Thoughts and Observations

There’s a lot going on in the financial world at the moment.  Quite a lot in the “real world” for that matter.  There’s so much to talk about that I don’t quite know where to start.

With that in mind, I want to just touch on a range of things that are sloshing around in finance-land (and my mind).

Technical Analysis

Let’s begin with a bit of simple technical analysis – focused on the US S&P 500. 

A decent correction throughout March.  Iran war.  Doom and gloom.  Then boom!

The recent correction has resolved the extreme overbought position the market developed.  Just hovering around in the middle of nowhere.  Solid support back around previous highs – 7,000.  There’s also that big gap around 6600/6700 – it’s remarkable how frequently the market seeks to fill gaps like that.

A few weeks ago, I caught some brief commentary from one of the superstar strategists from one of the major New York investment banks.  Can’t recall who and from where – not important…

It was towards the end of the recent tear higher in the market – driven by one of those periodical melt-ups in tech stocks.  He was basically asked what would cause the market to pull back.  His answer was if there was some meaningful selling pressure in Nvidia and Apple.  His logic was that their market caps are so huge, a decline in their price would drag the market lower even if that capital was being put to work in other corners of the market.

Hold that thought for a moment and we’ll return…

“AI”

AI is increasingly becoming a tool I use every day.  I find it incredibly useful.  We’re going to use some today…

The recent ramp higher in the U.S. market has been exclusively driven by a handful of “AI-adjacent” stocks.  The broader market hasn’t really moved.

I find that interesting in the context of the broader AI “debate”.  AI is supposedly going to change the world.  Going to supercharge productivity.  Increase GDP.  All that good stuff.

That being the case, wouldn’t major beneficiaries be all kinds of companies across all kinds of different industries?  Make no mistake – the entire market is strenuously valued, but right now investors largely seem to believe the only “winners” will be a cohort of AI-centric businesses rather than the actual users of AI.

What’s more, as has already been noted multiple times by multiple commentators (myself included), all these AI companies are priced as if they WILL be the winner of the AI race.  We still don’t’ even know what “winning” means or what the prize is, but their share prices sure assume they will be the winner. 

Looking at the suppliers to the AI arms race – the Nvidias, AMD’s and the like – their share prices reflect a view that their extraordinary profits will only continue to increase.  There’s some heroic extrapolation going on.

Echoes of yesteryear

There’s a lot of comparisons being made at the moment between now and the dot com bubble.  And for very good reason – the similarities are striking.

Bronte Capital’s John Hempton was reminiscing about that time the other week with the following observation:

It’s quite a provocative thought.  One of today’s multi-trillion dollar companies might be a shadow of its former self not far down the track.  Should that prove even half-true, there’s profound repercussions for the markets.

Even if AI does deliver everything the optimists think it will, that doesn’t mean “today’s market” will prosper.  Google first listed in 2004.  Netflix listed in 2002.  After the dot com bubble burst.  The point is the big winners from AI haven’t even started yet.  Their founders are still in high school.

Valuations

Let’s circle back to that strategist remark about Nvidia and Apple.  I’ve picked on Apple a bit in recent times.  It’s nothing personal – just that we all have an understanding of what it does and its history. 

Above is Apple’s price to sales ratio over the last 30 years or so.  Pushing 10 times. 

I’ve quoted that famous Scott McNealy “what were you thinking” remark a few times in the last couple of years – I’ll refrain from doing that again today. 

Let’s just reflect on the chart above.  What would you say has been the “average” price-to-sales ratio over the last 30 years.  4 times?  5?

To start with, in order for Apple to return to 5 times sales by Christmas, can we agree that its stock price needs to fall by about half? 

Moving on from there, in order to believe that Apple stock is reasonably priced, you need to believe one of a couple of things (or a combination thereof):

Perhaps you believe that the historical price to sales ratio is meaningless.  Irrelevant.  Who cares?

As a slight variation, perhaps you believe that the historical ratio is irrelevant because we are in a new world.  The market is somehow structurally different than in the past.  Valuations will stay higher – a “permanently higher plateau” if you will (stealing Irving Fisher’s infamous quote made a few weeks before the peak in 1929).

The other option is you believe Apple will “grow into” its current valuation.  Sure, if revenues double the valuation will look much better.  And sure, that could happen.  But the main problem is Apple is already a behemoth.  Here’s their sales growth over the past 30 years:

Growth has slowed.  Of course it has.  That’s an important point to remember – no company can grow its sales meaningfully quicker than nominal GDP over the long, long-term.  Doing so would mean their sales become so large they basically consume the economy. 

The “magnificent 7” have delivered extraordinary growth over the past few decades.  But just be careful about projecting those same rates of growth into the future.  Maybe one or two will.  But not all of them.  Again, refer John Hempton’s viewpoint above.

Cracks in the AI story

There’s been a few very significant developments over the past month. 

First, Google announced it is doing a capital raising in the form of a share sale in order to raise capital to assist in their AI investments.  Other tech majors have also announced plans. 

For years now, these companies have been generating mountains of cash flow and profit from a modest capital base.  Many have been returning capital to shareholders in the form of share buybacks.  Indeed, at many points over the last several years, ongoing buybacks have been cited by commentators as a reason to be bullish – both from the positive impact this stands to have on fundamentals and also the practical implications of the company being a major buyer of shares on the open market.

Now their need for capital has gone beyond their cash flow generation capabilities.  This is really significant given they seem hell-bent on continuing the current level of investment for years to come.

There’s a view that as long as the AI spending frenzy continues, the markets will continue.  Maybe.  But history demonstrates that the market peaks before the peak in the capex cycle.

The mag-7 companies have been amazing because they have had low capital intensity – generating substantial profits with high “return on invested capital” (ROIC) / high returns on equity (ROE).  They each carved a niche and became the dominant player in different areas.  That’s changing.  They are becoming highly capital intensive – fighting against each other in the same area.

A few observers have reported that the AI buildout seems to be rather behind schedule – projects that are supposedly going to be delivered quite soon have not yet started.  Maybe that’s a good thing…

Separately, AI providers have mentioned that the cost of their products is becoming a concern for their customers.  Humm…  Not exactly what you want to hear.  Yes, there are a lot of new customers still to be tapped – revenue will surely grow.  But it’s not great when existing customers are basically saying “we’re not sure whether we’re getting value for money with this”.

Along these same lines, there are massive price differentials between different AI platforms.  Commentary I’ve read suggests there’s not a great deal of difference between different AI platforms – including China’s DeepSeek.

Are we getting to the “land grab” phase?  If these AI tools are converging as largely a “commodity” product (little difference in them), then the race is on to get consumers using your platform.  That’s the tech strategy – become the dominant player, see off competition, then figure out how to profit. 

Uber is a perfect example.  It was well and truly a household name and dominant player by 2022… but it was still losing billions of dollars:

As I’ve already noted in recent months, these datacentres are vast money-pits.  Even being optimistic on user numbers and pricing, there’s not enough revenue available to cover the costs let alone produce an acceptable return on capital.  But what if the revenues fall even further short of expectations? 

Interest rates and Inflation

The Federal Reserve has a new chairman in the form of Kevin Warsh.  Most commentators see him as a good pick.  “The adult in the room” is how he’s been described by some.

Based on what he’s said in the past, many believe he’s keen to put an end to this “activist Fed” era we’ve been in since Greenspan – and certainly the Bernanke / Yellen and then to Powell era.  He’s expressed he’s very in-favour of reducing the Fed’s balance sheet – unwinding all that Quantitative Easing nonsense.

It’s going to be interesting to see what unfolds.  And what markets make of it.

Inflation continues to be well above the Fed’s supposed target.  And there’s evidence that it is accelerating again.  Will the end of the war with Iran deliver relief from inflation?  I’m really not sure.

With that in mind, interest rates are pretty decent at the moment.  You can get 5% on a term deposit here in Australia.  Certificates of Deposit in the US are not far off that. 

Generally-speaking, I feel that investors aren’t fully appreciating that right now.  5% is your risk-free rate.  You can get that without any risk.  In order to invest in anything else, you need to be confident you’re going to do better than that.

But that probably sums up the current market environment.  YOLO.  FOMO.  Investors are supremely confident they will generate excellent returns. 

10 times sales? 

Loss-making? 

More “meme coin” than equity (Space X)?

It’s all symptomatic of a bubble.  A good idea gone too far and expectations disconnected from reality.

Concentration

Reading commentary from a few US funds managers, it’s interesting to hear them report how many US corporates are increasingly focusing on the wealthy.  Businesses of all kinds.  The standard comments from business executives is that the low-end is struggling… but the upper-end is robust!

It’s said that around 50% of US retail sales are being generated by the top 10% of income producers.

And without a doubt the wealthy are feeling good about their financial situation owing to record high stock prices. 

It’s a rather troubling setup.  The economy barely growing.  Reliant on the wealthy.  The wealthy buoyed by extreme asset prices. 

There’s a lot riding on this stock market.  If the wealthy cut their spending by a lousy 5%, that probably translates into a 2.5% retail sales slump.  And given retail sales are roughly 70% of the US economy, that probably translates into about 1.75% reduction in GDP. 

So where are we?

Referring back to the dot com analogies, a number of strategists I very much respect think we’re in 1998.  They think we have a couple more years of heady bull market.

In terms of the shorter-term, strategists I respect point to the strong market, buoyant investor sentiment and the fact that the key drivers (AI spending and massive government budget deficits) remain intact.  They suggest a low-volatility drift higher over the U.S. summer.

On the flipside, there’s an awful lot of extreme “not since the last time” alarm bells going off at the moment. 

Extreme valuations.

Margin debt at records. 

Almost unbelievable earnings projections. 

Extreme market concentration.

Lopsided bullish sentiment.

Things that have never ended well.

I must say I’m quite agnostic about the share market outlook at the moment.  To borrow a line from veteran hedge fund manager Hugh Hendry – “I used to be bearish, now I’m just amused”.

Make no mistake, I fully expect the U.S. market to decline by 50% or more as this cycle completes.  But the million dollar question is when.  Or should we update that saying to the “3 trillion dollar question” in honour of SpaceX’s IPO market capitalisation?

This document contains information which is the copyright of Aviator Capital Pty Ltd (AFSL 432803) or relevant third party. Any views expressed in this transmission are those of the individual, except where the individual specifically states them to be the views of Aviator Capital Pty Ltd. Except as required by law, Aviator Capital Pty Ltd does not represent, warrant and/or guarantee that the integrity of this document has been maintained nor is free of errors, interception or interference. You should not copy, disclose or distribute this document without the authority of Aviator Capital Pty Ltd. Aviator Capital Pty Ltd does not accept any liability for any investment decisions made on the basis of this information. This information is intended to provide general information only, without taking into account any particular person’s objectives, financial situation, taxation or needs. It does not constitute financial advice and should not be taken as such. Aviator Capital Pty Ltd urges you to obtain professional advice before proceeding with any financial investment.