The AI Craze and the Fed’s Dilemma: How to Balance Innovation and Inflation
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The second quarter began with fears of contagion from multiple high-profile regional banks suddenly collapsing, continued inflation, and the probability of a recession. These fears still exist, but investor sentiment has remained positive as the Federal Reserve (Fed) held rates steady in June, allowing them further time to assess the economic situation.
During the second quarter of 2023, the S&P 500 Index gained 8.3%, the NASDAQ Index gained 12.8%, the Russell 2000 Growth Index gained 6.8%, and the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) lost 2.5%.1
The Fed inaction in June decidedly helped boost the quarterly return as the breadth turned positive, which means that more companies participated in the rally. Since May, without the top 8 names in the S&P 500 Index, the market return would have been negative year to date. As of the end of June things were better, but if 44 of the 500 companies in the index were excluded, the year-to-date returns would still be negative. The point is that without a very small number of companies participating in the market rally, and the Fed’s pause of raising interest rates to fight off inflation, market returns would be negative.
A key theme for the quarter was AI (artificial intelligence) and how it will shape the future. AI is developing at a blistering pace, and any company which rightly or wrongly associates itself with AI is given a premium value. This situation is eerily similar in many ways to the internet craze in the late 90s which ended very badly for many in early 2000.
AI in its simplest form is the combination of a computer using supplied data to produce content and answer questions. This is not a new concept; It could be argued that the abacus invented between 2,700 BC and 300 BC was artificial intelligence since it provided a counting answer without having to count each individual piece.
Jumping ahead a few thousand years, modern day AI arguably came to life after the 1956 Dartmouth Summer Research Project on Artificial Intelligence presentation. Around this time, computer technology made a quantum leap in being able to not only execute commands but store them for future use. A primary factor which stifled AI early development was the lack of computational power to do anything substantial: computers simply could not store enough information or process it fast enough.
Due to advances in computer technology, the world is on the cusp of exploiting the marriage of computers and databases. Whether AI will be beneficial or harmful depends on how it is used and for what reason. In computer science there is a concept known as GIGO which stands for garbage in, garbage out. The concept states that flawed, or nonsense input data produces nonsense output. The principle applies to all logical argumentation: soundness implies validity, but validity does not imply soundness.
Like the internet in the late nineties, investors are clamoring for anything AI with not enough regard to what they are paying for a stock. One of the leading AI companies, a great one, trades at 130 times its expected 2023 earnings and 63 times its expected earnings next year. From a portfolio
manager’s perspective in making sound investment decisions for clients, no matter how good a story may be, it is not prudent from a risk standpoint to pay a price of $130 for only $1 in earnings.
A gambler may take that bet, but long-term investors should stay away from paying ridiculous prices since these types of stocks can drop significantly or disappear if the story changes. Internet crazed investors experienced this action in 2000.
There have already been a few stumbling blocks for AI. Meta’s Galactica, which launched in Nov 2022, went up in flames when the scientific community criticized the tech giant’s model for producing disappointing results, and denounced it as potentially “dangerous” due to its biased and incorrect responses. Meta took the chatbot offline after that.
JPMorgan Chase has restricted the use of ChatGPT by staff, reportedly due to regulatory concerns over sharing data.
Amazon reportedly has similar fears.
ChatGPT, an AI response processing tool, has been banned in its entirety in China.
The White House and Congress have initiated steps to regulate AI.
Today’s AI is in its infancy and there will be plenty of time to identify which players will succeed and which ones can be bought at reasonable prices.
As for how the current quarter and the rest of the year will play out, investor attention will be on how the Fed balances its inflation fight by raising interest rates while not sacrificing the health of the economy and/or reigniting financial instability in both banks and financial institutions. The Fed’s job is particularly difficult at this time as the latest Consumer Price Index (CPI), all items less food and energy, and wage data are at odds with each other. The June CPI data moderated to a 4.8% increase for the previous 12 months and was a welcome relief versus last year’s 9.1%reading for the same period. A 4.8% rate is still high and may be hard to tame since the tight employment market and above-average wage gains have a greater chance of keeping higher prices sticky.
Market indicators suggest the Fed is expected to increase interest rates by another 0.25% on July 26th to combat inflation, but what happens in September and November is questionable since the bond market continues to flash a worrisome signal. In all 10 recessions from 1955, an inverted yield curve accurately foreshadowed their occurrence. An inverted yield curve occurs when the interest yield for three-month or two-year Treasury securities exceeds the interest yield for 10-year Treasury securities.
We have escaped a recession so far, but I believe one is coming. Since it has taken so long for one to develop, my guess is that it will not be as nasty as some fear. If it does indeed emerge, investors should expect a market correction and a rotation away from the latest Wall Street favorites which have been bid up in recent months.
A calming fact in the event a stock market correction materializes is that the banking system looks sound. The U.S. Federal Reserve recently released its annual banking stress test, which emulated a 10% unemployment rate, a 40% decline in commercial real estate, a 38% decline for house prices and 4.5% minimum capital ratio for 23 big banks (minimum of USD 250 billion in assets: Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, Wells Fargo, among others). The Fed reported all 23 banks had sufficient funds to operate under a severe recession scenario.
At this point, the stock market could remain flat while earnings catch up to frothy valuations or the correction I wrote about and then base before another leg up.
1 These returns are priced based and exclusive of dividend reinvestment.
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