Wesley Chapel, FL

Good news, no more banks failed in May! That is the first time in a couple months so that must mean that the government along with JP Morgan Chase Bank (JPM) saved the day, everything is fine, and the banking crisis is over… right?

Not so fast.

While that could absolutely turn out to be true there is still plenty of fundamental uncertainty underlying the current economic environment. In fact, one might go so far as to say that there is a great deal of certainty that the fundamentals underlying the economy today are very bad indeed.

But, “AI” will save the day, right?

Again, not so fast…

AI isn’t a new technology just like the internet wasn’t a new technology when the first web browsers were released, sparking the “dotcom” bubble. Anybody remember Netscape? Anybody still use Netscape Navigator? I didn’t think so.

Microsoft’s Internet Explorer was originally released in 1995 (the year after Netscape Navigator) and by 1999 owned around 99% of the market. But nobody uses Explorer anymore either. By 2010 Explorer’s market share was cut to about 50%, but it was effectively discontinued in 2022 because the program failed to keep up with innovation in the industry.

Microsoft isn’t out of the game though. Their Edge browser was first released in 2015 and failed to gain much traction. More recently, in February 2023, Microsoft announced that it was “reinventing” how we search the internet with “new AI-powered” functionality.

It seems like this announcement kicked off the latest technological arms race, this time its all about AI.

But just like the internet wasn’t a new thing when Netscape was first released in 1994, AI isn’t a new thing in 2023. In fact, the internet had been around for at least 25 years (since 1969) before it became widely accessible to the public via web browsers.

But get this, AI has been around for even longer than the internet!

The Logic Theorist was a program designed to mimic the problem-solving skills of a human and was funded by Research and Development (RAND) Corporation. It’s considered by many to be the first artificial intelligence program and was presented at the Dartmouth Summer Research Project on Artificial Intelligence (DSRPAI) hosted by John McCarthy and Marvin Minsky in 1956.
In 1970 Marvin Minsky told Life Magazine, “from three to eight years we will have a machine with the general intelligence of an average human being.”

Source: https://sitn.hms.harvard.edu/flash/2017/history-artificial-intelligence/

Recently, FactSet, a financial data and research firm, investigated mentions of the term “AI” during quarterly earnings calls of S&P 500 companies. They searched all the transcripts of all the calls that took place from March 15th to May 25th (probably using some form of AI to do so) and found that 110 of those companies mentioned the term “AI” at least once.

But what really interested me was that FactSet did the same search and provided the results for every quarter for the past 10 years! I was initially surprised that S&P 500 companies have been talking about AI for so long, given all the hype we have seen over these past few months.

In 2019 I started to create a list of “big themes” to pay attention to and look for opportunities to invest in for the upcoming year. Artificial Intelligence has been on the list every single year since. We’ve made a bunch of money in those big themes over the years. One of the first investments we made in the space was in The Trade Desk (TTD) where in the “one-pager” I wrote for the investment I said:

“Every second that goes by, nine million ad opportunities become available. The Trade Desk's artificial intelligence software, Koa, mines massive sets of data so that ad buyers can find that one-in-a-million ad space that works best for the campaign.”

We originally bought shares of TTD November 8, 2019, and exited it March 17, 2020, for a loss of 21.54%. We subsequently bought it back on March 26, 2020, and sold it March 30, 2021, for a gain of 194.86%, according to company records.

TTD has traded up and down and all around since we last owned it but during the bear market that began in November 2021 it dropped as much as 65.82% from its peak. It still trades 34% below that peak which means it would need to go up 52% from here just to get back to its all-time high from November 2021.

Another stock that has been involved with AI for years is Stitch Fix (SFIX).

Back on July 5, 2020, Venture Beat wrote:

Companies like Stitch Fix, Wantable, and Trunk Club have attempted to address this problem by hiring professionals to choose clothes based on your custom parameters and ship them out to you. You can try things on, keep what you like, and send back what you don’t. Stitch Fix’s version of this service is called Fixes. Customers get a personalized Style Card with an outfit inspiration. It’s algorithmically driven and helps human style experts match a garment with a particular shopper. Each Fix includes a Style Card that shows clothing options to complete outfits based on the various items in a customer’s Fix. Due to popular demand, last year the company began testing a way for shoppers to buy those related items directly from Stitch Fix through a program called Shop Your Looks.
AI is a natural fit for such services, and Stitch Fix has embraced the technology to accelerate and improve Shop Your Looks. On the tech front, this puts the company in direct competition with behemoths Facebook, Amazon, and Google, all of which are aggressively building out AI-powered clothes shopping experiences.

From the time of that writing, SFIX went on a tear, rising 242% (302% intraday) to its all-time high. Then, the stock crashed 97% to its recent low over the next 839 days (2+ years) putting in a low (for now) on May 8th.

While FactSet looked to see how many companies in the S&P 500 mentioned AI in their quarterly earnings call transcript, they didn’t provide a number for how many times AI was mentioned on each call, or in the aggregate. I bet it was a lot. I don’t really have the capability to perform that search with any reliability myself, but I can tell you that SFIX alone mentioned AI, ELEVEN times in its June 7th earnings call, according to an excellent new software I have been using called Quartr.

Here are each of the mentions:

They “have an AI roadmap” y’all! Forget the fundamentals of the retail business being what they are! WE HAVE AN AI ROADMAP! Problem solved!!!

And of course, despite reporting that they continue to lose money the stock went up 36% because why not? AI baby!

One of the most ironic things about the AI hype we are seeing is that hedge funds and other investment management firms have programmed their trading algorithms (which are AI) to buy stocks that are mentioning AI in their calls and press releases.

You can’t make it up.

Anyway, I am not here to dismiss AI. I want it to be as life changing as everyone has already decided it is. But from my personal experience so far, it isn’t there yet. And by “there” I mean where Wall Street has priced it. Wall Street always pumps “new” ideas to levels that make no fundamental sense. And then those prices come back to reality over time. Sometimes very quickly, other times over longer periods.

I am definitely finding ways to use AI to increase productivity, in fact, I am using AI to compose and edit this commentary! But I don’t trust it to do research for me just yet. Again, in my experience, it is too prone to be giving factually inaccurate information to be trusted for something like investment research.

I won’t bore you with a bunch of examples, but they are very basic errors that no human would ever make, like the Quarterly Revenue for Nvidia (NVDA) for the past few years, or the name of the CEO of GameStop (GME).

I have no doubt that the technology will learn, adapt, and get better over time, but it just isn’t “there” yet.

Just like with the internet as the underlying technology, there will still be winners and losers. There will still be good prices and bad prices even for the winners, like Nvidia, which I fully expect will continue to be a major winner.

Today, Nvidia trades at almost 40 times its revenue and over 200 times its earnings over the past 12 months. It trades at 21 times its annualized revenue projections (up about 60%) for next quarter.. That is extremely expensive. Of course, it could get even more expensive from here. But to buy it today with the expectation of making a great deal of money, which many people are doing, I think you have to expect that there is someone out there, a “greater fool,” who is going to be willing to pay an even higher multiple of revenue and earnings than you. There is not much fundamental “value” in the company’s shares at these levels even factoring in above-average growth.

The situation brings to mind a timeless and fairly famous quote from 2002 during the dotcom crash. Scott McNealy, the Founder and CEO of Sun Microsystems at the time said in an interview with Bloomberg:

At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?

Sun Microsystems had every reason to be a long-term winner from the mass adoption of the internet. It was a good business, much like Netscape, especially when compared to say, pets.com.

Sun’s market cap rose to a peak value around $200 billion. It was later bought by Oracle (ORCL) for a little over $7 billion.

Again, I don’t expect the same outcome for Nvidia, but you just never know. What we do know is that overpaying, even for a great company, is generally a bad idea. Nvidia has a history of falling 50% or more. In fact, it dropped 69% from November 2021 to October of 2022, dropped 42% in 2020, and dropped 55% in 2018.

So, unfortunately, I didn’t buy Nvidia back in January when I got an alert to do so. I thought it would pull back from there to its 200-day moving average but it never looked back (yet). The stock is up 100% since. I should have bought some for our growth strategy and put a stop at the 200-day moving average. It is a mistake I am not likely to forget for as long as I live.

That said, if I had bought it back in January and held on, we’d be sellers here and reducing if not exiting our position. I won’t be surprised if Nvidia pulls back to $300 or so in the near term. At that price, it will still be incredibly expensive.

Thankfully, we do own plenty of other stocks in the Growth Strategy that have massive exposure to the “AI” hype, and these stocks have done well over the past few months. Two of them are household names, Microsoft (MSFT) and Alphabet (GOOGL), both of which are up almost 50% from their bear market lows. Alphabet still actually looks relatively cheap. Microsoft, not so cheap at 10 times revenue but historically speaking that is a fair multiple for Microsoft. Only the best companies in the world maintain that sort of price tag, and Microsoft is one of them. Nvidia probably is too, and from here on out I will need a really good reason not to buy it when it trades at 10 times sales (or less). Notice that I used when, not if.

Let’s change gears and get into some economic data.

Everyone’s favorite acronym, SLOOS data points to an economic slowdown. SLOOS is the Senior Loan Officer Opinion Survey. The SLOOS covers a range of loan categories, including commercial and industrial loans, residential mortgages, and consumer loans. The survey asks questions about changes in lending standards, terms and conditions of loans, loan demand, and factors influencing credit availability which is then used by the FED and market participants to assess the current state of credit markets.

Click Image to Enlarge
Source: Federal Reserve Bank of St. Louis

The FED raises rates to tighten monetary policy but occasionally, like now, the banks tighten lending standards enough on their own, thus tightening monetary policy overall, that the FED may not have to raise interest rates as much as they otherwise would. That is something the FED has alluded to possibly being the situation now.

Ultimately, does it really matter whether the FED or the banks tighten policies? I don’t really think so. The impact is largely the same. So, if the FED decides not to raise rates because the banks tightened lending standards enough on their own, it is a net-neutral outcome. Meaning, the FED not hiking isn’t necessarily bullish if the reason for not hiking is because the bank beat them to it. In either case, the end result of tightening is a slower economy.

It isn’t only the bankers that are concerned…

According to a recent Gallup poll, about half the people in the U.S. are worried about the safety of their money in the banks. This is roughly similar to the levels seen after Lehman Brothers failed back in 2008.

The scary part here is that the banks’ loans haven’t even begun to fail yet. And as I pointed out last month, one of the biggest concerns moving forward is the wall of $1.4 trillion of real estate debt that needs to be refinanced at higher rates before the end of 2024. Many of those borrowers are unlikely to be able to refinance or repay those debts. As Bloomberg recently reported, commercial real estate prices in the U.S. dropped in the first quarter of 2023 for the first time since 2011!

The only way I see out of it is for the FED to start cutting rates which carries the consequence of reaccelerating inflation.

So, what will the FED choose? A wave of real estate defaults or a resumption of multi-decade high inflation? Perhaps some other magical outcome I haven’t thought of…

10-year treasury yield in blue, 2-year treasury yield in orange, and the spread between them below in black.
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Source: Tradingview.com

Meanwhile, the 10-year treasury yield has moved higher since it dropped during the recent string of bank failures. The only problem is that the 10-year yield continues to rise more slowly than the 2-year yield which has led to a re-inversion of the 10’s minus 2’s spread to -0.84%. The magnitude and duration of this inversion is disturbing.

Love him or hate him (I think most of us probably don’t care for his old boss), Stanley Druckenmiller was the lead portfolio manager for George Soros’ Quantum Fund from 1998 to 2000. During his time there, he generated massive returns for the fund, achieving an average annualized return of around 30%. He then went on to launch his own hedge fund which he also ran with similar returns until 2010 when he turned that fund into his own family office/firm.

To put it plainly, he is a legend. When he speaks, I listen. He has made more headlines than normal over the past month with speaking engagements around the world. He gave the keynote speech for the 37th USC Marshall Center for Investment Studies Annual Meeting on May 1, 2023, which you can listen to here. It’s about an hour long, but again, the man is a legend and if you are interested in economics, finance, or if you just have some money in the markets, it might be worth a walk with a set of headphones.

Here is one quote from the keynote:

"This is what really annoys me, how no one talks about it... Do you know that the $32 trillion [national debt of the USA] assumes the federal government will never make another Social Security or Medicare payment? Only government accounting could think that the government is never going to make another payment, not one."

If you actually accounted for those (big) government programs, Stanley Druckenmiller said credible estimates put the value of that debt at $200 trillion, not $32 trillion.

He was also interviewed at Norges Bank Investment Management’s Annual Investment conference. You can find that here.

To be transparent, in his interview at the 2023 Sohn Investment Conference, he was bullish on AI while continuing to expect a hard landing/recession in the U.S. To reiterate my position, I am not bearish on AI. I agree with Druckenmiller here. The key is not only to identify the winners in the AI space and invest in them when they trade at reasonable valuations, but also to identify the frauds and avoid them.

Moving along…

Despite the SPY being up slightly (+0.46%) for the month of May, 8 of the 11 sectors in the S&P 500 were down for the month.

Further, as of the end of May, the S&P 500 was up approximately 10% for the year 2023. Meanwhile, the “S&P 493” was up about 1%.

To put it another way, 7 stocks: Alphabet (Google), Apple, Microsoft, Amazon, Meta (Facebook) Tesla and Nvidia, in the S&P 500 were up about 44% while the other 493 stocks were basically flat.

Thankfully we own 4 of those 7 (Alphabet, Amazon, Apple, and Microsoft) in our Growth Strategy and we also own Apple in our Value strategy. We have also increased our exposure to those companies during 2023.

It is pretty amazing how much the positive performance has concentrated in so few stocks. The “diversified” S&P 500 Index is now over 14% invested in just two stocks (Apple and Microsoft) and over 22% of the index is in the top 5 stocks (Amazon, Nvidia, and Alphabet in addition to the first two).

S&P 500 (SPY) in blue, S&P 500 Equal Weight (RSP) in orange. In RSP, all 500 companies get the same allocation, not 20%+ in the top 5 companies. Since just before the banking crisis on March 9th, the SPY is up over 10% while the RSP is up less than 2%,
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Source: Tradingview.com

That doesn’t seem very diversified to me, nor is it an accurate representation of “the market.” This is really just 7 stocks out of several thousand. The “market” as a whole is really not doing so well. These benchmark indexes (the S&P 500 and Nasdaq) are broken. They are providing very misleading information about a diversified portfolio.

We’ve also been keeping track of the S&P 500’s 200-day moving average. We originally wanted to see it trend higher for 21 consecutive trading days, which it did. It then stalled out after 33 days when it declined from May 15th to May 16th. Since then, it has bounced around going mostly sideways. As it stands today, we are now on a 4-day streak of the 200-day moving average rising.

S&P 500 (SPY) 200-day moving average is the blue line. It recently rose for 33 consecutive trading days ending May 15th.
Click Image to Enlarge

Given the new uptrend in the 200-day moving average, we have gotten a little more active in adding stock exposure back to both strategies at Elevate, with the Growth Strategy taking a much more aggressive approach.

We have also begun to take more of a “trading” approach to getting back into stocks that are breaking out and heading higher even if the company doesn’t seem like a good long-term investment. So far that has been working. What I have seen is that many companies that I don’t actually like in the long run have been punished (down 80% or more) for so long, that they are bouncing 20% or more just because when something falls so far it is easy to get a bounce of that magnitude.

But keep in mind that a stock which is down 80% needs to bounce by A LOT more than 20% or even 80% to get back to even. In fact, from down 80%, a stock needs to rise by 400% just to get back to even.

Many of these stocks are never going to get back to where they once were in November of 2021. But that doesn’t mean we can’t buy them for a bounce and use a tight trailing stop to get out and protect our capital.

At the end of the day, my job is to make money regardless of my personal views on fundamental economics. And the market can stay irrational for a very long time, indeed.

The FED starts its 2-day meeting tomorrow. We will also learn what the Consumer Price Index (CPI) measure of inflation was for the month of May tomorrow. The market is expecting the annual inflation rate to come in at 4.1% and the monthly inflation rate at 0.2%. These are down from April where the annual rate was reported at 4.9% and the monthly rate ticked up from 0.1% in March to 0.4%.

The Core CPI which excludes food and energy prices is expected at 5.3% for the year and 0.4% for the month.

The FED tends to focus a little more on the Core rates which are (supposedly) less volatile.

The important thing to note here is that none of these numbers are anywhere close to the FED target of 2% annual inflation. And it is interesting that the core inflation is staying higher for longer than the so-called headline CPI.

As a result of these projections and other internal market data, some members of the FED have expressed their interest in continuing to hike interest rates. James Bullard recently said said he expects not one, but two more rate increases this year.

Meanwhile the market is still praying for them to cut rates. I think it’s a coin flip as to whether they raise by 0.25% or do nothing this week. I don’t see them cutting though.

There will probably be some big reactions tomorrow when CPI is released and Wednesday when the FED decision on interest rates is announced. Stocks are likely to be volatile over the next couple days before finding their path forward.

Another potential headwind for the markets is in play now that the debt ceiling has been raised. Many people think only about the first order effects of raising the debt limit. Sure, it would have been very bad for the global economy if we had defaulted on our loans. No question about it. But now that the debt limit has been raised, the government is actively issuing bonds (i.e. borrowing). And who does the government borrow from? Largely its citizens and corporations. This new bond issuance by the government has the second order effect of sucking a lot of liquidity out of the economy, and thus, out of the stock market. During the first half of 2023 the government could not borrow additional funds and so this liquidity vacuum was turned off. So, we’ll be keeping a close eye on that situation as it develops. The higher rates go, the more people must consider buying treasuries over taking risk in the stock market.

Believe it or not, I could keep going. I didn’t even get to any charts from JP Morgan’s Guide to the Markets presentation, but I will leave it here for now and come back to that next month. Perhaps I will plan on hitting that quarterly going forward.

To wrap things up here, I am very much surprised by the steady march higher in the markets so far in 2023. I do not think that the economy is in good enough shape to support it. On the other hand, technical indicators are strong.

I continue to think that we are in an “in between” moment much like the period in 2008 between when Bear Stearns failed and was bought by JP Morgan and when Lehman Brothers failed 6 months later. In the period between those two events, the market had largely shrugged off the fundamental economic data which was obviously bad to anyone who cared to look. And upon the failure of Lehman there was no more hiding it and markets dropped precipitously.

Time will tell. All we can do is trade the market we have, not the market we want. I will keep you posted as the situation develops and work hard to capitalize on opportunities for gains without exposing your hard-earned capital to unacceptable risks. That means we will likely sacrifice some upside in the early days of any new bull market that should develop. If that is already happening, I am confident there will be plenty of opportunity to make up for it in the years to come, buying dips as the markets grind higher.

Clients, I encourage you to click here to access your personalized performance portal to see how your portfolio performed vs. the markets last month.

Until next time, I thank God for each of you, and I thank each of you for reading this commentary.

Shane Fleury, CFA
Chief Investment Officer
Elevate Capital Advisors

Legal Information and Disclosures

This commentary expresses the views of the author as of the date indicated and such views are subject to change without notice. Elevate Capital Advisors, LLC (“Elevate”) has no duty or obligation to update the information contained herein. This information is being made available for educational purposes only. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Elevate believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Elevate. Further, wherever there exists the potential for profit there is also the risk of loss.