For those of you who would prefer to listen:
We are nearing the end of September; Historically the worst for stocks. This year has certainly bucked that trend. The month started out with a bang as the S&P 500 extended the rally, going farther and faster. For months, stocks climbed that wall of worry. The dips kept getting bought. The trend is your friend, as they say. However, the trend has changed a bit. This week the rally stalled.
America’s Stock Market saw its first 3-day losing streak in months. The streak ended Friday in the green, but still ended the week in the red. After hitting fresh, new highs day after day, Bullish sentiment and complacency set in. Importantly, we would characterize the Market as a little overhyped and overbought in the short-term, but still positive on the long-term. The earnings growth has been real. The sustainability is the question.
Market leadership has been crystal clear and quite concentrated since 2022. Roughly 75% of the S&P returns have come from AI-related stocks. The reason: 80% of earnings growth and 90% of capital expenditures have come from AI. In fact, there has been more money spent in the last 3 years on AI infrastructure than was spent over the course of 4 decades building out the interstate highways in America. And that is inflation-adjusted.
Spend now and figure out later. That seems to be the strategy. There are no signs of slowing the spend. Quite the contrary; It’s been accelerating. A new report from Bain estimates that while AI companies will need $2 Trillion in combined annual revenue to fund computing power by 2030, their revenue is likely to fall $800 Billion short. There are so many questions. How will they pay for it? Is the spending worth it? Will there be a return on that investment? That’s the ultimate issue, which of course is a present unknown. Remember, more than anything else, it’s earnings that drive stock prices.
Forecasts are merely predictions. They generally come from informed opinions. They aren’t blind guesses. They’re educated guesses. That said, forecasts are definitely not guarantees. It’s Market meteorology. Let’s not forget what my favorite philosopher Yogi Berra once said: “It’s tough to make predictions, especially about the future”.
Echoes of the Dot-com Bubble? That was definitely a topic this week on Wall Street. That raging Bull Market in the 1990s was driven by the advancement of the internet. There was massive spending in capital equipment and fiber optics to broaden the reach. The investment was necessary. It changed the world. History also proved that the over-investment was not. The telecom companies footed the bill. Unfortunately, they wrote checks that their revenues couldn’t cash. Highflyers like Nortel and JDS Uniphase led the charge. The companies are nowhere to be found today. At one point, Nortel alone accounted for 1/3 of the Toronto Stock Exchange. These were real companies that got caught up with the hype which led to their demise. The Dot-com bubble burst hurt far more than the fly-by-nights like Pets.com. There’s definitely a lesson to be learned.
Despite the excesses that led to the bubble formation and subsequent burst, the world was completely transformed. The internet changed everything. Business, commerce and communication took off. It became far more efficient and easier to interact. The world became connected like never before. The Stock Market reached a euphoric state by the turn of the century. The ultimate winners were not obvious back then. Most flyers failed.
AOL and Yahoo were Dot-com royalty. All of you over the age of 50 remember that. However, both companies peaked at that period, forfeiting their dominant stake. They failed to innovate. Companies like Apple and Amazon survived the bubble bursting and became Tech Titans. They embraced the web, expanded their offerings and secured loyal customers. Google and Facebook were born during the bubble and disrupted their way to Titan status. Nvidia was a baby in the 1990s. It sure has evolved over the decades, becoming the most valuable company in America. Microsoft is a rare breed that’s been a leader in both periods.
Market bubbles are nothing new. History has a fascinating way of repeating. Well, more like rhyming as Mark Twain put it. The reason is simple, most people don’t learn from history. Smart people learn from their mistakes. Brilliant people learn from other’s mistakes. Most people never learn. Hence history’s noted track-record of repetition.
Even the brightest have been caught up in Market bubbles. Sir Isaac Newton lost a fortune in the South Sea Bubble of 1720. That was believed to be the first of history’s most famous Market Manias. It trailed the infamous Tulip Mania in the 1600s. Despite being one of the greatest scientific minds, Newton was seduced by the speculative fervor and greed that infected the rest of the British investing public. He reportedly lost nearly Tens of Millions in today’s Dollars. Newton learned about gravity from both apples and stocks.
Have you heard this story before? For those of you interested, the South Sea Company was founded in 1711 by an Act of the British Parliament. The company was a public and private partnership that was designed to reduce and control the national debt and to help Britain increase its trade in the Americas. The problem: It didn’t work. Trade never materialized as expected. Colonialism created barriers. The Spanish also possessed a surplus of strategic territory in the western hemisphere. Spain squeezed British profits with restrictions and taxes. The South Sea Company was struggling. But investors weren’t necessarily aware.
King George took over governorship of the company in 1718. This enhanced the image and the brand of the company which further inflated the stock. The endorsement of the ruling monarch saw investor confidence explode. It triggered demand throughout the British Stock Market. In February of 1720, the South Sea Company stock surged from £128 to nearly £1,000 that Summer. The stock bubble expanded in feverish form while the company was not actually making anywhere near the profits it had promised. It did not end well.
Initially, Sir Isaac Newton played the Market somewhat masterfully. He reportedly bought the stock in the low £100’s and sold it all within 2 months at over £300. Newton tripled his money and walked away. Unfortunately for him, he didn’t stay away. Like so many investors before and after him, Sir Isaac Newton couldn’t resist the temptation of the skyrocketing Stock Market. He could not stand seeing his friends and other investors continuing to get richer. Newton’s brilliant mind gave into the herd mentality of the fear of missing out. Sir Issac put his money back in the South Sea stock at over £700 per share and saw his fortune crash, losing a reported £30,000. That translates to nearly $50 Million in today’s Dollars. Even the brightest of minds can get seduced by temptation.
Back to today:
Fed Chair Powell said the Stock Market was “fairly highly valued”. That was this week. Fed Chairs don’t usually comment on the Stock Market. But when they did, it left a mark. Alan Greenspan notoriously coined the term “irrational exuberance” describing the euphoric Stock Market in the 1990s. The thing is, Greenspan made that comment in 1996. That was 4 years before the Dot-com bubble burst! The S&P doubled in value during that time. Overbought lasts far longer than oversold. It’s because fear is a much stronger sensation than greed. Plus, making money tends to mask many problems.
Risks are everywhere. It’s been that way for a while. A government shutdown looms. The Market has largely ignored the issue. It’s seen this behavior before. This, from one of our Washington sources:
“President Trump cancelled a meeting with Democrat leaders this week. He characterized their position (on repealing the OBBBA Medicaid cuts in particular) as radical & this removes doubt about any daylight between Trump & congressional GOP re scope for a deal with Dems. Ds will spin this as Trump/GOP refusing to negotiate. So, both sides positions are hardening. We continue to believe in high likelihood of a shutdown. The probability of a shutdown and the duration of it is now completely up to Ds. Expect Senate votes on the 29th and 30th with shutdown on Oct 1. The last time we had a full shutdown (defense/non-defense agencies) was October 1st, 2013, and it lasted 16 days. October 1 there would be up to about $10bn in missed paychecks for federal workers/active-duty military”.
The last complete government shutdown was in 2013. As you might expect, the Stock Market initially sold off, approximately 2% on the event. But perhaps counter to anticipation, stocks quickly reversed and rallied to a 3% gain during what was a 16-day shutdown. More recently, there was a partial shutdown in 2018. That resulted in $18 Billion in delayed payments. That impacted government salaries and general operations. If you’re flying next week like I am, expect some impact. TSA will be scheduled to operate regular way. But you can imagine some employees that won’t get paid to call in “sick”. The Travel Industry could lose $1 Billion every week. It’s still unbelievable that our Federal Government shuts down. It’s not a good look. Polymarket is assigning a 77% probability of a shutdown next week. Political divide continues to be a major problem in America. There’s a bubble in Washington. It’s called Congressional ineptitude.
So where does this leave investors heading into October? We think this Market is way overdue for another breather. Despite the S&P hitting new highs earlier in the week, only 11% of its 500 components are trading above their 20-day high. That is a sign of internal sluggishness. For perspective, it was nearly half over the Summer. There was far greater momentum then. Call it yellow lights flashing for some healthy back-and-filling.
Besides, there’s still this: The concentration of leadership has been as dominant as it’s ever been in history. Rivaling the Nifty 50 in the 1960s and the Dot-com dominance in the 1990s, enthusiasm for Tech and specifically semiconductors has rarely been this crowded. Nearly 90% of chip stocks are above their 200-day moving average. Those levels have historically been consistent with near term tops. That doesn’t necessarily mean bubble. It’s more about the need for a breather. The S&P hasn’t had a 2% daily decliner in over 100 trading sessions. It’s due.
Are we in the midst of an AI bubble? Maybe. Probably. Beyond the Tech Titans, there have definitely been some high-flying speculative stocks with some out of this world returns. What’s different about the AI rally compared to the Dot-com days is the Tech Titans are extremely profitable. The issue is how valuable their businesses are. That will be determined by the size and sustainability of the growth. Bubbles tend to inflate far bigger than people think possible. You don’t want to fight the tape. It’s just imperative that investors know where the exits are in advance.
The point is, when the masses are calling for a bubble, the Market tends to keep chugging higher. Investor sentiment is definitely elevated today, reflecting the gains. But it’s by no means euphoric. Politics and general uncertainty around multiple issues are playing a role there. A government shutdown is exhibit A. The Market has a masterful way of doing the opposite of conventional wisdom. Its very existence is priced by the wisdom of crowds. The Market is all about expectations. It quickly prices in anticipated outcomes. It’s when the herd is overly optimistic when the Market tends to pull the rug out. It’s essential to understand what Newton learned.
Have a nice weekend. We’ll be back, dark and early on Monday.
Mike
