Gold, Bitcoin, Dividends, A.I., Private Equity | Barron's Streetwise

Key Concepts

• Earning Season: The period when companies report their financial results for a specific quarter.
• S&P 500: A stock market index representing 500 of the largest publicly traded companies in the United States.
• Earnings Per Share (EPS): A company's profit divided by the number of outstanding shares.
• Consensus Estimates: The average forecast of financial analysts for a company's future performance.
• Capital Expenditures (Capex): Funds used by a company to acquire, upgrade, and maintain physical assets like property, buildings, and equipment.
• Hyperscalers: Large cloud computing providers that operate massive data centers.
• Decoupled: Not influenced or affected by something else.
• Store of Value: An asset that can be saved, retrieved, and exchanged at a later time, and be predictably useful when retrieved.
• Geopolitical Risks: Potential threats to a country's security and stability arising from international relations.
• Risk Asset: An investment that carries a higher risk of losing value but also offers the potential for higher returns.
• Dividend: A distribution of a portion of a company's earnings to its shareholders.
• Stock Buyback: When a company repurchases its own shares from the open market.
• Preferred Stock: A class of ownership in a corporation that has a higher claim on assets and earnings than common stock.
• Private Equity: Investment funds that are not publicly traded and invest in private companies.
• Private Credit: Loans made by non-bank lenders to companies.
• Accredited Investor: An individual or entity that meets certain net worth or income requirements and is therefore presumed to have the financial sophistication to participate in more complex investments.
• Illiquidity Premium: The potential for higher returns offered by illiquid assets to compensate investors for the inability to easily sell them.

Earning Season and Market Outlook

The discussion begins with the start of the third quarter earning season. While there's no formal definition, it's generally marked by the reporting of major banks. This past week, the big four banks (JP Morgan, Wells Fargo, Croup, Goldman Sachs) all exceeded consensus earnings per share and revenue estimates, showing strong performance in trading and investment banking.

Key Points:

• UBS estimates 10% year-over-year growth for S&P 500 third-quarter earnings. This figure represents the aggregate earnings of companies included in the review period, not necessarily their individual third-quarter results.
• The stock market is considered expensive, with the S&P 500 trading at 25 times projected earnings for the year. This high valuation necessitates strong growth to justify current prices.
• A 10% growth in Q3 would imply actual results beating estimates by 3-4%. The market's reaction, however, is driven by investor expectations.
• Investor concerns are mounting regarding consumer spending, evidenced by weak data in the auto loan market. However, improving credit card delinquencies from big banks suggest resilience.
• Credit quality concerns are being addressed, with recent bankruptcies like First Brands and a subprime auto lender deemed company-specific rather than indicative of broader deterioration.
• The "Magnificent 7" (large tech companies) are a significant driver of earnings growth, investing heavily in AI infrastructure. They grew by nearly 30% in Q2, but UBS expects this to slow to 20% in Q3.
• This slowdown in MAG 7 growth is expected to be offset by broader earnings growth across other sectors. Energy companies may see more favorable comparisons due to oil prices, banks are strong, and a weaker US dollar benefits companies with international exposure.
• Currently, about 10% of Q3 earnings reports are in, and the initial numbers are healthy.

Gold and Bitcoin: Decoupling from the Dollar

The first listener question, from Frederico in Italy, addresses how investors can ensure their gold or Bitcoin investments are truly decoupled from the US dollar, and how these assets are fundamentally priced.

Key Arguments and Perspectives:

• Common Benchmark Misconception: The speaker clarifies that while prices are often quoted in dollars, there hasn't been a formal benchmarking between gold and the dollar for over 50 years, and Bitcoin has never had one.
• Gold's Intrinsic Value: Gold is presented as an element dug from the earth, with a long history as a store of value due to its unique properties (non-tarnishing, non-poisonous, non-radioactive, stable reactivity, rarity). These characteristics make it historically suitable for use as money.
• US Policy Influence: While gold is largely decoupled, US policy actions can indirectly affect its price. For instance, concerns about inflation and the freezing of Russia's foreign exchange reserves after the Ukraine invasion have led central banks (like China) to increase gold holdings, viewing it as outside US policymakers' reach.
• Bitcoin's Decentralization: Bitcoin's core principle is its decentralization, meaning its rules are not dictated by central banks.
• Divergent Performance: This year, both gold and Bitcoin have risen, but recently Bitcoin has shown weakness while gold has continued to climb.
• Ed Yardi's Outlook: Economist Ed Yardi has a bullish outlook on gold, with a target of $4,000 per ounce by the end of 2025 (already surpassed) and a new prediction of $5,000 by next year, potentially reaching $10,000 by the end of the decade.
• Bitcoin as a Risk Asset: Yardi suggests that Bitcoin's recent weakness, in response to Trump's tariff announcements, indicates it's behaving more like a risk asset that sells off with high-flying stocks.
• Gold as a Hedge: In contrast, gold is seen as a hedge against inflation and geopolitical risks. Yardi posits that "risk-off investors may increasingly be concluding that gold is a better protection for geopolitical risks than is Bitcoin."

AI Spending and Customer Adoption

The next question, from TJ, questions why customers of the "MAG 7" companies aren't leveraging AI to build new products or cut costs, despite the significant AI infrastructure spending by these tech giants.

Key Points and Data:

• Massive Capex by Hyperscalers: The largest hyperscalers are expected to increase their capital expenditures on data centers by approximately 30% over the next two years, reaching $500 billion annually by 2027.
• Decelerating Growth: Despite the large absolute numbers, this represents a slowdown in the rate of growth compared to the past year. Furthermore, $500 billion is a significant but still relatively small portion of the overall US economy ($30 trillion) and business fixed investment ($4 trillion).
• Impetus to Demand: Barclays notes that the primary impetus to aggregate demand growth from this spending is already behind us, and future growth depends on the increase in spending, which is decelerating.
• Customer Spending Lag: The speaker emphasizes the need for increasing spending by customers, not just infrastructure investment.
• Deutsche Bank Report on ChatGPT: Proprietary transaction data from Deutsche Bank Insights in major European markets (UK, Germany, France, Italy, Spain) suggests that European spending on ChatGPT has stalled since May.
• Subscription Model Challenges: While ChatGPT has over 800 million weekly active users, the number of paid subscribers for its Plus ($20/month) and Pro ($200/month) versions may not be keeping pace with user growth.
• Valuation vs. Revenue: OpenAI, valued at around $500 billion in a recent transaction, has projected revenues of $13 billion this year. This is significantly lower than Netflix, which has a similar market valuation but projected revenues of $45 billion.
• Need for Revenue Growth: OpenAI needs to demonstrate rapid revenue growth from paying customers or new products to justify its valuation and prove the technology's sustainability beyond hype.
• Competitive Landscape: The market faces numerous free competitors, and concerns about the financial sustainability of AI investments and potential bubbles are growing.
• Potential for Justification: The ultimate justification of AI investments hinges on whether end-user spending materializes. If it does, the market's current valuations may be correct. If not, the market may have gotten ahead of itself.
• AI's Potential: Despite current challenges, OpenAI's subscription spending in Europe is approaching Spotify's levels and is a quarter of Netflix's, with projections to overtake Spotify by May 2027 and Netflix by February 2028.
• ChatGPT's Criteria for Justified Investment: ChatGPT itself outlines conditions for justified AI investments: clear customer value, aligned pricing, high retention, low churn, and scalable use cases. Conversely, investments would be unjustified if features are gimmicky, willingness to pay is low, high compute costs erode margins, or competition commoditizes the technology.

Dividends vs. Stock Buybacks and Dividend Predictability

Machik from California asks about the predictability of dividends, referencing Intel's decision to cut and then suspend its dividend.

Key Arguments and Perspectives:

• Tax Advantage of Buybacks: Stock buybacks generally have a tax advantage over dividends because they are not taxed as income to the investor (though a small excise tax now exists).
• Value of Dividends: The speaker still considers dividends valuable, providing a tangible return to investors and a source of capital to reinvest during market downturns. Historically, dividends have played a significant role in total returns, especially over longer periods due to compounding.
• Intel's Dividend Suspension: Intel's decision to suspend its dividend was a cost-cutting measure, which is disappointing for investors.
• Lack of Strict Rules for Common Stock Dividends: For common stocks, companies have the discretion to cut or stop dividend payments at any time. Preferred stock has more rules, but payment is still contingent on the company's ability to pay.
• Negative Impact of Dividend Cuts: A dividend cut typically leads to underperformance of the stock. BFA Global Research data shows that stocks meaningfully underperform the S&P 500 following a dividend cut, with cumulative relative median performance dropping by about 15 percentage points over 60 months. This underperformance is not a sudden drop but a sustained period of poor performance, acting as a disincentive for companies to cut dividends.
• Protecting Against Dividend Cuts:
  • Financial Analysis: Investors should carefully study company finances, examining the cost of the dividend as a percentage of profits or cash flow. It's crucial to assess normalized cash flow and ensure the dividend is affordable alongside other company obligations and investments.
  • Diversification: Investing in a basket of dividend-paying stocks through ETFs can mitigate risk. Examples include Vanguard's VIG (for less current income) and Schwab's SCHD (for more current income), prioritizing low fees and the sustainability and growth of payments.

Private Equity and Private Credit

Peter, a 74-year-old investor, inquires about private credit and private equity, noting their increased media presence and his difficulty understanding them.

Key Points and Explanations:

• Private Equity (PE):
  • Definition: Similar to the stock market but without daily liquidity and trading. Investors buy stakes in businesses not listed on exchanges.
  • Valuation: Pricing occurs infrequently when stakes are sold. Accountants estimate values in between, which critics argue can lead to claims of lower volatility than reality.
  • Returns vs. Stocks: Compelling evidence that PE reliably beats stocks is lacking. The best evidence suggests investors can achieve similar returns with low-cost stock index funds.
  • Advantages of Index Funds: Low fees and liquidity are key advantages over PE.
  • Illiquidity Premium Theory: The PE industry claims an "illiquidity premium" compensates for locking up money for years. However, research doesn't consistently support this.
• Private Credit:
  • Definition: Similar to private equity, it offers an alternative to traditional bonds. Firms that offer PE also provide private credit, taking on roles traditionally held by banks in commercial lending. They make loans to companies and sell them to investors.
• Increased Media Attention and Gatekeeping: The recent surge in discussion is not coincidental. Both PE and private credit have historically involved gatekeeping, requiring investors to be "accredited" (meeting net worth and sophistication requirements). This creates an aura of exclusivity, similar to a prestigious credit card, where benefits and costs are unclear to outsiders.
• Potential for 401(k) Access: There's a push to allow PE investments in 401(k) accounts, which could lead to more money chasing fewer lucrative opportunities, potentially diminishing future returns.
• Spectacular Returns Exist, but Identification is Difficult: While some PE funds have achieved exceptional returns, it's challenging to identify them in advance.
• Sophisticated Investors and Fees: Large institutional investors can negotiate lower fees. However, even these sophisticated investors are not consistently outperforming with alternative investments.
• No Obligation to Invest: The speaker suggests that investors not currently in private equity or private credit are likely not missing out.
• Entertainment Recommendation: For entertainment on the subject of private equity, the Instagram account "PE Guy" (Johnny Hillbrandt) is mentioned, known for his posturing about lifestyle and family.

Conclusion and Call to Action

The episode concludes with thanks to the listeners and an invitation for further questions. The speaker encourages listeners to use the voice memo app on their phones and send questions to jack.houg@bearren.com. The podcast is available on Apple Podcasts, Spotify, and other platforms, with a request for reviews on Apple Podcasts.