NVIDIA and the Super Bowl Champs

What’s the best part about writing The Deep Woods? My answer to this question, which I field frequently, is that I get to make connections between usually disparate fields in order to illustrate something interesting about the world. Today, I am going to do just that once again, this time with the help of my “secret market insider,” i.e. my collaborator in our daily market briefing Eagle Eye Opener. 

Now, we all know about the artificial intelligence (AI) enthusiasm that has powered the tech and tech-aligned sectors higher over the past year. Remarkably, the gains in these stocks have accounted for the vast majority of the gains in the S&P 500. But with one-year returns in mega-cap tech stocks at eye-popping levels, a lot of investors are wondering if AI enthusiasm has entered a bubble phase. And with NVIDIA Corp. (NASDAQ: NVDA) set to report earnings after the closing bell today, we wanted to address this issue and investigate if AI tech is in a bubble, and if so, what it means for stocks.

The following is an excerpt from this morning’s Eagle Eye Opener, which subscribers received in their inbox at 8 a.m. EST. 

First, the impact of AI enthusiasm on the market can be easily demonstrated via any number of startling statistics. NVDA has been the “poster child” of AI enthusiasm because NVDA makes the type of semiconductor chips that power generative AI and demand for those chips has gone through the roof. So too has NVDA’s stock, which has gained 218% over the past year. But while NVDA is the proverbial “picks and shovels” of the AI gold rush, other large-cap tech companies such as Microsoft (NASDAQ: MSFT), Meta Platforms (NASDAQ: META), Alphabet (NASDAQ: GOOGL), Amazon.com (NASDAQ: AMZN)and Apple (NASDAQ: AAPL) also have seen large stock rallies as investors expect these companies to harness the power of generative AI to boost revenues and increase earnings and profitability. And it’s not just those stocks. AI enthusiasm has spread beyond tech to “tech-aligned” sectors such as Communication Services (XLC) and Consumer Discretionary (XLY).

Consider these stats:

• More than half of the 23.8% 2023 gain in the S&P 500 was driven by five stocks: NVDA, MSFT, META, AMZN and AAPL. Rallies in those names combined with their weightings accounted for nearly 55% of the gains in the S&P 500.
• Three S&P 500 sectors (Tech, Communication Services and Consumer Discretionary) accounted for nearly 80% of the gains in the S&P 500 in 2023, more fully revealing that last year’s gains in stocks were totally AI-driven.
• At current valuations, NVDA has a market cap worth more than the entire S&P 500 Energy Sector (XLE) and NVDA is worth more, by itself, than the entirety of the Chinese stock market.
• The market cap of the Magnificent Seven stocks combined is larger than every other country stock exchange in the world (second only to the U.S. exchanges).

We can go on and on with these superlatives, but we trust you get the point. So, on to the bigger question: Has the AI mania gone too far and are we looking at a bubble situation?

Based on what most of us think about typical bubbles, the answer is “no,” they are not in a bubble, and here’s why. Their valuations really haven’t changed despite these massive share price increases.

We looked at the forward- and backward-facing price-to-earnings (P/E) ratios of five of the Magnificent Seven stocks (NVDA, MSFT, AAPL, META and AMZN). While there’s been some volatility over the years with Covid and other surprises, by and large, the forward- and backward-looking P/Es of these stocks are roughly where they were over the past several years, including before Covid and before AI mania.

This is an important distinction between now and the late 1990s/early 2000s, when the P/Es of tech stocks exploded higher, revealing unsustainable valuation expectations. The fact that forward or backward P/Es haven’t changed much reveals a very important reality of this AI-stock-driven rally in tech: It has occurred because these companies are making a lot more money, not just because people hope these companies make a lot more money.

We reviewed the actual earnings of the five stocks referenced above (NVDA, MSFT, META, AMZN, AAPL) and the results were remarkably consistent. Across the board, these companies are earning 2X-3X what they were just several years ago, and EPS for all of them are at or near multi-year highs. So, a large part of the rally in these stocks has been driven by actual earnings growth. These companies are making a lot more money, so their shares are worth a lot more!

The conclusion of this research is clear. The AI-driven rally in the “Mag Seven” is largely justified by the fact that they’re making a lot more money than they were previously. As such, their stocks should rally! But that does not mean this historic move higher in the Mag Seven or tech/tech-aligned sectors doesn’t pose a risk to the market. It does.

The easiest way to explain that risk is that the performance of the Mag Seven (from earnings growth and stock appreciation) is essentially making the rest of the market look a lot stronger than it actually is. And if the Mag Seven stocks stop performing like money-printing factories, then the market as a whole is worth a lot less than people think. Here’s a stat that explains what I’m talking about.

In 2024, analysts expect the S&P 500 to earn about $243 per share. Over the next 12 months (so, basically 2024), analysts expect earnings from just the Mag Seven stocks to account for $74 of those $243, or about 30% of 2024 earnings for the S&P 500. Put differently, 1.5% of the S&P 500 is expected to account for 30% of the index’s earnings. If these seven stocks do not deliver, then earnings expectations for the S&P 500 will get revised sharply lower, and that’s where the risk lies. 

Here’s a slightly easier way to explain it. The stock market is kind of like the Kansas City Chiefs (for all you football and Taylor Swift fans). The Kansas City Chiefs, like the S&P 500, had an amazing year, winning the Super Bowl. But the team doesn’t have that many great players, except the two especially amazing players. Quarterback Patrick Mahomes and tight-end Travis Kelce are so good that they produce results far above what the rest of the team should expect. Essentially, those two players help produce results for the team that are much better than the team’s aggregate talent level would warrant or imply.

Similarly, the historic AI-driven earnings growth in the Mag Seven is producing returns for the S&P 500 far above what the “rest” of the market would warrant based on actual earnings. And as long as they (Mahomes, Kelce and the Mag Seven) continue to perform, the Chiefs (and the S&P 500) can keep winning. However, if one falls off or gets injured, then the reality that the rest of the team isn’t that good will be exposed, and the Chiefs will likely quickly go from Super Bowl champs to just another team.

Completing the analogy, the Mag Seven stocks are the “MVPs” of the 2023 rally, but their amazing earnings growth and performance is masking an otherwise average rest of the market, and if earnings growth doesn’t meet expectations, then the average nature of the rest of the market will be exposed (and a decline in the S&P 500 will likely follow).

So, what does this mean for markets? From a tactical standpoint, the takeaway from this analysis advocates for allocations to the Invesco S&P 500 Equal Weight ETF (NYSEArca: RSP), unless you are a true believer in the never-ending profit generation of the Mag Seven. I say that because if the Mag Seven disappoints versus expectations and AI isn’t as profitable as expected, we’re going to see their earnings drop while other, unrelated sectors (that have lagged) are unaffected. So, we’ll likely see a reversal of the 2023 market, where the S&P 500 drops on tech while RSP outperforms and closes.

Conversely, if the Mag Seven meet expectations, they’re just fulfilling what’s already expected and as such, we could see investors continue to rotate into other parts of the market to try and capture some relative value, as RSP is trading at a near-20% valuation deficit to SPY. The only scenario where the Mag Seven names continue to lead markets higher is if AI’s ability to maximize profits is greater than expected. And while that may turn out to be true, we do think the expectations for AI are pretty lofty here (although admittedly, we are not AI experts).

Would you like to get an analysis like this every morning in your inbox before the market opens each trading day? And at the mere price of a cup of Starbucks each morning? If so, then I invite you to check out the Eagle Eye Opener, today! It might be the best decision you’ll make this year. 

*****************************************************************

In case you missed it…

A Thin Line Between Love and Hate 

It’s February 14th, and that means it’s Valentine’s Day, a day dedicated to celebrating love. And so, on this occasion, I have decided to explore the thin line between love and hate in a couple of areas that I consider to be very important in all our lives.

Now, what do I mean here by “a thin line?” Well, I mean that as with so many things, you can love certain aspects or elements of that thing, person, concept, etc., and you can hate many aspects of that thing, person or concept. Often, it’s the flipside of a given coin that you hate, and as it is with every coin, there’s always a flipside.

So, what are some of my “thin line” pet peeves on issues, people and concepts? Let’s take a look at two of these, as I hope they serve as a launching point for a conversation we can have on what you consider to be your important thin lines between love and hate.

Thin Line One: Conversation. When it comes to determining what one should do, or what a society should do, or how groups should resolve conflict or how to come to decisions about what is right and wrong, the only rational tool we have is conversation.

I love productive, rational conversation where the parties come together in good faith to air out ideas and to consider different viewpoints and debate those views, identify those differences and come to points of agreement. This kind of productive discussion can take place in the boardroom, in politics, in the ivory tower and in personal relationships. And when you think about it, conversation is really the only tool we have to make things better. The alternative to this kind of conversation is violence, and that is something that, while sometimes required of us, is also something to hate.

I hate non-productive, irrational conversations of the sort I see going on in the political arena these days. I have to admit that while I was once very interested in the machinations of politics and battles that took place in Washington, these days my distaste for these subjects has become caustically unpalatable. Today, I have grown to hate the tribalistic, petty, nationalistic, non-intellectual, non-serious, race-driven, grievance-driven and fact-discarding nature of the conversation I see out there. It’s like there are two realities operating in distinctly different universes.

There’s the Fox News universe, where all things “liberal” and “leftist” (siloing terms I also hate) are the main destructive causes of all the evil in the world and must be destroyed. Then, there is the MSNBC universe, where all things “MAGA” and “Trumpism” are the existential threat to democracy and to the survival of the nation as we know it.

Now, both of these sides of the coin have valid points, and both also have some extreme flaws. But is it any wonder why half of the country sees the other half as out to destroy the nation? I mean, the conversation always seems to descend to the tribalism of “us versus them,” and that is what I hate the most.

Thin Line Two: Merchants of Doom and Gloom. In the financial advice business, there is no shortage of those willing to sell you a scenario where your money is about to evaporate into the ether. Whether it be via government fiat, or war, or destruction of the world’s reserve currency, these merchants tell us that we must act now to protect ourselves from these threats.

I love the idea of taking action to protect our money by being aware and prepared for the biggest threats to our freedom and to our personal financial well-being from the many legitimate destructive forces that exist. I mean, my Successful Investing advisory service is based on having a plan in place that protects your money during bear markets and grows your money during bull markets. So, I understand this need quite well.

I hate the ideas promulgated by some in the industry designed to scare us into taking action from threats that are just cooked up in a marketing lab to feed on our fear of loss. Feeding on the fear of loss is not a rational way to persuade someone to do what is in their best interest. And while being aware of threats and being prepared for those threats is something I love, what I really hate is the idea of living in a state of fear about these things. One can be rational without succumbing to living in a state of fright.

Ok, now it’s your turn. What are your, “Thin line between love and hate” subjects? Why do you love them, and why do you hate them?

I need to know. So, put on your thinking cap and send me your ideas.

*****************************************************************

Don’t Build Those Walls 

“The walls we build around us to keep sadness out also keeps out the joy.” –Jim Rohn

Sadness is a serious problem, and we need to find ways to keep it from invading our being. However, when we put up barriers to stave off sadness, those same barriers can keep us from experiencing the extreme joys in life such as love, excitement and new experiences. If you want to live life the way it should be lived, then don’t build those walls. If you get sad, embrace it, for sadness is also a part of a life well-lived. 

Wisdom about money, investing and life can be found anywhere. If you have a good quote that you’d like me to share with your fellow readers, send it to me, along with any comments, questions and suggestions you have about my newsletters, seminars or anything else. Click here to ask Jim.

In the name of the best within us,

Jim Woods