"Let's Not Kid Ourselves Here"

As I type, stocks are rallying nicely in response to a cooler than expected Producer Price Index… The S&P, at 5398, is about to test what I, in last weekend’s video, suggested was a pretty compelling area of potential resistance (5,400)… Wednesday’s CPI print, followed by Thursday’s retail sales number will of course be key determinants as to whether stocks fold at that key technical level, or whether they blow right through it and try to recapture the S&P’s all-important 50-day moving average (currently 5450), and, not to mention, a few other technical barriers between here and the recent high.

Now, beyond all this short-term, largely technical, stuff, we have to focus on what, at this stage of the cycle – and at these equity market valuations – is the ultimate question: 

Is there a recession on our near-term horizon?

If the answer is yes, stocks have a problem, regardless of how high they trade in the meantime (as the data [like today’s PPI print] cool), and regardless of what the Fed does in response.

If the answer is no, we can breathe a collective sigh of relief, and invest accordingly.

Thing is, investing “accordingly” (per the below) virtually cannot mean investing heavily in the current cycle’s big winners.

Much of the following (I’ll highlight where) from last week’s Macrovoices podcast, featuring investor, author and head of Gavekal Research, Louis Vincent Gave, will sound very familiar to clients.

Erik: Louis, you mentioned that there were a number of assets that were overpriced, the obvious one being the AI bubble. How should we think about this bear market? Is it mostly an AI unwind where, you know, the biggest thing that you want to short now is going to be Nvidia? Or is it more the case that that part of it already popped and now it's going to be the contagion into other sectors that we need to worry about? 

Louis: That's the all important question, and for what it's worth, my starting point when I look at asset prices is that assets can have value for one of two reasons, either because they're scarce, i.e. a gold bar, a vintage Ferrari, a bottle of Petrus, or a mansion on the peak in Hong Kong. What gives these assets value is their scarcity factor. 

Or, assets are perceived to be efficient. They're a source of future cash flows. And usually, most of the time, people spend most of their resources investing in assets that generate future cash flows. 

Now, I think what's happened with AI is that the expectations for future cash flows got blown way out of proportion, and the excitement really stopped corresponding to reality. 

And then in the past, really two, three months, we've had a reality check. We've had pretty much every big tech company, whether Alphabet, whether Facebook, whether Microsoft, all come out and say, hey guys, yeah, we did spend tens, if not hundreds of billions on AI. Yes, we did think that this would generate returns very quickly. Actually, it turns out that we're not quite sure when we're going to see the returns from this, or if we're going to see any returns at all. But if we're going to see returns, it's going to be further out into the future. 

Now, this has basically been the message coming out of the AI space, where really quickly, from six months ago, oh my god, AI is going to completely change the world, to we're not quite sure how we're going to make money with this. And so, the bear market, I think we're seeing that is starting to unleash is linked to this very notion of, oh, hold on, we've put all this money in efficiency assets on the premise that we get huge productivity gains very, very quickly. Turns out, actually, we may not get these productivity gains very quickly. Therefore, we need to reprice all these assets. 

And now, as this unfolds, and I think this has started to unfold, obviously, everybody starts clamoring for a Fed rate cut, right? Everybody's like, Oh, my God, things are terrible. We're not going to get the returns on our investments in AI that we thought we would. That's obviously the Fed's fault. So the Fed should cut 50 basis points, 75 basis points, 125 basis points. In fact, it should have done so already, and the Fed needs to cut right here right now. 

But if the Fed cuts right here right now, concretely, that's not going to make the past investments you made in AI more productive. It's not. It's not going to all of a sudden boost the cash flows at Microsoft or at Alphabet. 

What it might do is actually, all of a sudden, make the scarcity assets more valuable. Remember, there's two kinds of assets, the efficiency assets and the scarcity assets. So as the Fed starts cutting, to answer your question, do you go back into Nvidia? Or do you think, hold on, if the Fed starts cutting, we're now in a different cycle, one where the US dollar probably goes down and where, because people don't want to own Nvidia anymore, because the returns over the next 10 years or 5 years aren't going to be what I thought they were six months ago, I want to own the scarcity assets. 

Maybe I want to own, I don't know, a gold bar, or a Ferrari, a vintage Ferrari, or whatever else. 

So that, for me, is the big question is, again, first, if you think of your decision tree, have we started a proper bear market? Yes or No? I think yes. 

The second question is, have we started? Will this lead to a Fed cutting cycle? And I think yes, because each time you have a bear market, you get a Fed cutting cycle. 

Let's not kid ourselves here. 

And you know, with that, does that mean that, oh, great, I go back to buying US growth stocks. Or does that mean that with this new Fed cutting cycle, we actually have a new investment cycle with new assets that start to do well here? 

I'll go back to what one of my oldest clients always says is, look, bear markets are there for a reason, and it's to return capital to its rightful owners. And the idea is, as you start a bear market, usually, you have a rotation, and the past winners are seldom the new winners, especially if the past winners drove to really silly valuations. So I do think we're planting, with this bear market, we're planting the seeds for the next bull market, and it'll be our job to figure out what it is.