Jason's World

Yet another blockbuster earnings report by Nvidia, the godfather of the current bull market, has initially fueled continued hopes that the market rally will continue. 

However, the market’s response to the Nvidia report yesterday is much more subdued than what happened in late May-the reaction of the broader market was much worse. Nvidia barely changed, but the Dow shed 370 points and the Nasdaq shed more than 250. During after hours yesterday it was up to as much as 520.

This counterintuitive reaction spread to other AI plays as well. Palantir, which has reported multiple insider sales over the past few days, crashed from 16 after hours yesterday, to 14. Advanced Micro Devices crashed 7%. It’s as if the magic that powered the market following the Nvidia report in May has disappeared.

A lot has changed since the roaring days of late May and early June. Firstly, the markets were breathing a mass sigh of relief as the debt crisis resolved. I, at that time, predicted that we would come dangerously close to default-based on the prediction that Rep. Thomas Massie would block the debt ceiling bill-a prediction that, fortunately, did not come to pass. 

Leading up to the earnings in late May, the CNN’s Fear and Greed Index characterized the market as driven by a modest greed, which ratcheted up after Nvidia’s earnings. It is notable that this bullishness was present even under the shadow of the debt ceiling crisis-a sign that most market analysts never believed that we’d get to default in the first place.

The Nvidia earnings last quarter built upon already existing enthusiasm in the markets which was likely due to the fallout from the March-April banking crisis being less severe than expected as the nation’s largest banks helped to absorb the impact-JPMorgan took on First Republic’s clients, while First Citizens and New York Bancorp bought SVB and Signature, respectively. 

Nowadays much of the AI enthusiasm seems to have been priced in, with Nvidia soaring another 15% since late May, and Nasdaq being at times 10% higher than it was in late May. Moreover, the market is currently facing intense pressure from the Fed.

While the markets initially discounted the possibility of higher-for-longer interest rates, they are gradually being priced in. The most recent CME FedWatch reading shows markets pricing a less aggressive rate cutting schedule than previously. 

As you can see the expectation for rate cuts by the end of next year has declined somewhat, from 4-6 cuts expected in late July to only 3-5 cuts expected now. As the economy continues to show signs of strength, with the Atlanta Fed expecting the economy to grow at a 5.8% pace in the third quarter, the notion that the Fed will keep rates higher for longer is setting in.

However, the factors that have fueled the economy’s resilience seem to be running out of steam. The San Francisco Fed has estimated that families have saved up as much as $2.1 trillion by August 2021. As the pandemic gradually receded, consumers began to go out and spend that extra money. This has fueled the services sector, which constitutes about 70% of the US economy, but these savings are close to being depleted-in fact, they are set to run out next month. This amounts to, on average, $1 trillion in excess spending a year resulting from pent-up demand for the past two years. In 2022, the real GDP grew at 2.1%, to a level of $25.46 trillion. If we take out the excess spending, that leaves us with $24.46 trillion in 2022 GDP. The rate of growth in nominal GDP would be 4.9%, which will be lower than CPI growth in 2022 (6.8%). This indicates that GDP would have contracted in ‘22 if not for these excess savings. When these excessive savings inevitably dry up, the ensuing contraction in demand would only be made worse by the elevated interest rates now compared to most of 2022. 

Simply put, the excess savings accumulated during the pandemic helped to put off a recession for the past few years, creating an illusion that the economy is invincible. All the pomp and celebration these past two months is based on this illusion. But it seems that people are waking up to the fact that the prosperity that we experienced over the last two years, and in particular the past few quarters, is in no way sustainable. It may seem like a bummer to the “to the moon” vibe that people thought was going to continue after Nvidia’s stellar report, but this is a grim reality that investors would do well to respond to now, before the next few GDP reports come out.