Record Highs Again
After a brief pullback last month, the stock market indices rallied to new record highs driven by Fed Chair Powell’s comments that interest rate hikes are off the table and subdued payroll and consumer price reports allayed inflation fears. A solid corporate earnings season has also been supportive of the rally. The economy is still quite robust in general but not so much as to reignite inflation - at least that is the sentiment today. While the market is no longer expecting substantial interest rate cuts from the Fed this year, the market seems fine with that. Meanwhile, there is growing evidence that artificial intelligence (“AI") is here, it is real, and that we do not have an electricity infrastructure capable of generating enough electricity in future years. These two investment themes have been important for us, and they are now driving markets higher.
Even the fixed income market bounced back after a tough April as interest rates declined marginally. Bond volatility has declined dramatically relative to last year and yields are attractive, which makes adding duration to one’s portfolio quite tempting. (Adding duration means adding interest rate sensitivity, so if you think interest rates are heading down you want duration.) Bonds have been a losing bet for the last four years as interest rates have reset to levels not seen in nearly two decades. According to the Fed, there is approximately $6.4 trillion parked in money market funds, which is over twice the amount pre-Pandemic[1]. Eventually this money could move into bonds, stocks and other assets, which is an important tailwind in the coming months and years.
NVDA…phew!
Nvidia (“NVDA”) is the face of the AI revolution. Revolution is probably the correct description of the impact artificial intelligence will have on various industries and on worker productivity. AI, itself, is nothing new. The term was coined in the mid-1950s by researchers at Dartmouth College and many attempts have been made to create AI applications since. The promise of AI is tantalizingly massive but until Nvidia introduced their groundbreaking Hopper semiconductor chip architecture last year computers were not powerful enough to bring this promise to reality. But that’s all changed.
Nvidia recently reported another blowout quarter. The magnitude of their growth is like nothing we have ever seen. Revenues for their 1FQ25 totaled $26 billion up 262% year-over-year and during this time the stock has rallied 240%. Nvidia is now the third largest stock in the S&P 500 accounting for 5.8% of the index, so its performance is crucial to the overall market. For example, Nvidia accounted for 25% of the S&P 500’s rally since the recent bottom on April 19th.
While Nvidia’s performance has been impressive, the transformative impact its products will have on society and the economy has only just begun. Fortunes will be made and lost in the coming years as applications of AI are developed. Some business models will flourish, and some will be rendered irrelevant. Two areas we know will be impacted are increased demand for data centers globally and much higher electricity consumption. We believe that AI could speed drug discovery and development. Industrial processes, pricing algorithms, inventory ordering, worker productivity all stand to benefit. We have even developed an AI application that helps us analyze client brokerage statements faster. The point is that understanding how AI can transform business models is now a critical element of our investment process.
Market Outlook
AI and its impact will be an important factor in our outlook for various individual stocks. Innovation tends to impact specific industries or individual businesses more acutely because of its idiosyncratic nature. But innovation like AI could also have a much broader impact akin to the Internet. This secular trend is powerful and may provide insulation from the cyclical aspects of the economy.
Nevertheless, the market is still subject to macroeconomic conditions. For now, inflation and the labor market remain the key drivers. As long as inflation remains above the Fed’s target, we do not expect interest rates to fall materially. The weaker than expected April payroll report, which showed a lower than expected 167,000 jobs created, introduced a new element to the market narrative. Given recent skittishness from hotter inflation reports, investors treated payroll weakness as a positive signal.
We are highly focused on weaker economic datapoints. As we have discussed previously, the big risk to the market is that we have not seen the full impact of higher interest rates flow through to the consumer and businesses. Importantly, these elevated interest rates are coming at a time when prices for goods and services are also very elevated. The consumer price index is 22% higher than four years ago and wages have not caught up[2]. Could the consumer finally be tapped out? The recent drop in the University of Michigan’s Consumer Sentiment Index may indicate a new trend (see chart below). Or, it may not. Time will tell if we need to become more conservative in our positioning.
Conclusion
Innovation is exciting. It creates opportunity and can propel stocks to new heights. It can also create excesses, so we remain disciplined. For now, market sentiment is quite bullish and we, of course, hope this remains, but there are some economic cracks emerging. Therefore, we remain vigilant and ready to change course as necessary.
Disclosures
LIM is a Registered Investment Advisor based in Dallas, Texas and registered with the Securities and Exchange Commission. Registration does not imply a certain level of skills or training. LIM is a company with purpose, dedicated to creative and unique thinking. We focus on portfolio valuation and research, along with superior client experience. We seek to identify investment opportunities by looking at economic factors, security valuation and human behavior. We start with the fundamentals of portfolio management and valuation. Then we build on these fundamentals with unique thinking and creative intelligence gathering to form a viable investment thesis. We believe this approach leads to dynamic global portfolios with increased return and managed risk. LIM utilizes Charles Schwab & Co. Inc. (“Schwab”), a FINRA-registered broker-dealer, member SIPC, as its custodian of assets. LIM is independently owned and operated and not affiliated with Schwab.
Additional disclosures:
This document may contain forward-looking statements based on LIM’s expectations and projections about the methods by which it expects to invest. Those statements are sometimes indicated by words such as “expects,” “believes,” “will” and similar expressions. In addition, any statements that refer to expectations, projections or characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Such statements are not guaranties of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual returns could differ materially and adversely from those expressed or implied in any forward-looking statements as a result of various factors.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results.
Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
This document is a general communication being provided to you for information purposes only. This communication is educational in nature and not designed to be a recommendation for any specific investment product, strategy, plan design feature or any other purpose. By receiving this communication, you agree with the intended purpose described above. Any examples used in this material are completely hypothetical and for illustration only. The document is for the sole use of the person to whom it is addressed and is privileged and confidential. Use by anyone other than the addressee is strictly prohibited.
Definitions
The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock’s weight in the Index proportionate to its market value.
The Nasdaq Composite Index is a market cap-weighted index, representing the value of all stocks listed on the Nasdaq Stock Market. The composition of the Nasdaq Composite is a mix of long-established companies that have been on the exchange since inception, to IPO newcomers, companies that grew from OTC exchanges or switched from other exchanges.
The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry. It has been a widely followed indicator of the stock market since October 1, 1928.
The Bloomberg US Aggregate Index is a broad-based flagship benchmark that measures the investment grade, US dollar-dominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate pass throughs), asset-backed securities and commercial mortgage-backed securities.
The S&P 500 Equal Weighted Index is the equal-weight version of the S&P 500. The index includes the same constituents as the capitalization weighted S&P 500 index, but each company is allocated the same fixed weight at each quarterly rebalance.
The Russell 2000 Index is comprised of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 Index total market capitalization.