Market Pulse
Saturday, December 21, 2024
Welcome to this week's Market Pulse, your 5-minute update on key market news and events, with takeaways and insights from the Sidekick Investment Team.
Our three stories this week:
1. Feeling Bubbly: Understanding Market Valuations
2. The Everything Boom: AI’s Voracious Resource Demand
3. To Grow or Not to Grow: The UK’s Budget Dilemma
It’s important to note that the content of this Market Pulse is based on current public information which we consider to be reliable and accurate. It represents Sidekick’s view only and does not represent investment advice - investors should not take decisions to trade based on this information.
As 2024 draws to a close, equity investors have much to celebrate, with the S&P 500 likely to close the year up more than 20%. This strong performance, however, has also stoked fears that the market is becoming overvalued. The cyclically adjusted price-earnings ratio, a widely used market valuation measure, currently sits at more than twice its long-term average.
Investors are right to be cognizant of market valuation levels. A recent report from UBS, however, makes a compelling argument that bubble fears are overblown. Due to structural changes in market indexes over the past few decades, it may not be fair to directly compare current valuation levels to historical ones.
The first argument for this idea is that tech has come to comprise a much greater portion of the market as a whole. Over the past 30 years, tech-related companies have grown from just 10% of the S&P 500 by market cap to more than 40%. Compared to businesses like manufacturing or construction, the generally capital-light economics of tech allow for much more rapid growth. Thus, it shouldn’t be surprising that these companies achieve higher valuations.
The analysts also make the point that modern, capital-light companies generate much more cash than their predecessors. At 28.5, the S&P 500’s price-to-free cash flow ratio is only a bit higher than a long-term average of 23.7. Because the amount of cash generated per dollar of earnings can change over time, price-earnings ratios can be misleading on their own.
Finally, the report argues that companies now have a much easier time funding their operations thanks to historically low corporate spreads. The “spread” indicates what a company has to pay in interest above the risk-free Treasury rate in order to borrow money. Because spreads today are so low, companies can borrow cheaply, thus enhancing the leverage they can safely use to boost equity returns.
All this is not to say that fears of elevated valuations are unfounded. As the broader context makes clear, however, the fact that some figures have risen above their long-term averages does not necessarily mean that a bubble is forming.
As artificial intelligence grows in popularity, much attention has been focused on the potential economic benefits associated with the technology’s downstream use. Research, writing, coding, and many other white-collar tasks are already benefiting from AI productivity enhancements. Surprisingly overlooked, however, are the potential economic benefits associated with the upstream demand of AI itself.
Unlike many other software tools, AI development is phenomenally resource-intensive. OpenAI’s ChatGPT-4 model, for instance, may have cost over $100 million to train and deploy. While chip companies like Nvidia have benefited most directly from this resource intensity, elevated demand is beginning to materialise across the computing value chain.
Microsoft, for instance, needs so much energy to power its data centres that the company recently made a multi-billion-dollar deal to help reactivate a long-dormant nuclear reactor in the US. Similarly, Amazon and Google have both announced investments in small experimental reactors. All this energy demand is also translating into the need for increased grid capacity, with Goldman Sachs estimating that US utilities will need to invest at least $50 billion in grid expansion by 2030.
With the price of chips soaring, the cost of the materials necessary to make those chips has risen too. Amidst supply bottlenecks, prices of both common metals like copper and esoteric ones like germanium have soared in recent years. As we discussed last week, AI chip demand is even sparking interest in new types of computing entirely.
While most of this resource demand can be managed with elevated investment levels, there is one area in which AI-driven demand could prove to be a major hurdle – data. Large language models rely on vast amounts of data to be trained, and estimates show that these models may run out of novel training data in less than four years’ time. When this occurs, it could become much more challenging for successive generations of AI models to achieve the types of staggering leaps we’ve seen over the past several years.
Note: Amazon, Alphabet, Microsoft and Nvidia are all in Sidekick's Flagship portfolio
Even before it was officially unveiled in early November, the most recent UK budget has been heralded by the Labour government as a key tool for the country’s growth. On the surface, the budget does seem expansionary, with £70 billion in new spending by 2030 and significant public investment planned. One other perspective, however, holds that the UK’s budget is no better than austerity in disguise.
One of the centrepieces of the budget is an increase in employers’ National Insurance Contributions from a rate of 13.8% to 15% (along with a decrease in the earnings level at which employers pay NICs). Measures like this are one way the Labour government has sought to preserve its pledge not to raise taxes on “working people”.
Academic research, however, finds that workers and consumers typically end up paying a substantial portion of business taxes as companies pass on increased costs. What’s more, the increase in NICs has made it more expensive for businesses to hire workers. A recent survey showing a sharp decline in UK employment has been linked by some economists to the NICs hikes.
Finally, while expanding public spending through tax rises and borrowing could help boost the economy, it may be hard to ensure that such spending results in net new growth. The UK’s public sector is dramatically less productive than the country’s private sector. Any transfer of money to the government therefore faces a natural hurdle in terms of boosting growth.
Only time will tell if the UK’s new budget ends up being a net contributor to the economy in the long run. These concerns do show, however, that the budget is not going to be the economic quick fix the Labour government hopes for. To get the UK economy back on track, the budget should be treated as just one piece of the legislative puzzle.
Please remember, investing should be viewed as longer term. Your capital is at risk — the value of investments can go up and down, and you may get back less than you put in.
