed income markets a B- because they have chopped around so much. The indecision of how many rate cuts are coming in Canada & the US has rendered it tough to eke out positive performance this year. North American bond indices are mostly flat year-to-date.

With that said, the ever-changing interest rate expectation haven’t stopped companies coming to capital markets to borrow. Investors have been keen to put cash to work and many investors like the risk-reward profile of lending right now. Legendary debt investor Howard Marks is one of those and remains optimistic on corporate credit as an investment asset class. During the Oaktree conference, he noted that:

“I believe fixed income investing may be better positioned today in risk/return terms than equity investing. Liquid credit instruments currently offer yields in the high single digits, and the yields on private credit are in the low double digits. These yields are highly competitive with the excellent historical returns on equities. (The S&P 500 Index has an average annual return of roughly 10% for the last 100 years.) These yields also exceed most investors’ required returns and are considerably less uncertain than the returns on equity and other ownership strategies. In other words, they have a high probability of delivering what they promise.”

Putting all this together, markets have had a good start to the year but performance hasn’t been overly broad. It has been heavily weighted towards companies directly linked with the artificial intelligence. The optimist in me believes this gives a lot of room for performance of all other stocks, which exhibit lower valuations, but who will stand to benefit indirectly through the general advancement of technology and productivity in the economy. I do expect investors will want answers on the many questions we all have from AI. Companies bought time by mentioning AI as many times as they have during recent earnings calls, but tangible evidence will need to be delivered over the next 6-12 months. Markets can run on hopes and dreams for a while but it gets tired and looks for answers eventually.

On the fixed income side of the ledger, I expect bonds will deliver more in the second half of the year. However, performance of each category will vary based on the performance of the US economy. Let’s end there and be content with how markets have performed and optimistic about where we are going from here. Pens down, cowboy hat on, let’s stampede!

I would like to wish you a wonderful July. If there is anyone that you think might benefit from reading this, please let me know and I will happily add them to the distribution list.

Until next time,

Chris

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