Big Tech earnings preview: AI, valuations, and layoffs

Key Concepts

• Market Resilience and Enthusiasm: Current market sentiment is characterized by optimism, driven by expectations of economic resilience, healthy earnings growth, and potential Federal Reserve rate cuts.
• Lack of Fear: A notable concern is the absence of fear in the market, suggesting a potential complacency that could be a precursor to a downturn.
• Potential Market Derailers: Key risks include the outcome of trade talks, upcoming major tech earnings, and the Federal Reserve's stance on interest rates and quantitative tightening.
• AI Investment and Sustainability: The market is heavily reliant on continued and increasing investment in Artificial Intelligence (AI). Questions arise about the sustainability of this pace of spending and its potential parallels to the dot-com bubble.
• Big Tech Earnings: A significant earnings week for major tech companies (Microsoft, Meta, Google, Amazon) is anticipated, with AI capex and future spending being a critical focus.
• Federal Reserve Policy: Market expectations are for interest rate cuts and the end of quantitative tightening, with scrutiny on the Fed's commitment to future cuts and its view on inflation targets (2% vs. 3%).
• Valuation and Fundamentals: While tech valuations are high, they are currently supported by strong fundamentals and earnings growth, distinguishing the current environment from historical bubbles.
• Infrastructure vs. Application: The investing case for AI is seen to be stronger in infrastructure providers rather than solely on end-users, with a focus on APIs and protocols connecting to AI models.
• Job Cuts and Economic Signals: Layoff announcements from major companies like Amazon and UPS contrast with positive private payroll data, indicating a mixed economic picture with AI's transformative impact on efficiency and workforce.
• Diversification: A strategy of broad diversification across asset classes, geographies, and investment styles is recommended to navigate the current market.

Market Action and Concerns

Steve Sausnik of Interactive Brokers highlights the current market's upward trend, attributing it to perceived economic resilience, healthy earnings growth, and anticipated Federal Reserve rate cuts. However, he expresses a primary concern: the "lack of fear." This sentiment, where a daily market rise seems almost inevitable, feels "too good to be true" and warrants caution, as "trees don't grow to the sky."

Sausnik's Radar of Concern

Sausnik identifies several potential derailers for the current market momentum:

• Trade Talks: The market has placed significant enthusiasm on upcoming trade talks. However, past experiences show these can devolve into "frameworks, not deals," leading to market volatility.
• Earnings Season: This week is critical for earnings, with major tech companies like Microsoft, Meta, and Google reporting. High expectations for these "Mag Seven" companies, especially regarding AI, could lead to significant market reactions if not met.
• Federal Reserve Meeting: The market anticipates rate cuts and the end of quantitative tightening. Key questions for the Fed include their commitment to future cuts and their acknowledgment of persistent inflationary pressures, with the debate around whether "3% is the new 2%" being a significant point of discussion. The last GDP report showed positive surprise, but the sustainability of a 3% inflation rate is a concern.

Sausnik's mantra is "don't fight the tape, but insure against it." He notes that even a slight uptick in the VIX (volatility index) to the 15-16 level suggests a growing awareness of the need to hedge against potential events this week. He advocates for an opportunistic approach rather than outright shorting.

AI Investment and Dot-Com Echoes

The discussion pivots to the role of AI in driving big tech earnings. A critical question is whether these companies will continue to increase AI capital expenditures (capex). The market has largely priced in continuous AI spending. However, recent layoffs at Meta and Amazon raise questions about whether they have overspent or are using AI as an excuse for prior overhiring.

Sausnik draws parallels to the internet bubble of the late 1990s, specifically the bandwidth buildout. While the need for bandwidth was real, companies like Lucent, Global Crossing, Northern Telecom, WorldCom, and Enron, which built the infrastructure, ultimately faced significant challenges. He cautions that while not suggesting current big tech companies are "frauds or doomed," the "gold rush" into AI makes sustaining enthusiasm and high profitability difficult.

Tech Stock Dominance and AI Economy

Jessica and Skip Stockberers discuss the dominance of S&P 500 tech stocks, noting their performance is approaching dot-com era levels. The recent news of Microsoft's $135 billion stake in OpenAI is seen as solidifying exposure to the AI economy.

The Race to Artificial General Intelligence (AGI)

The conversation touches upon the race to AGI, described as a "friendly type of competition" and a "game theory" where being in the game is crucial. The iterative nature of AI technology and the compounding advancements make AGI's exact definition elusive. The importance of open-source coding is highlighted as a factor in bringing minds together.

Open Source and Global Competition

A point is raised about the strength of open-source models originating from China, which are also more cost-effective. The need for Chinese developers to access the US tech stack is emphasized for collaborative innovation.

Microsoft's OpenAI Stake and Investment Opportunities

While Microsoft's stake in OpenAI doesn't necessarily put it in a "better spot" than competitors, it provides solidified, accessible exposure to OpenAI for investors. The AI market is perceived as large enough for multiple players. Opportunities are seen in:

• Infrastructure Providers: Companies building the underlying technology and platforms for AI.
• Brokerage Firms with APIs and MCPs: Protocols that connect to AI models, enabling the creation of custom interfaces using data. This is particularly relevant in regulated environments like financial services, where it can circumvent fiduciary responsibilities by creating bridges for data utilization.

Oracle is highlighted as a potential top pick for its ability to create custom interfaces using data.

Earnings Expectations and Options Positioning

Options positioning indicates exceedingly high expectations for upcoming earnings, particularly for Amazon, where the call-to-put ratio is significantly higher (2.8:1) than for other tech stocks (1.8:1). This suggests a higher potential for a sell-off if Amazon's results disappoint. Microsoft and Google are considered "okay," while Amazon's high expectations raise concerns. The market's reaction to these earnings, in conjunction with the Fed's announcement, will be crucial.

Market Pillars and Fed Influence

The market is currently supported by three pillars: economic growth, earnings growth, and an easing Federal Reserve. Any disruption to these pillars could lead to a market "collapse." The Federal Reserve's upcoming meeting and press conference are therefore highly significant.

Corporate Profits and Earnings Season

Data from FactSet shows corporate profits are holding steady, with S&P 500 net profit margins above their 5-year average for six consecutive quarters. Analysts expect this trend to continue.

Michael Ryan King, NYC Senior Market Strategist, notes that the earnings season has been solid, with financials performing well, aided by trading and investment banking. Industrials are also showing strength, driven by AI infrastructure demand. Regional banks were less robust, but the focus is now on the upcoming tech earnings.

High Expectations and Market Response

Similar to the previous discussion, there are high expectations for the Fed to cut rates and for tech earnings. The sustainability of AI hype and the market's response to solid, but perhaps not spectacular, earnings are key questions. It's unlikely that companies will report a slowdown in capex spending this quarter, with most indicating ramp-ups.

The market's reaction to earnings has been volatile, with stocks gapping up and then selling off, but often returning to their original levels over a few days. Options positioning is seen as a significant driver of this volatility.

Trade Headlines and Market Overhang

Positive headlines from Asia regarding a potential trade deal framework, even if provisional, are providing relief. The removal or postponement of trade war overhangs allows markets to focus on earnings and other catalysts. A recent 3% drawdown, the largest since April, was quickly reversed, resetting market positioning and allowing a push to fresh highs.

Earnings Growth Projections and Economic Data

Expectations for strong earnings growth into next year, potentially double-digit, are present. The flow-through of investment into the US economy to corporate earnings and economic data is anticipated.

Operating Without Government Data

In the absence of extensive government data (except CPI), market participants are relying on private data, central bank indicators, and corporate commentary. Corporate commentary suggests a cautious but stable environment, with some caution on hiring but no mass layoffs. A "K-shaped" recovery is observed, with the higher-end consumer holding up well, while the lower-income consumer struggles with inflation.

Federal Reserve Catalysts and Rate Cut Expectations

The market largely expects a 25 basis point rate cut from the Fed. There's also a growing expectation for the end of quantitative tightening (QT). Fed Chair Powell is expected to maintain optionality rather than fully commit to a December rate cut.

The recent CPI data, which did not show a significant upside surprise and saw shelter costs moderating, supports the Fed's ability to proceed with cuts. Markets are now pricing in a higher probability of a third cut in January.

Tech Stocks: Bubble or Sustainable Growth?

Peter Oppenheimer, Goldman Sachs Chief Global Equity Strategist, argues that tech stocks are not currently in a bubble. While equity prices are at all-time highs, this is a necessary but not sufficient condition for a bubble.

Supporting Evidence for Non-Bubble Status

• Strong Fundamentals: Rising valuations, particularly in tech, are supported by "incredibly strong fundamentals" and "consistently strong earnings growth," not just speculation.
• Valuation Levels: Current valuations, while high, are not as extreme as those seen in historical bubbles like the late 1990s dot-com era or Japan in the late 1980s, where valuations were nearly double current levels.
• Long-Term Outperformance: The US equity market, led by technology, has consistently outperformed other regions since the 2009 financial crisis. When adjusted for growth and profitability, valuations are comparable to other markets.

Historical Parallels and Transformative Technologies

Oppenheimer acknowledges that many historical bubbles have been driven by transformative technologies (steam engine, railways, computers, internet). These booms attract significant capital for infrastructure buildout. However, the biggest benefits often accrue to new companies that leverage the embedded technology and capital to create new products and services, rather than the initial infrastructure builders.

Investment Strategy in the AI Era

The question for investors is not necessarily whether it's a bubble, but where to allocate capital to benefit from innovation. Oppenheimer recommends:

• Broad Diversification: Across asset classes (private and public markets), geographies, and investment styles.
• Beyond US Tech: Recognizing that other regions are performing well, and some value-oriented stocks are also seeing gains.
• Infrastructure and Energy: The significant energy demands of AI suggest growth opportunities in energy generation and distribution infrastructure outside the tech sector.

OpenAI and the Ecosystem

The sustainability of the AI trend is also considered in light of OpenAI, which is not yet profitable. However, Oppenheimer points out that historically, many companies growing around new technologies are capital-hungry and reinvest heavily. The current ecosystem is supported by large, profitable companies with strong balance sheets and cash flow, which is a healthier sign than the speculative IPO market of the dot-com bubble. These companies are funding their spending from profitability rather than debt or equity financing.

Job Cuts and Economic Signals

Recent news includes significant layoff announcements from major companies:

• Amazon: Plans to lay off 14,000 employees, citing a desire to be a "leaner organization" and referring to AI as the "most transformative technology since the internet." This aligns with CEO Andy Jassy's vision of operating "like the world's largest startup."
• UPS: Announces layoffs of approximately 34,000 positions as part of a strategic shift to deliver long-term shareholder value, partly due to reduced package volume from Amazon and a need to reduce management layers.

These announcements contrast with positive private payroll data from ADP, which added 14,250 jobs over the past four weeks, a significant improvement from the previous month's loss. ADP will now release its data on a more regular cadence.

Other companies that have announced layoffs include Meta, Rivian, Ford, and Starbucks, indicating a broader trend of workforce adjustments.