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Good morning. After a few months of risk taking, the market got nervous again. The S&P 500 is down 3 percent from its recent peak, as investors sweat the timid price reaction to the earnings beat. Technology seems to be the most shaky. With long earnings up, Microsoft stock is down 11 percent from mid-July, while Nvidia stock is down 14 percent. More on the latter below. Email us: firstname.lastname@example.org and email@example.com.
Nvidia 2023 = Cisco 2000?
Here is an infographic that I carefully designed to make it as scary as possible:
This is the percentage rise in Nvidia’s price over the past four years, versus the rise in Cisco’s share price in the four years leading up to August 11, 2000. The reason the graph is so scary isn’t simply because of the amazing rise of the two tech companies. It’s scary because the stories driving stock in the two time periods it’s depicted are remarkably similar. Cisco was presented as the primary infrastructure provider for the Internet revolution – whatever the Internet became, we were told at the end of the last century, that it would use Cisco switches and routers to become it. Nvidia is presented as the primary infrastructure provider for the AI revolution — whatever AI becomes, we’re told, it will use Nvidia chips to become it.
What makes this similarity unsettling is Cisco’s price return since August 2000:
The stock rose from $64 to $54 over the course of 23 years. Dividends include, and investors are about to break even. It’s been a horrible two decades, and the crucial point about its awfulness is that Cisco’s underlying results over that period have been very good. Cisco’s earnings have grown at a compound annual rate of just under 10 percent since 2000. But the stock was too expensive to begin with for growth to provide.
How much did Cisco cost? The following are the potential profit ratios of the two companies during the same periods shown in the first chart:
I could have chosen a different time period to make the rise in Cisco and/or Nvidia stock prices more or less extreme. But lagging P/E ratios are what they are, and Nvidia is even more expensive than Cisco in 2000 on that metric.
Nvidia management suggests that investors should use a non-GAAP calculation of earnings per share, and Wall Street analysts obediently do so. According to Nvidia’s calculation, the stock looks less expensive — 133 times late earnings instead of 212 times, which is slightly cheaper than Cisco. But Nvidia’s non-GAAP earnings exclude stock compensation and merger-related costs, which should never and almost never be excluded, respectively, from earnings. Obviously, GAAP is the better measure.
Earnings in the current fiscal year at Nvidia, however, are expected to rise to approximately $8 per share from last year’s $3.43, on a non-GAAP basis. So reverse the bogus non-GAAP adjustments, and assume Nvidia earns $6.50 on a GAAP basis this year. Then the chipmaker’s earnings would be 60 times or so, much cheaper than what Cisco was in 2000 (though not a bargain!).
But it’s not that simple. Is the current fiscal year exceptionally good, a cyclical peak or near-peak in earnings? Or is it a new profit plateau that Nvidia will only build on? On the one hand, the chip industry is cyclical and hyper-competitive; On the other hand, by all accounts Nvidia has a significant technology lead over its peers. I don’t have an opinion on this, but the market is betting pretty hard that this year is just the beginning. The Wall Street consensus is for Nvidia to make $19 a share in GAAP terms in 2028.
What if bonds are no longer the safe haven asset?
Bonds have been criticized in 2022, but the worst is behind us. After a one-time valuation reset from Uber-low rates, bonds are back to form the “safe” asset class. With inflation low, the strong yields available on the 10-year Treasury look attractive. Investors better lock them up now.
This thinking is common enough, and it is represented across the financial press as well as in this column. Is it wrong? Over the weekend, two distinguished financial writers, John Plunder of the FT and WSJ’s James SpencerPublished articles arguing the risks of bonds due to a rethink. They join a growing number making some form of this case, notably including Charles Goodhart’s demographic-focused argument and Nouriel Roubini’s doomsday prophecies.
Between them, Blender and Jakab highlight four risks to bonds, which we distilled:
The bond bull market is over. Jane Hughes wrote in her unprotected article last month about the five long-term shifts in prices since the mid-nineteenth century. One seems to have just finished. Gone are the tailwinds of rising bond capital after 40 years of low interest rates:
An environment in which inflation and rates are higher and more volatile would destroy the benefits of short-term bonds that mitigate volatility.
In the long run, rising inflation and a dire fiscal outlook for the United States raise the specter of outright negative real returns.
The 2022 episode showed that the stock-bond correlation can take off during bad times. This calls into question the biggest long-term rally in bonds, which is the ability in a downturn to rebalance the bond market’s gains toward distressed stocks.
There is a lot here that one can take issue with, but one should take it seriously for a moment. Leaving aside unusual issues like insurance companies and pension funds, if Plunder is right that bonds are “insecure and very dangerous,” then what?
First of all, cash looks better. Jacob quotes Ray Dalio: “Cash used to be frivolous. Money is very attractive now. It’s attractive about bonds. It’s actually attractive about stocks.” A six-month bill currently yields 5.5 percent, much higher than the 4 percent available on long notes and without any equity risk. You also get some optional value. If the shares fall from their high valuations, there will be a useful source of funding at your disposal. In an environment of high inflation and rising prices, a similar rebalancing from bonds to equities risks making paper losses on bonds. In other words, holding a bond to maturity has an opportunity cost.
Bonds are still a different asset class than stocks, and with some diversification it could potentially be a benefit to holding both. But if bonds lose their safe, boring place in a volatile world of inflation—that is, if real returns are not guaranteed, even when held to maturity—the investment approach must change. A bond investor may need the discipline and risk management of a stock picker.
Of course, it’s a different story if fears of higher inflation have been exaggerated for much longer. Bond bulls, such as JPMorgan’s David Kelly, tend to believe that the economy will gently return to a 2 percent inflation rate by next year. With inflation offset, rates could return to neutral, which the Fed believes is around 2.5 percent. Lower rates would dampen the return on liquidity, leaving bond investors who locked in returns of more than 4 percent feeling complacent. It would also give bond investors some huge capital appreciation.
There’s a lot to be said here, and we’d be interested to hear what you think. (Ethan Wu)
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