Insights
Quarterly Commentary
2Q 2024
US stock indexes advanced 3.2% in Q2, again led by large technology names even as most stocks declined. Since their abysmal performance in 2022, a handful of the tech giants have ridden the AI wave and accounted for more than one-half of gains in the major US stock benchmarks.
The world as we see it
To restate the case for investing in stocks: The two factors that drive long-term returns are the future cash flows of the underlying businesses and the price that investors are willing to pay for those cash flows. Over the past eighteen months, earnings growth at AI-related chipmakers (Nvidia in particular) has surpassed earnings growth elsewhere to an amazing degree, while at the same time, investor enthusiasm has pushed prices (per unit of earnings) to the high end of their historical range.
Earnings growth elsewhere has generally been healthy but has been met with much less enthusiasm from investors.
The market’s message to investors – you will be rewarded if you buy what is currently working (i.e. AI related stocks) but be careful about owning just about anything else. That leads to some good questions.
Is all the hype justified? There are two main theses we are aware of regarding why recent developments in AI will change the world and thus justify current lofty valuations.
First, solving hard problems. AI could lead to breakthroughs in pharmaceutical formulations or advanced material designs, for example, or lead to major advances in data encryption or weather modeling. The main question regarding these applications is not whether AI will prove useful, but to what degree and when. If it is a long story, current optimism may be ahead of itself.
Second, efficiency gains. If AI can multiply the productivity of a worker at a given task, fewer workers will be needed. This could lead to higher margins for companies and would help alleviate the demographic challenges of an aging society. However, at current costs, it has been pointed out that in many jobs, replacing workers with AI is more expensive! The question is – will costs come down enough to change this math? If not, it is difficult to imagine that AI tools for businesses will become as dominant as many are predicting. If prices businesses pay for these new tools do fall significantly, margins for the current AI darlings may shrink.
Another important consideration that merits attention is the effects of generating the necessary electricity and providing other resources for this AI-led data center boom. The massive build out is projected to grow to a level that is likely to “crowd out” other potential uses, raising the overall costs to society. This might be justified if AI comes close to living up to its promise, but success is not guaranteed.
Looking ahead
We mentioned in our last quarterly note that we saw reasons for caution on the horizon. Data released at the end of the second quarter and in early July seem to confirm our suspicions. The labor market continues to soften, albeit from a very strong level, and inflation continues to cool. It is very likely that the Federal Reserve will cut interest rates before the end of the year.
The Fed will be dancing on a knife’s edge trying to maintain economic growth while keeping a watchful eye on inflation to ensure it doesn’t reaccelerate. Should it succeed, we see the potential for a significant shift in the market, benefiting smaller and more rate sensitive stocks.
Reasons to remain optimistic include a relatively healthy US consumer, strong corporate balance sheets, (hopefully) falling interest rates, and most importantly, undemanding valuations for many sectors of the stock market.
We expect slower growth and inflation. While it will be remarkable by historical standards if inflation returns to the Fed’s 2% goal without a recession, these are remarkable times. We also expect that the performance gap in stocks will narrow over the rest of 2024, but just how and when remains to be seen. It is important to note that bonds and cash are offering reasonable returns and for now, will provide a nice alternative should stock investors get spooked.
In conclusion
AI excitement reigns over stocks, but investor cash flow expectations can change quickly. In 1999 it was hard not to get excited about how the internet could expand a company’s addressable customer base; today it is easy to see the potential of AI to redefine human productivity and problem solving. Yet we often project high rates of return on tech investment incorrectly; the gains to pioneers of exciting advances are often very high, but the profits after widespread adoption can be quite muted. In a competitive environment, the benefits of groundbreaking technology will likely accrue more to consumers than to shareholders in the long run.
