The AI trade: Key themes for investors to consider

Key Concepts

Big Tech Earnings: Financial results reported by major technology companies.
CPI Report (Consumer Price Index): An economic indicator measuring the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
Fed's Next Move: The Federal Reserve's potential future actions regarding monetary policy, such as interest rate adjustments.
Valuation Stretch: A situation where the price of an asset is considered high relative to its underlying fundamental value.
Mega Cap Names: Very large companies by market capitalization.
Rally Broadening: An increase in stock prices that includes a wider range of companies and sectors, not just a few dominant ones.
Idiosyncratic Stories: Unique or specific situations affecting individual companies, distinct from broader market trends.
Corporate Health: The financial well-being and performance of businesses.
Aggregate: The total or combined amount.
Dovish Direction: A monetary policy stance that favors lower interest rates and easier credit conditions.
Labor Market: The supply and demand for labor, including employment levels and wage growth.
Normalizing: Returning to a more typical or expected state.
Coming off the Boil: Cooling down from a period of intense activity or growth.
Stimulus: Measures taken by a government or central bank to boost economic activity.
Financial Conditions: The ease with which businesses and consumers can access credit and financial services.
Accommodative: A policy stance that aims to stimulate economic growth.
Momentum: The tendency for an asset's price to continue moving in its current direction.
Technical Corrections: Short-term declines in asset prices that occur after a period of strong upward movement.
Risk Assets: Investments that carry a higher risk of loss but also offer the potential for higher returns.
Meme Stocks: Stocks that gain popularity through social media and online forums, often detached from fundamental value.
Speculative Excess: Excessive buying of assets driven by speculation rather than fundamental value.
Ample Liquidity: A large supply of money available in the financial system.
Debasement Trade: An investment strategy that seeks to profit from the potential devaluation of currency.
AI (Artificial Intelligence): The simulation of human intelligence processes by machines, especially computer systems.
First Order Effects: Direct and immediate impacts of a phenomenon.
Second and Third Order Effects: Indirect and subsequent impacts.
Infiltrate the Economy: To spread and become integrated into various sectors of the economy.
Diffused: Spread out over a large area or among many people.
Financials: Companies in the banking, insurance, and investment sectors.
Labor Intensive: Requiring a large amount of human labor.
Regulatory Requirements: Rules and laws that businesses must follow.
Payments Processing: The systems and technologies used to handle financial transactions.
Cost Structure: The total expenses incurred by a business.
Enhance Margins: To increase the profitability of a product or service.
Industrials: Companies involved in manufacturing, construction, and other heavy industries.
Displace Labor: To replace human workers with machines or technology.
Autonomy: The ability of a system to operate independently.
Robotics: The design, construction, operation, and application of robots.
Automation: The use of technology to perform tasks previously done by humans.
Priced for Perfection: When an asset's valuation assumes optimal future performance.
Relative Value: The comparison of the attractiveness of different investments.
AI Boom/Bust: The rapid rise and potential subsequent fall in the valuation of AI-related companies.
Yellow Flags: Warnings or signs of potential problems.
Dot-Com Bubble: A speculative bubble in internet-related companies in the late 1990s and early 2000s.
Froth: Excessive speculation and inflated prices in a market.
Hundreds of Times Earnings Multiples: A very high price-to-earnings ratio, indicating that investors are paying a large premium for each dollar of earnings.
High Beta: A measure of a stock's volatility in relation to the overall market.
Free Cash Flow: The cash a company generates after accounting for cash outflows to support operations and maintain its capital assets.
1-800-2000 Deadline: A reference to the Y2K bug, a potential computer issue at the turn of the millennium.
Infrastructure: The basic physical and organizational structures and facilities needed for the operation of a society or enterprise.
Conference Calls: Meetings where companies discuss their financial results with investors and analysts.
Metrics: Standards of measurement.
Data Points: Specific pieces of information.
Private Markets: Investments in companies that are not publicly traded on a stock exchange.
Public Side: Companies that are publicly traded.
Hyperscalers: Large cloud computing providers like Amazon Web Services, Microsoft Azure, and Google Cloud.
Capbacks (Capital Expenditures): Funds used by a company to acquire, upgrade, and maintain physical assets.
AI Value Chain: The various stages and components involved in the development and deployment of AI technologies.
Asset-Heavy Businesses: Companies that require significant investment in physical assets.
Data Center Buildout: The construction and expansion of facilities that house computer systems and associated components.
Debt Funding: Borrowing money to finance operations or investments.
Power Generation: The process of producing electrical energy.
Nuclear Power: Electricity generated from nuclear reactions.
Market Caps (Market Capitalization): The total value of a company's outstanding shares of stock.
Tech Enablers: Companies that provide the foundational technologies for other industries.
Semiconductors: Electronic components made from semiconductor materials, crucial for computing.
Tech Value Chain: The various stages of technology development and delivery.
Geographically: Relating to specific regions or countries.
Overseas: In or to a foreign country.
Circular Web of AI Deal Making: Interconnected investments and partnerships within the AI industry.
Artificially Propping Up: Supporting something in an unnatural or unsustainable way.
Stable Free Cash Flows: Consistent and reliable generation of cash from operations.
Pivot: To change direction or focus.
Stewards of Capital: Individuals or entities responsible for managing financial resources effectively.
Deploy Cash: To invest or spend money.
AI Browser Wars: Competition among web browsers incorporating AI features.
Chat GPT Atlas: OpenAI's web browser.
Global Market Share: The percentage of the total global market that a company or product controls.
Safari: Apple's web browser.
Differentiator: A feature or characteristic that distinguishes something from others.
Natural Voice Search: Using spoken language to search for information.
Google Docs: A word processing application offered by Google.
URLs (Uniform Resource Locators): Web addresses.
Agent: In this context, a feature within a browser that can perform tasks.
Instacart: An online grocery delivery service.
Generative AI: A type of artificial intelligence that can create new content, such as text, images, or music.
Chrome: Google's web browser.
Gemini: Google's AI model.
AI Mode/AI Overviews: AI-powered features within Google Search.
Perplexity: A search engine that uses AI to provide answers.
Microsoft Edge: Microsoft's web browser.
Co-pilot: An AI assistant integrated into Microsoft products.
Existential Threat: A danger that could lead to the destruction or fundamental change of something.
Alphabet: The parent company of Google.
Mind Share: The extent to which a brand or product is recognized and remembered by consumers.
Purposeful: Done with intention.

Earnings Season and Economic Health

The current earnings season is showing positive results, with corporate earnings generally exceeding consensus estimates. Despite concerns about trade war disruptions and policy uncertainty, the aggregate corporate health appears strong, indicating a resilient economy. This resilience is translating into healthy earnings growth, which is supporting the market's upward movement.

Federal Reserve Policy and Market Support

The Federal Reserve has adopted a more dovish stance, incrementally moving towards lower interest rates. This policy is intended to provide insurance against potential labor market weakness. While the labor market is not considered to be in acute distress, it is seen as normalizing. The combination of Fed stimulus (rate cuts and forward guidance) and a reasonably healthy economy and labor market is creating a supportive environment for corporate health and earnings.

Market Valuation and Speculative Excess

A key question is how much of this positive news has already been priced into the market. The mega-cap tech segment and high-beta, high-growth sectors, including meme stocks, are showing signs of speculative excess. This can continue as long as financial conditions remain easy and accommodative, which is currently supported by the Fed's actions. This environment suggests a continued momentum for risk assets, despite potential minor corrections.

Meme Stocks as a Symptom

The resurgence of meme stocks like Krispy Kreme, GoPro, and Beyond Meat is viewed not just as entertainment but as a symptom of speculative excess and ample liquidity. This is tied to the accommodative Fed and a broader theme of liquidity seeking a home in risk assets, contributing to a general sense of froth in the market.

The Second Chapter of the AI Story: Value Stocks

The discussion shifts to the AI boom, with a distinction made between the first-order effects (companies directly involved in creating AI, like Nvidia, Meta, Google) and the second and third-order effects (how AI infiltrates and diffuses into other sectors).

First-Order Effects: Priced In

The first-order effects of AI are largely considered priced into the valuations of companies directly involved in AI development. Expectations for the future of AI are already baked into their stock prices.

Second and Third-Order Effects: Opportunities in Value Stocks

The real opportunity lies in the second and third-order effects, where AI integrates into other sectors.

Financials: AI can enhance efficiency in payments processing, reduce cost structures, and improve margins by integrating technology to handle regulatory requirements and labor-intensive processes.
Industrials: AI can lead to labor displacement through autonomy, robotics, and automation.

These sectors are not necessarily priced for perfection, offering attractive relative value compared to the highly valued mega-cap tech names. This transition is expected to play out over several quarters or years.

AI Bubble Debate: Froth vs. Fundamentals

There is a significant debate about whether the AI market is in a bubble.

Arguments for Froth and Potential Bubbles

Some high-profile investors see echoes of the dot-com bubble, with smaller-cap names trading at extremely high earnings multiples (hundreds of times earnings).
Jared Bernstein's definition of a bubble: "A bubble occurs when the level of investment in an asset becomes persistently detached from the amount of profit that asset could plausibly generate." He suggests AI investment fits this pattern.
Concerns are raised about "asset-heavier businesses" that require significant upfront capital, such as data center buildouts and power generation (especially nuclear), where some companies with no revenues are seeing large market caps. These are seen as "mini bubbles."

Arguments Against a Broad-Based AI Bubble

Mega-cap tech stocks leading the S&P 500 are still considered more reasonably priced and generate strong free cash flow.
Unlike the dot-com era, there isn't a similar "deadline" driving immediate, widespread equipment purchases. There's a longer runway for AI infrastructure development.
Valuations for AI are not entirely detached from fundamentals. The market is pricing in mid-20s to 30% growth for US AI names over the next three years, which is in line with consensus analyst expectations of around 25%.
A key differentiator is that the current AI investment is driven by highly profitable companies with substantial free cash flow, not just speculative borrowing.

Identifying Pockets of Concern and Opportunity

Pockets of Concern (Mini Bubbles): Asset-heavy businesses like data centers and certain power generation companies (e.g., nuclear) that require large upfront investments and may see prices dislocate from near-term fundamentals. Early-stage companies with rapidly rising stock prices and valuations are also a concern.
Attractive Entry Points:
- Utilities/Power Generation: Traditional utilities like Duke Energy are seen as attractive based on analyst growth expectations.
- Tech Enablers (US): Semiconductors like Nvidia are still considered good value based on growth. Marvell and Amazon are also mentioned as being at the forefront of the tech value chain.
- Smaller Cap Semis: Companies like MKSI are seen as having growth potential that the market may not be fully pricing in.

Geographic Breadth of the AI Trade

The AI trade is not solely a US phenomenon. International markets also offer attractive opportunities:

China: Alibaba and Tencent are highlighted as interesting names.
Other International Markets: TSMC and SK Hynix are mentioned as options outside of China.

This suggests that investors should look beyond US mega-cap names for AI-related investments.

The Circularity of AI Deal Making

Concerns have been raised about the "circular web" of AI deal making, such as Nvidia investing in OpenAI, which then commits to buying Nvidia chips. This has led some to believe that the boom is being artificially propped up.

Counterargument: The initial funding source for these deals often comes from the free cash flow of companies like Nvidia. These companies have stable free cash flows and the ability to pivot to growth opportunities. As long as management is seen as a good steward of capital, they can effectively deploy cash.

The AI Browser Wars: OpenAI vs. Google

OpenAI has launched "Chat GPT Atlas," its own web browser, directly challenging Google's Chrome, which holds approximately 72% of global market share.

Key Features of Chat GPT Atlas

Integrated ChatGPT: ChatGPT is built directly into Atlas, allowing for natural voice search of past tabs, Google Docs, and standard URL inputs within the same interface.
Agent Functionality: The browser can perform tasks like shopping for groceries or booking restaurant reservations.
Generative AI Integration: It incorporates generative AI know-how directly into the browsing experience, eliminating the need to navigate to separate AI websites.

Competitive Landscape

Google: Chrome has Gemini capabilities and AI overviews in its search.
Perplexity: Offers its own AI-powered browser.
Microsoft Edge: Includes built-in Co-pilot.

Threat to Google

While Chrome remains the leading browser and Google Search is still dominant for standard searches, OpenAI's Atlas poses an "existential threat" to Google in the long term. The concern is not immediate, but rather about mind share. When people think of AI, they often think of ChatGPT and Nvidia, whereas Google is primarily associated with search. While Google is integrating AI into search, users need to be more purposeful to use dedicated AI tools like ChatGPT. This shift in user perception and engagement with AI-centric platforms is where Google might be vulnerable.

Conclusion/Synthesis

The current market environment is characterized by strong corporate earnings, supported by a resilient economy and accommodative Federal Reserve policy. While there are signs of speculative excess, particularly in certain tech and meme stock segments, the broader market is not considered to be in a full-blown bubble. The AI story is evolving, with significant opportunities emerging in the second and third-order effects of AI adoption across various sectors, particularly in value stocks that are not yet priced for perfection. Investors are advised to look beyond the immediate AI creators and consider companies that will benefit from AI integration. Geographically, both US and international markets offer AI-related investment potential. The competitive landscape for AI is intensifying, with new products like OpenAI's Atlas challenging established players like Google, raising questions about future market share and mind share in the AI-driven digital landscape.