Welcome to the inaugural edition of the Market Factors newsletter, a re-imagined version of the previous Globe Investor newsletter. I’ll be your host, Scott Barlow, and today we’ll obey Charlie Munger’s command to “always invert” by looking at how the AI investment boom could fail. Also, I’ll detail how asset markets are handicapping the U.S. presidential race.
Nvidia CEO Jensen Huang poses for a selfie with members of the media at Computex Taipei last month.Ann Wang/Reuters
Tech
The Pessimistic Investor’s Guide to AI
A recent in-depth report from Goldman Sachs - featuring its head of global equity research Jim Covello as well as M.I.T. economist Daron Acemoglu - highlights the inevitable backlash that looms for AI investment hype. It offers compelling arguments against the near-term success of this allegedly world changing technology.
Mr. Covello, a former semiconductor analyst, thinks AI costs too much relative to the problems it can solve. “Replacing low wage jobs with tremendously costly technology is basically the polar opposite of the prior technology transitions I’ve witnessed,” he notes.
Comparisons with the initial buildout of the internet are misplaced, according to Mr. Covello. The internet was a low-cost technology that replaced expensive incumbent solutions, as providers of long distance telephone service would discover.
Despite his skepticism, he does not believe that a major market correction is imminent. An AI arms race throughout the technology sector will support outsized profit growth for chip makers, utilities and related companies involved with the buildout of AI infrastructure. Mr. Covello’s mid-term prediction is ominous, however, as he states “Over-building things the world doesn’t have use for, or is not ready for, typically ends badly.”
Mr. Acemoglu, co-author of the brilliant Why Nations Fail: The Origins of Power, Prosperity and Poverty, is a bit more positive about the AI future. He recognizes its potential transformative power in research and development and scientific discovery. Importantly, he questions whether these benefits will be apparent within the next 20 years and posits that humans will always be necessary to steer AI processes.
The professor emphasizes that optimistic forecasts of AI capabilities are based on feeding more data into AI models. He does not accept the argument made by AI evangelists, however, that the relationship is linear – adding twice as much data to a large language model will not make it twice as capable or efficient.
Mr. Acemoglu is not concerned about AI applications developing superintelligence but does urge caution: “The risk that our children or grandchildren in 2074 accuse us of moving too slowly in 2024 at the expense of growth seems far lower than the risk that we end up moving too quickly and destroy institutions, democracy, and beyond.”
I will restate the investing tenet that no one can consistently predict a market top, and this also applies to those who tell you they can after getting lucky once. That said, there is one group of investors that should be paying attention to AI-related risk when I suspect they might not be – passive index investors in the S&P 500. The apparent diversification of holding the entire index has been very much offset by the dominance of Nvidia Corp., Microsoft Corp. and the other AI giants in driving upside returns, a process that would reverse painfully if the AI investment boom fails.
Goldman Sachs, by the way, makes a lot of research like this publicly available here and I highly recommend investors go browsing.
Donald Trump on stage during the last day of the Republican National Convention.BRENDAN SMIALOWSKI/Getty Images
U.S. Politics
Trump Trades mini-reversal
The political situation in the U.S. has been a tad volatile in recent weeks and this might have been reflected in asset markets. President Biden’s alarming debate performance saw betting market probabilities of a Trump victory climb above 60 per cent according to Citi research. Alongside this, the so-called ‘Trump trades’ also appreciated.
A steepening U.S. yield curve and small-cap outperformance of the S&P 500 have been the trends most consistently correlated with the odds of Republican victory. The yield curve steepening reflects a belief that Republican tax cuts will lead eventually to stronger economic growth expectations, and thus higher yields for longer-term bonds.
The Russell 2000 index of small-cap stocks has a 25 per cent weighting in energy and financials, two sectors expected to benefit from Mr. Trump’s deregulation plans. Further gains, however, might be complicated by the 40 per cent of the Russell 2000 that is unprofitable, according to Wells Fargo strategist Paul Christopher.
Citi global strategist Alex Saunders sees post-Biden candidacy market action “consistent with a small unwind of ‘Trump trades” but Goldman Sachs economist Jan Hatzius derives a 41 per cent chance of a Republican sweep of the White House and both houses of Congress from betting markets. Mr. Hatzius adds that the Republican sweep “remains the most likely outcome by a significant margin.”
There is a long, likely maddening way to go before the election but investors should be able to discern the market’s view of the outcome by watching small caps and the yield curve.
Diversions
The New York Times published a list of top 100 books since 2000 which gave me a lot of feelings, most of them negative. The first was embarrassment since I’ve only read about 20 of them and also irritation that Canadian author Emily St. John Mandel’s Station Eleven was criminally underrated at number 93. I’m well aware that lists are designed to irritate but they successfully do so, which is even more irritating.
The Essentials
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What’s up next
U.S. small caps: Last week, Goldman Sachs strategist David Kostin noted that the Russell 2000′s return relative to large caps was the biggest on record. This trend will be tough to maintain for the reason expressed by Wells Fargo above, and also because the Citi U.S. Economic Surprise continues to decline – small-cap outperformance is historically associated with an accelerating economy and that is not the case now.
As a side note, if this were last week, I would be awaiting domestic retail sales, the most important indicator of debt-related financial stress for households, which came out last Friday (and the results were terrible). No surprise that the Bank of Canada cut interest rates again Wednesday morning.
See our earnings and economic data calendar here.