On Tuesday (2/13) the Dow suffered its worst decline since March 2023 after hotter than expected US inflation numbers spooked the market into believing that the Fed may not cut rates as quickly as expected. However, US equities recovered most of their losses later in the week. Per JPM, “The CPI for All Urban Consumers (CPI-U) marked a 0.3% increase in January on a seasonally adjusted basis – a slight acceleration from the 0.2% rise observed in December. The incremental rise is unwelcome news for policymakers and markets, as it indicates the Fed may have to keep money more expensive for longer. Notably, the shelter index surged by 0.6% in January, significantly contributing to over two-thirds of the month’s total increase in all items.” The all items index rose 3.1% over 12-months, still well above the Fed’s 2% target. On top of the bad CPI news, January PPI was released on Friday, 2/16, and also came in hotter than expected.
While the transitory factors that caused CPI to peak at 9.1% in 2022 have passed, the “last mile” (term used by Wall Street to describe the desired final drop of CPI from 3-4% down to 2%) has remained elusive. It may be the case that sticky service price inflation will keep CPI from dropping to 2% anytime soon, which would mean that the market is still expecting too many rate cuts this year.
Passive Investing Takes Over
According to Bianco Research, passively managed mutual funds and ETFs have just surpassed 50% of all assets for the first time. This is a major development because passive investors insert and withdraw capital from markets without consideration to any value metrics of individual stocks. That means if you buy into a cap-weighted S&P 500 ETF like SPY, over 4% of that investment is going into NVDA regardless of how you feel about its high PE ratio (over 97 as of 2/15/24). Active managers who are benchmarked against the S&P 500 have a hard time avoiding index behemoths like NVDA because as long as it keeps rising, they will struggle to keep up with their benchmark unless they invest in the momentum driven high flyers. Momentum trades can last far longer than traditional valuation metrics indicate they should, and investors need to be aware of the fact that major bull runs which are driven by a handful of stocks make their portfolios less diversified than they may have intended.
Nvidia Earnings are Coming Up
Speaking of NVDA, the company is scheduled to report earnings after US equity markets close on 2/21/24. The anticipated AI revolution enabled NVDA to massively grow its margins, and Wall Street’s consensus is for gross margins (non-GAAP) to hit 75.5%. The question though is, how sustainable are NVDA’s earnings? Regardless of how high demand for compute power is, capitalism should dictate that NVDA’s elevated margin earned on chips should normalize at some point.
AI is expected to increase worker productivity, and that is enabling a few stocks to drive cap-weighted equity indices higher. It is worth remembering that investors had similar hopes for the internet in the lead up of the 2000 tech bubble. Companies like Pets.com experienced extreme valuations based on the expectation that the internet would change how people shop. The market was half right, the internet did change how consumers shop, but they didn’t expect a book seller (AMZN) to be the biggest winner. While we certainly don’t expect NVDA to be the next Pets.com (NVDA bears might compare it to CSCO, although Morningstar explains why they don’t think that comparison is entirely fair either in the linked article), we want to remind readers that 2 things can be true at the same time: 1) AI bulls may be correct about future demand for compute; 2) we can’t predict how the market will supply that compute. For example, SoftBank founder Masayoshi Son is reportedly working to build a rival to Nvidia. “The race for dominance in the realm of generative AI is reaching new heights as SoftBank’s Founder and CEO, Masayoshi Son, unveils ambitious plans to raise a staggering $100 billion for his AI venture. This move is seen as a direct challenge to the supremacy of graphics chip giant Nvidia. Reports from Bloomberg suggest that SoftBank intends to inject $30 billion of its own capital into the venture, with an additional $70 billion sought from investment firms in the Middle East.”
By the way, we wrote 2 deep dive reports (here and here) last July on how blockchain technology could be utilized to make compute more affordable. From our first report, “Web3 may be able to substantially lower the costs for an AI startup to develop and train a machine learning (“ML”) model through Decentralized Physical Infrastructure Networks (DePINs). DePINs utilize blockchain technology to build and operate physical infrastructure and hardware networks. This emerging Web3 technology enables supply-side providers to earn tokens in return for renting out hardware capacity (i.e. GPU compute power) from idle hardware to end users. Essentially, hardware from across the globe can power a cloud-like network.”
Either way, expect market participants from around the world to attack NVDA’s market share with their own chips, blockchain technology, or traditional cloud technology. There is certainly room for multiple winners, but prices and profit margins should come down.
Coinbase Crushes Earnings
Coinbase crushed earnings expectations, earning $953.8 million in revenue for the quarter, vs predicted quarterly revenue of $826.1 million. Revenue grew 41% quarter-over-quarter, enabling them to earn a net income of 273 million for the quarter. This is a sign of significant life coming back into the crypto market because the growth primarily came from transaction revenue.
Week at a glance:
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