The Nasdaq is on new record highs, led by the dominant tech stocks that are building and delivering the first waves of generative AI.

Meanwhile, the Russell 2000 (small caps) is down on the year, though less so after today.  The nearly 9% divergence started to slowly close today.  The Russell 2000 was up 1.7% on the day.  Nasdaq was relatively flat.

The performance divergence isn’t just small cap related, it’s broad-based, as it was for much of last year.  If we look at the equal-weighted S&P 500, it’s up just half a percent on the year.

But remember, the performance divergence between “big tech and the rest” narrowed aggressively over the final two months of 2023.  And it was triggered by Jerome Powell’s signal that the tightening cycle was over (late October).

At this point in the New Year, the view on the direction of rates remains clear, but the view on “when” and “by how much” has changed.  The view has adjusted to two, if not three fewer cuts this year.  And that adjustment in market expectations has been deliberately manipulated by the Fed.

The higher the borrowing cost, the stiffer the headwind (at the moment) for most companies not innovating on the leading edge of the next industrial revolution.

So, with that in mind, the interest rate market is now leaning in a direction that creates the opportunity for a positive surprise.  In this case, a positive surprise would be (more) weak inflation data, which could influence the Fed to lose its “patience.”

And we have two inflation data points coming over the next five days.  Tomorrow the Bureau of Labor Statistics will publish the revisions to its CPI seasonal adjustments.  These are adjustments that can change the CPI data for the past five years.

That’s a big deal — a big enough deal for both the Fed Chair and Fed governor (Waller) to recently emphasize it as something that could “change the picture on inflation.”  They both pointed to the adjustment last year that reflected hotter than previously reported inflation data.

So, clearing that hurdle tomorrow, with no adverse adjustments to the current inflation trajectory, would be a positive for rate cut outlook. 

And then we get the January CPI report next Tuesday.

We’ve looked at the below chart on the Fed’s New Financial Conditions Index over the past couple of months.  Let’s revisit this, and talk about how it relates to what the Fed did with “real interest rates” (Fed Funds rate adjusted for inflation) in the late 90s …

As we discussed in one of my notes last month, if we look back at moments when financial conditions were historically this tight (denoted in the chart above), every moment was soon followed with some form of Fed easing (either rate cuts, QE or, in the case of 2015-2016, removing projected rate hikes).

In the 1994-1995 period, the Fed continued raising rates into a low inflation, slow economic recovery.  It was a mistake.  Financial conditions were tight.  By July of ’95, the Fed did indeed start cutting rates (i.e. easing).  And in doing so, they set into motion a boom-time period for growth and stocks.

The economy went on to average 4.5% quarterly annualized growth through the end of the 90s.  And stocks put up five big, double-digit return years, averaging 26% per annum.

But as you can see in the next chart, the Fed kept real rates at historically high levels throughout this boom.  

So how did the economy and markets do so well, with the Fed holding real rates high (which is restrictive to economic output)?

We were in a technology revolution — rapid adoption of the internet.  Productivity was high.  Inflation was low.  The economy was booming, even with the Fed tinkering with interest rates around 5%.

So, with this late 90s period, we can see parallels to the current environment.

Could the Fed hold real rates here (at historically high levels), and still get a boom-time period, driven by the technology revolution of generative AI?

Growth solves a lot of problems.  But the U.S. debt/gdp has doubled since the late 90s.  And while the debt service/gbp is comparable to the late 90s period at the moment, it won’t be as they continue to refinance at high nominal rates. 

The Fed doesn’t have the luxury to sit around and watch for long.  They have to cut.  

The Fed Chair (Jay Powell) appeared last night in a sit down interview on 60 Minutes.

This type of mainstream media interview/Q&A session with the Fed Chair has historically been rare, though less rare in the post Global Financial Crisis era. The Fed Chair tends to talk economics and policy with economic and policy practitioners.  These types of Q&A’s are typically done in Congressional hearings, following Fed meetings, or at select economic conferences.

With that, these 60 Minutes interviews have clearly come at times, over the past 15 years, when the Fed has the desire to speak directly to the broader public.

Last night’s sit down with 60 Minutes was Powell’s fourth, in his five years as Fed Chair.  His predecessor, Ben Bernanke, also used the 60 Minutes platform to speak to the American people a couple of times.

What was the common theme in each of these interviews?

A crisis of confidence, or (at best) the vulnerability of confidence.

For Bernanke, back in 2009 and 2010, he was directing the Fed through the storm of the financial crisis, and he and the Fed were being destroyed in the media.  And that media tone was opening the door for global leaders to take shots at the Fed.

The Fed was trying to restore confidence, and it wasn’t going well.  So, Bernanke took to 60 minutes to speak directly to the people – to set the record straight.  He shot down the media criticism and said he was seeing signs of “green shoots” in the economy.  This first Bernanke interview (in March 2009) set the bottom in the stock market — and it turned the tide in global sentiment.

In late 2010, the Bernanke interview followed a bad jobs report that left confidence vulnerable, and left stocks vulnerable to undoing the progress of the previous year.  Bernanke’s attempt to assuage fears led to a 10% break higher in stocks, to new post-Lehman highs.

For Powell, his first sit down with 60 Minutes was in March of 2019.  We had just ended the week with a 4.4% plunge in Chinese stocks.  Powell appeared on 60 Minutes that Sunday night.  It was a response to the growing risks of a confidence shock (given the December 2018 stock market decline, Brexit drama and China/U.S. trade uncertainty).

It was an opportunity to tell the public that the economy is doing well, despite the media’s doom and gloom stories.  Stocks bounced and rallied 9% over the next month and half and went on to new record highs.

In May of 2020, Powell made another 60 Minutes appearance.

It came on the back of a very soft CPI number, which created chatter about negative interest rates and a deflationary spiral (this, despite the massive policy response to the lockdowns just months earlier).

Stocks went south.  Powell emerged.  By Monday morning, stocks were popping, continuing the sharp recovery (17% higher in just three weeks).

Powell appeared again, for a 60 Minutes sit down, in April of 2021.  Stocks had just finished the prior week on record highs (unlike prior 60 Minute appearances).

But a risk to confidence was lurking.  The threat of an inflation shock was building.  Ten-year Treasury yields had nearly doubled on the year, back to pre-pandemic levels (of around 1.7%).  CPI data was on the calendar for the coming week, and expectations were for another hot number.

The Fed’s concern at that time?  A stall in the momentum of the fragile economic recovery.

So, in that interview, Jay Powell assured the public that the Fed would not budge on its ultra-stimulative policy, until the recovery was “complete.”

The 60 Minutes effect worked, again.  Stocks went up.  Yields went down.  And to cement confidence that the Fed would keep the pedal-to-the-metal on the economic recovery, they introduced the word “transitory,” when describing inflation, later that month.

Now, Powell was back in the seat again last night for another interview (actually record last Thursday).

He had just finished the recent Fed meeting, where he implied they had the luxury of being patient with rates at these currently high and restrictive levels, because the economy is strong, the labor market is strong, and inflation is going their direction.

What’s the concern this time?  If the history of these interviews is our guide, it’s the threat of waning confidence.  In this case, waning confidence would mean maybe the Fed doesn’t have the luxury of being patient.

With that, the 60 Minutes interviewer told him he had “disappointed a lot of people on Wednesday.”

 

Stocks finish the week on record highs.  And it was fueled by the earnings and insights from the big four tech companies that are working on the frontier of generative AI.

As we discussed on Wednesday, when this big trendline was tested in the S&P, a bounce to new highs would confirm the underpinnings of this stock market strength (i.e. it’s the technology revolution boom).  

As we’ve discussed here in my daily notes, with the events of the past year, it’s clear that we are in the early stages of a new industrial revolution.

Remember, generative AI is game changing technology, because it can create new output, based on the patterns and knowledge it has learned from data and interactions — and, importantly, it can innovate. 

Clearly from the earnings call this past week, the tech giants have full conviction in this new industrial revolution.  They’ve completely shifted the focus on their businesses to AI.

The “ChatGPT moment” (as the Nvidia CEO/Founder has called it) was the starting line.  That reset the outlook for the economy and for markets.  That moment crystallized how to transition from the technology of large language models to a product and service.

With that, the best time to invest in this new technology era was November 30, 2022 (when ChatGPT was released).  

And you can see it in the chart of Nvidia …

   

The next best time to invest in this new technology era is now.

Not only is it not too late, it’s still in the early stages.  But as we’ve discussed, it is fast moving.

The first Industrial Revolution brought us steam engines and mechanized manufacturing.  The second, electricity and mass production.  And the third, computers and the internet.

Each grew the economic pie.  This one will too.   

Moreover, the CEO of OpenAi (developer of ChatGPT), Sam Altman, said the next iteration of ChatGPT (5) “will change the world.”  

And it’s rumored that it has been developed and is being tested right now.

Here are some things he’s recently said about it:

He says it’s a tool for productivity — it will magnify what we can do (a personal AI “assistant”).  Costs will go down.  Capabilities will go up.  He says it will be more reliable than earlier versions, have better reasoning abilities, and be customizable to everyone’s individual styles, and we will run it on our own data.   

He says it will be “multimodal.”

What does that mean?  It means the model will understand and interact with not just text, but images, audio and video. 

This opens up an entirely different level of human-computer interaction. 

Robots will understand human commands, voice and gestures, facial expressions, tones of voice, etc. 

Autonomous vehicles will have a better understanding of their environment.  In-car assistants will truly be an in-car assistant (engaging in natural language, interactive, responsive to verbal and visual cues).  Your car will know your behaviors and preferences. 

Education will be more engaging and interactive, and tailored to the styles of needs of every student.  As Satya Nadella (CEO of Microsoft) said, every person in the world will have their own personally tailored AI tutor.

This probably all sounds interesting, but nothing too groundbreaking (given the technology we have now). 

The real difference maker in this next version of models, is the “learning” feature of generative AI.  In the above examples, the models will need less and less human command over time.  They learn from previous commands, interactions, feedback and they adapt and optimize their behaviors.  And they become more and more accurate in their predictions/output.

This technology will revolutionize product development, improve disease diagnosis and solve complex problems — and do it all much faster than has been done in the past.

With all of the above in mind, we’ve been working on identifying and thoughtfully building a portfolio of companies on the leading edge of this transformation, in my AI-Innovation Portfolio. 

We now have 14 stocks in the portfolio, since we launched in June of last year.  

We started with a focus on AI infrastructure stocks.  These are the “picks and shovels” of this technology revolution.  And we’ve since added massive SaaS companies that will deliver the capabilities of generative AI to companies around the world.  As the Microsoft CEO has said, 2024 will be the year generative AI scales.

Today we made another addition to the portfolio.  It’s a company that’s key to securely powering generative AI applications.  With a client list that reads like a who’s who of industry, and partnerships with the dominant cloud platforms deploying AI, this company is uniquely positioned to benefit from the massive surge in data center demand.

And that’s a fresh growth catalyst for this company that has already achieved an eye-popping growth trajectory, having grown revenue 20x since 2017.

This is another exciting high-growth, high-margin, founder-led stock for our AI-Innovation Portfolio — at the forefront of the gen AI-driven technology revolution.

And again, it’s still early in this technology revolution. There are tremendous investment opportunities, in an era that has already brought us the multi-trillion dollar companies.  More are coming.

If you aren’t yet a member, and you’d like to join us and get all of the details on this stock and the rest of our portfolio, you can do so following the instructions below. 

The next wave will be the tremendous potential for new businesses to form around generative AI, and for old businesses to adopt and realize the benefits of generative AI.

Here’s how you can join me…  

The AI-Innovation Portfolio is about allocating to HIGH-GROWTH.

For $297 per quarter ($99 per month), you’ll gain exclusive access to my in-depth research, expert analysis, and timely investment recommendations focused on the generative AI revolution.

You can join me by clicking here — get signed up, and then keep an eye out for Welcome and Getting Started emails from me.

 

After the Fed yesterday, we talked about the shrug given from the interest rate market. Despite Jerome Powell’s best efforts yesterday to curb enthusiasm about the rate outlook, rates slid even lower today.

And we talked about this big trendline that was testing in stocks, following yesterday’s sell-off.

Remember, we had a similar chart/similar trendline in the Nasdaq, Dow and Russell 2000.

My view: If this shallow dip in stocks were to hold this line, bounce, and make new highs, it would be extremely bullish for stocks — confirming the boom from the generative AI-driven technology revolution.

That was the case today, at least in the S&P futures.  And, fittingly, it traded to new highs after the earnings from three of the tech giants late this afternoon.  Amazon, Meta and Apple all put up big numbers.

So, we’ve now heard from the big four tech giants that are working on the frontier of generative AI (Microsoft, Google, Amazon and Meta).  It’s all about generative AI.

They’re all building data center capacity to handle AI workloads and they are all working on commercializing generative AI products for their customers.  And it’s clear they are already benefiting internally from the productivity enhancements of generative AI.

As we’ve discussed over the past couple of quarters, this (gen AI) technological revolution is productivity enhancing for the economy.  It’s a formula to grow the economic pie (and the size of the stock market).

We averaged just 1% productivity growth for the decade prior to the pandemic, and negative 0.7% since the fourth quarter of 2020 (through the middle of last year).

We had almost 5% productivity growth in Q3.  And the Q4 report came in this morning, at 3.2% growth.  We are in a productivity boom.

As we’ve discussed in my daily notes, high productivity growth is a driver of higher long-term potential economic growth.  With that, we shouldn’t be surprised by the strength of the economy, though the Wall Street and economist community continue to be.

And as you can see in the chart below, early indications on Q1 growth look like more of the same …

 

For my AI-Innovation Portfolio members, please keep an eye out for a note from me tomorrow morning.  We will be making a new addition to the portfolio.  If you are not a member, you can join us here.

We heard from the Fed today.

Before we get into what happened, let’s revisit my note from the last Fed meeting, on December 13th …  

During the Fed’s November press conference, Jerome Powell said there was ‘significant tightening in financial conditions in recent months.’

 

The Fed had projected one more rate hike for 2023, but he implied, at that moment, that the rise in bond yields (to 5% on the 10-year Treasury), weakness in stocks and strength in the dollar had already done the Fed’s job (i.e. added additional tightening).  He signaled the end of the Fed’s tightening cycle. 

 

With that, a month later, Jerome Powell was on stage giving prepared remarks at a fireside chat at Spelman College.  The S&P 500 had just recorded its best November in over 40 years, 10-year Treasury yields had fallen almost three-quarters of a point and the dollar had weakened by three percent. 

 

The conditions he cited a month prior had all reversed. 

 

But he did nothing to push back against the idea that the tightening cycle was over.  He did nothing to push back against a market that was pricing in the next move as a rate cut (and perhaps as early as March).

 

Fast forward (to the December meeting), and the financial conditions referenced by Jerome Powell six weeks prior had continued to ease.  However, not only did Powell (and his Fed colleagues) show little-to-no concern, he all but explicitly claimed victory on inflation.

 

That’s a greenlight for stocks. 

So, this was clear and intentional signaling from Jerome Powell, not only that the tightening cycle was over, but also that the potential for aggressive rate cuts were coming in 2024.  And that did indeed give way to a huge year-end rally in stocks. 

Moreover, he (and the FOMC) telegraphed the continued fall in inflation into the end of the year (through his words and through the Fed’s Summary of Economic Projections), which removed uncertainty about the next two inflation numbers.

So, on December 13th, we knew the Fed had real rates (the Fed Funds rate minus the inflation rate) at historically high levels, which continued to put downward pressure on the economy AND on inflation.  And inflation had methodically, stair-stepped down to 3%, closing in on the Fed’s target of 2%.  To top it off, Jerome Powell had told us they will have to start cutting rates “well before two percent.”

With all of the above in mind, by early January the market was pricing in seven quarter-point rate cuts for 2024.

But by mid-January, the Fed had successfully curbed some of that enthusiasm. 

And that brings us to today’s meeting. 

With all of the buildup of the past two months, and given that the market was now pricing in a, less aggressive, coin flips chance of a March rate cut, this seemed like an easy set up for the Fed to stay on the path of market expectations, by: 1) acknowledge the continued success in the path of inflation (lower),  and 2) acknowledge the outlook, over the coming meetings, to reverse what has been an increasing level of restriction on the economy.

What did we get?   The Fed left policy unchanged.  Okay.  But the Fed Chair did not follow the easy path of market expectations in his press conference. 

He said they are in no rush.  He said they still have the (equal) risk of acting too early (i.e. still worried that inflation stalls or starts moving higher again).  He said no one proposed a rate cut today.  And he said (voluntarily) that a March cut is unlikely. 

This doesn’t sound like the same guy of the past two months.  But that’s not too surprising.  The Fed’s most effective policy tool of the past fifteen years has been perception manipulation, and Jerome Powell seemed to be wielding that tool today — tamping down the expectations that had stocks on record highs and the 10-year yield back below 4% going into today’s meeting.    

The key message today:  Powell thinks they have the luxury of being patient because the economy is strong, the labor market is strong and inflation is going their direction.

But, as we know, keeping this highly restrictive policy in holding pattern weakens the economy, weakens the labor market, and can accelerate the disinflation (threatening an overshoot to the downside).  And that “overshoot” threatens deflation. 

On that note, he did say, “very persuasive lower inflation” means they would move “faster and sooner.”  Faster means bigger cuts.

Now, with all of this said, the interest rate market wasn’t too bothered by the Fed’s message of “patience.”  The market is still pricing in a coin flips chance of a March cut. 

And the 10-year yield finished back on the lows of the day …

As for stocks (chart below), we finish on the lows of the day, but into a big trendline that represents this “end of the tightening cycle” Fed communication timeline we discussed above …

We have a similar trendline across the Nasdaq, the Dow and the Russell 2000.  So, all of these major indices trade into this big trendline support, as we head into a big productivity report coming tomorrow and the January jobs report on Friday. 

If this shallow dip in stocks were to hold into this trendline and make new highs, it would be extremely bullish for stocks (confirming the technology revolution boom for stocks).  We will see very soon. 

We heard from two of the big tech giants today that are working on the frontier of generative AI (MSFT and GOOG).  They reported on earnings after the market close.  And we’ll hear from the two others on Thursday (META and AMZN). 

As we discussed in my last note, more important than the record revenues, and double-digit earnings growth that will come from these tech giants, will be the education gleaned from their work on, and outlook on, AI.

Indeed, the numbers today from Microsoft and Google were big.  And, indeed, we got an education on the evolution of this generative AI-driven technology revolution.     

Microsoft, now the most valuable company in the world, grew revenue by 18% and earnings (EPS) by 26%.  Google, the fourth most valuable company in the world, grew revenues by 14% and grew earnings by 56% (all compared to a year ago).

But both stocks were down after the reports. 

Why?  The financial news will tell you that Google (Alphabet) disappointed on ad revenue growth.  And Microsoft disappointed on cloud revenue growth. 

This is Wall Street trying to find something to scrutinize. 

Keep in mind, these are high-margin, double-digit growth companies with a competitive moat that has only grown wider with the introduction of generative AI — which happens to be a transformative growth and margin expanding catalyst.

Remember, it was only eight months ago that Nvidia’s CEO shocked the world, declaring “the beginning of the major technology era.”  He told us there was a “rebirth of the computer industry” underway, where “AI has reinvented computing from the ground up.”

With that, this is just the third quarterly earnings report for the big tech giants since that “Nvidia moment.”  And they have all reoriented their businesses around AI — a total transformation.  They are leading what Satya Nadella (Microsoft CEO) has called the “productivity revolution.”

And, as we’ve discussed in my daily notes, this is very fast moving. 

Nadella has said this is the year “generative AI will scale.” 

Indeed, both Microsoft and Google reported rapid adoption of their respective commercialized large language models last quarter.  Nadella said, half of Fortune 500 companies are already using Microsoft’s ChatGPT.

We open the week with stocks making new record highs.

Over the next two days, we’ll hear from the “big tech” oligopoly on earnings.  And for the third consecutive quarter, we should expect the earnings calls to be dominated by the discussion on AI – the businesses they’re developing, the investments they’re making, the new customers they’re reaching and the visibility on the total addressable market in front of them.

Microsoft, Google, Amazon and Meta are all working on the frontier of generative AI.  So, more important than the record revenues, and double-digit earnings growth that will come from these tech giants, will be the education gleaned from their work on, and outlook on, AI.

Now, for the better part of this month, we’ve talked about the build up to the December PCE data (the Fed’s favored inflation gauge), as it relates to “how early” and “how aggressive” the Fed will be cutting rates this year.

The data is in, and once again, the Fed has underestimated the pace of disinflation. From the report this past Friday, inflation over the past three and six months is running below 2% (annual rate) — below the Fed’s target.

As we discussed last week, this should be concerning territory for the Fed (deflationary risk).  With the Fed holding rates above 5% as inflation is closer to 2%, they are putting more and more downward pressure on the economy AND inflation.

On the latter, the Fed has told us that they will have to start cutting rates “well before two percent” (the Fed’s 2% inflation target).  Why?  As Powell has said, if they wait for two percent, “it would be too late.”

What does “too late” imply?  It implies that they would overshoot to the downside.  And an overshoot to the downside means the Fed would risk inducing a deflationary spiral.

With that said, we have the Fed meeting this week (Wednesday).  And the Fed has, over the past few weeks, in contradiction to the discussion above, successfully convinced the markets that it won’t be aggressive on the timing and number of rate cuts it will deliver this year.

This sets up for a positive surprise for markets on Wednesday.  In this case, a positive surprise would mean a more dovish stance, which could come in the form of a discussion on winding down their quantitative tightening program, and/or rebuilding market expectations for a March rate cut.

Even among all of geopolitical risks and events, the most meaningful drag on stocks over the past two years has clearly been Fed policy.

And that’s reversing.

As we discussed in my Thursday note, with the Fed doing its best to strangle the economy, we still had 6% nominal growth last year. Clearly it could have been much stronger, with the (still) strong undercurrent trillions of dollars of money supply growth that was front-loaded from the pandemic response.

With that in mind, the Fed also did its best to strangle the stock market, in the name of taming inflation.  Yet with the Fed Funds rate still on the cycle highs, stocks are now UP a few percentage points, from the date the Fed started telegraphing a tightening cycle (in late 2021).

With $3 trillion of excess money still sloshing around the economy (referencing the below chart), how high might stocks go when the Fed formally releases the strangle hold?