Artificial Market

Why is this man so smug? I'll tell you why. He has been to the future and back. Now he's about to make you pay for it.

During his COMPUTEX keynote last week, Jensen Huang, Nvidia's CEO declared victory over his rivals in the AI semiconductor wars. He is looking like a combination of Tim Cook, Elon Musk, and Satya Nadella. He controls the gates to the promised land of chatbot heaven. His company's stock has doubled already and analysts are targeting a further 60% gain for the year. The mania over AI is just starting to go critical. I don't expect this to end well, but it won't end soon either.

Before you accuse me of being an old man yelling at clouds (the computer kind), hear me out.

When a market starts to make headlines based on a theme, and not on mundane things like earnings and cash flows, I get worried. But worrying about something doesn't make it go away. It always goes further than you think it will. I remember Nortel all too well.

Right now, the land rush to claim a stake in the artificial intelligence boom is dominating not only the headlines but the markets too. The result is a poorly diversified rally based on too much money chasing too few stocks. We all know that this newest member of the trillion-dollar club, NVDA, has the upper hand in this arms race to claim dominance over the artificial intelligence space. The problem is, There is not enough NVDA to go around. But it just keeps going and people keep on buying. Attribution bias theory would explain it this way: "the stock is going up so it must be good". And so Nvidia benefits, despite the grossly inflated valuation it now sports.

The semiconductor boom history books are full of shooting stars that take over the mind-share of eager investors. Here are a few examples:

Early 80's Mainframes = IBM

Mid 90's PCs = INTC

Video+Games = ATI

Wafer supply players, Taiwan Semi and ASML, also rallied hard during these boom/bust cycles as they are now. But despite all the promise of a wonderous future, these stocks had a period of dominance, followed by a painful correction. There is a sober second-thought phase in NVDA's future at some point. It's already trading at 10X TAM. But investors are undeterred by such trivialities.

So the 'artificial' economy has taken over from the real one. With slowing growth combined with a sticky rate of inflation, investors have been drawn back into risk assets that have more sex appeal. Who needs a market with breadth when there are a couple of mega-cap story stocks to play?

As economic growth slows, the market acts more like a bathtub in which the water sloshes back and forth. There is no new water from the tap as investors hoard cash due to a dwindling set of options. But what water there is pushes up the few favourites that remain. AI stocks are today's darlings just as Crypto, meme stocks, and WFH plays were last year. Again how did that end?

So I guess I really am an old man yelling at the clouds. That being said, I can't see the resurgence of the left-behind segments of the market recovering until such time as the Fed tightening cycle reverses. For that to occur, a lot more water has to flow under the bridge. This is a slow-motion, rolling recessionary environment. There doesn't seem to be a killer blow from the huge rise in interest rates we have seen. Consumers were cushioned by high levels of Pandemic related savings and protected from rate hikes by 30yr fixed mortgages and high equity levels in housing.

Interest rate immunity in the U.S. economy is causing a slow, grinding deceleration without a crisis. Add to that a structural labour shortage that perpetuates consumer confidence. So it is unsurprising that in the absence of any economic panic investors have selectively 'played' the market and rewarded the 'few' over the 'many'. I just have to deal with it. There is nothing artificial about that reality.

Risk Model: 3/5 - Risk On

Canadian investors have been left behind by the narrow MegaCap Growth rally south of the border. Our relative performance has definitively broken down (chart). Down south, with the debt deal behind them, the AAII survey this week should go positive, leaving only their overbought RSI and dismal Copper/Gold ratio to rain on the new AI-driven parade.

TSX/S&P 500 Relative Performance

The plight of the 'real' economy is depicted in the chart below. It's what I call a 'razorblade banister' - the further down you slide, the deeper it cuts. A reversal of this downtrend is likely at some point, but I don't see the debt deal or the Fed pause helping this just yet. China could help if they ever got their real estate act together. Talk about grasping at straws!

COPPER/GOLD