The stock market started the first half right where it left off 2023 — snowballing uphill. Nvidia (NVDA) mania continued as optimistic vibes for artificial intelligence spread like political memes. 

As the S&P 500 continues higher, the economic cycle continues to transition. The extreme outperformance of the anointed technology stocks masks a slowdown in parts of the U.S. economy. 

A few things changed in the past six months — inflation is lower and job openings declined. While lower prices are cheered, the lower inflation can also have a dark side. On one side, lower inflation is good for the Federal Reserve’s confidence to lower interest rates, but on the other side, the slowing growth could continue to an uncomfortable level and miss the soft landing.

This year presents a unique phenomenon as most investors realize there will be a day of reckoning for the lofty AI stock valuations, but missing the ride could be detrimental to achieving investment goals. For investors like us, the ride has been rewarding, but the key will be the dismount. In other words, when should gains be realized and portfolios shifted from AI-tech to other securities?

Below are our thoughts on the events of the past six months and the second half of the year.

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Let’s first explore inflation. We continue to track a real-time inflation measure offered by Truflation.com as opposed to solely relying on old, antiquated government-manufactured readings like Consumer Price Index (CPI).  The chart below is from Truflation.com – displaying their US Daily Truflation Rate.

The slowdown is clear in the chart above. The lower inflation is giving the stock market confidence that the Fed will lower rates soon as the tighter monetary policy achieved its purpose, but there is more to the story. While the lower inflation is what we have all been hoping for, it is important that the prices do not fall too much. The trend above should put investors and the Fed on the watch for deflation. 

Economic data has pointed to a slowing economy. There is also evidence of this in the employment data, which tells an interesting tale. The job openings have retreated from their lofty peaks and now stand in the same range as before COVID. This normalization is good for now, but investors must watch this trend. 

The job openings tell the story of much of the economy — slowing, but still doing just fine. The concern is that the trend of the cooling economy extends toward a less optimistic picture than the stock market has priced in. In other words, will the downward trajectory continue? Will the Fed wait too long to normalize interest rates?  We believe that each day they wait to lower rates increases the risk of this economic cycle ending like all others before — in a recession.  The higher interest rates are outstaying their welcome as the higher interest payments are hurting companies and consumers.

To date, the bad news (slowing growth) has been good news (lower rates) for the stock market. This will change if the bad news gets worse for several quarters and the Fed is not able to reverse course in time.

Second Half Preview

We are now four months away from the presidential election. See Stock the Vote for detailed thoughts on this subject. The election season promises to be unpredictable and could bring volatility back to the stock market. Buckle-up and make sure to have some dry powder for buying opportunities. 

Perhaps more important than the election will be the Federal Reserve. As mentioned above, the slowing economy gives the Fed confidence that their restrictive policy has achieved the mission and now rates can be normalized. The lower rates could lead to attractive opportunities in fixed income and other yield-producing securities.

There are other niche areas to watch that could be such powerful forces that they are not as affected by an economic slowdown. For example, the AI-fueled future will require massive amounts of power. We hate to break the news that sun and wind will not be the sole source of this power.  Thus, we look to select commodities (like natural gas and Uranium) as potential sources. We also look to technologies that help make the use of resources more efficient.

As mentioned in financial news ad nauseum, Nvidia is the driver of the stock market. The second half of the year will bring two more earnings reports for the company and others in this space. The world will be glued to the quarterly earnings releases seeking evidence that there has not been a slowdown in the building of data centers.   We believe the growth will continue, but at a slower pace than the astronomical climb in the past twelve months.  Further, the growth is largely priced into the stocks at this point.  It would take some shocking over-the-top expansion to surprise investors to the upside. 

Attention will also be paid to non-NVDA companies to see if these other companies have begun to harness the power of AI to increase profits. Building out AI is expensive — when will the profits be realized?

Conclusion

The lower rate expectations must be weighed against the slowing economy, but the great tiebreaker could be the profits from AI-related companies.

We are optimistic for specific areas of the stock, bond and commodity markets.  We look for increased volatility in the second half to add to stocks we have been watching and waiting for lower entry points.   Lower rates, business friendly politics and the digital revolution should continue to push the snowball up the hill as the economy slows to a more normal growth.

The next six months will be a great time to be a dynamic investor willing to take advantage of opportunities as the economy continues to transition from the COVID era craze and settles into the next phase.