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Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
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Head of Fixed Income Strategy
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The AI hype feels like an echo from past bubbles
Peter Garnry
Chief Investment Strategist
Summary: The vast majority of growth theme baskets have done bad over the past week while semiconductor and AI related stocks have marched on pulling the market out of what would have been a dismal weekly performance. Excitement and hype over AI have pushed semiconductor stocks to their highest forward equity valuations since January 2010 and Nvidia is now valued at levels where it can almost only disappoint investors in terms of future returns.
The key points in this equity note:
- Most of the equity market strength the past week has come from AI related stocks while the majority of growth equity themes are actually down highlighting the shallow equity market.
- Valuation of semiconductor stocks has risen to the highest level since January 2010 and Nvidia’s valuation relative to expected revenue has now risen to levels that should alarm investors.
- The key risk for AI related stocks is now that expectations are set too high in which these stocks will only disappoint as past exuberance stocks have done.
Underneath the AI surface there is weakness in equities
When we observe global equities over the past week they were slightly down with the semiconductor theme basket standing out rallying 6.7% as the AI hype gathered momentum with Nvidia’s CEO talking about a new era lasting 10 years. However, if we look outside the segments related to AI then the vast majority of growth pockets in the global equity market were down last week with baskets such as Payments, Luxury, Energy storage, and NextGen medicine leading the declines.
A concerning development for equity markets is the concentration of positive contributors this year to market performance and zooming in further it is clear that AI related stocks have done the most part of the heavy-lifting. However, these dynamics are not without consequences. This frenzy to “get into AI” has pushed the semiconductor industry to its highest valuation ever measured on 12-month EV/EBITDA which is already factoring in expectations of EBITDA over the next year. At 18.7x the semiconductor industry is now valued 72% above the global equity market raising expectations to levels that might dearly disappoint investors over the coming years.
Nvidia is up in pre-market zooming in on $1trn market value
Nvidia, the leading manufacturer of GPUs used in AI developments and researching, is the frontrunner in the current AI hype phase and is up 3% in pre-market trading taking the market value above $1trn for the first time in its history. As we have written about recently Nvidia’s valuation has reached levels which are difficult to accept unless the growth trajectory in the years to come will be anything we have ever seen before. Of course there is always room for a new unique trajectory in life and Nvidia could be this outlier, but the probability of that happening based on past experience is very low. At 22 times 12-month forward revenue the expectations for Nvidia are incredibly high and the stock is in the top decile on 12-month forward EV/Sales in the Russell 1000 Index.
If one backtests the 12-month forward EV/Sales factor over the past 25 years then the top decile bucket (those stocks with the highest EV/Sales ratio) had an annualized return of 4% while the lowest decline bucket had an annualized return of 16.7%. In other words, the boring stocks tended to outperform their expectations while the most exciting stocks tended to disappoint investors. This historical fact is an important decision variable for investors considering rushing into Nvidia shares.
In many ways do the current AI bubble feel like an echo from the dot-com bubble and in recent time the crypto and blockchain bubble. There is a group of influencers on social media there is pushing AI related sensationalism in huge quantities to take advantage of the “next thing” and it distorts people’s expectations of the future creating bubbles in public equity markets. Remember the days when we were promised blockchain and self-driving cars technologies would revolutionize financial markets and allow to sip your cappuccino while the car took you to work? Over the past week we have written several equity notes touching on the topic of Nvidia, AI, risks, opportunities, thew fight between Google and Microsoft, and the galloping demand of GPUs.
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