This is the Biggest Risk to the Stock Market

I spoke with Professor Scott Galloway this week

Author

Josh Brown
May 25, 2024

Welcome to the perpetual motion machine, where Microsoft announces a huge capex spend, Nvidia is the recipient of that capex spend and both stocks rally endlessly on the same news.

The hyperscalers (Amazon Web Services, Oracle Cloud, Microsoft Azure, Google Cloud) continue to fund massive data center expansion plans to grab their share of the AI revolution, which in turn generates hundreds of billions of dollars worth of market cap increase and revenue opportunity for the entire ecosystem. It’s a carousel that feeds on its own momentum and everyone’s having the time of their life.

Until one of that carousel’s pony’s stumbles. Or some CFO somewhere looks at the spending, compares it to the actual return on investment, and decides to slow things up. Then what happens?

Does the narrative around AI spending change? Do other CFOs follow suit, pushing back their spending plans or moderating the expectations of their shareholders? What does this mean for the fifty or so stocks that investors are riding upon? What does it do to the multiples we’re all paying for these names? How about the indices themselves, as concentrated as they are with gigantic technology stocks as their most heavily weighted components?

I think this is a bigger risk to the stock market in the second half of the year. I know there are other risks - inflation reaccelerating forcing the Fed to hike rather than cut, or a credit event in commercial real estate, or a sudden spike in consumer loan defaults. I think a hiccup in tech spending is a bigger potential danger for stocks. It’s not something that is guaranteed to happen, of course, I just think it’s got a high enough likelihood that we should be thinking about it.

Jeremy Bowman writing at the Motley Fool, says “Tesla noted that it had installed 35,000 of Nvidia's H100 GPUs in supercomputers.”

Nvidia’s chips and software products have become indispensable to the largest technology companies in the world, which has been the blessing that’s enabled the company to become a $2.7 trillion giant as of this week, with another massive earnings beat and a ten-for-one stock split to stir the martini even faster. But there’s a great deal of concentration among Nvidia’s top customers - and we need them all to keep playing in order for the outlook to remain intact.

Nvidia doesn't disclose who its biggest customer is. That's not surprising since that information would be valuable to competitors. However, in its recent 10-K filing, the company did say that one customer represented 13% of its revenue from its compute and networking segment, and an indirect customer that purchases Nvidia products through integrators and distributors, including the customer above, represents 19% of the company's revenue. This name is also from the compute and networking segment.

It's not completely clear who that customer is, but we have a good sense of who Nvidia's biggest customers may be based on media reports and deduction.

Unsurprisingly, big tech companies like Amazon, Meta Platforms, Microsoft, and Alphabet are believed to be among Nvidia's biggest customers, making up roughly 40% of its revenue.

It's also clear that AI start-ups, like OpenAI, and autonomous vehicle companies, like Tesla, are significant customers of Nvidia. At this point, any company investing in AI is almost certainly an Nvidia customer.

The earnings power of the hyperscalers has been incredibly important for the recent corporate profits surge underpinning the bull market. The theme has fed on itself and grown in strength, but it requires everyone to keep riding the ride.

What happens if someone gets off?

This week I walked Professor Scott Galloway and his co-host Ed Elson through this merry-go-round concept and why I think it contains the seeds of its own potential destruction. It sounded familiar to Scott, as he lived and invested through the original dot com revolution (and crash) twenty five years ago.

Make no mistake, I am as bullish on the potential of generative AI as all of you are. I am not a technologist, but I am now seeing the first wave of AI startups coming into the wealth management business and some of the tools they are building for firms like mine. I get it. The efficiency this technology is bringing to us all is going to reshape the entire economy.

But, as in previous technological revolutions, there is always a point where we begin to pull too much enthusiasm into the present before the profits can actually materialize. This has been referred to as an “air pocket” and air pockets mean disappointment in the short term. They lead to retrenchment and revision, stock price collapse and a thousand failed ideas along the side of the road.

We were right to be bullish about the creation of the internet in 1999. We were wrong to think there wouldn’t be an air pocket.

I am trying to balance the promise of AI in my mind with the wariness of my experience as an investor through previous cycles. I think that’s a rational framing of the times we are living in, don’t you?

I hope you enjoy the discussion. You can listen to the episode rather than watch if you prefer, get it here.

The Biggest Boss

The legendary Joe Moglia joined Michael and I for an all new episode of The Compound and Friends this week and the stories he told us were amazing. Joe began his career as a high school football coach with a child to support, living in a storage unit at the school without heat through a New Hampshire winter. How he rose up to become the top bond salesman at Merrill Lynch followed by becoming the CEO of Ameritrade is the story you have got to hear.

We asked Joe about the recent leadership change at Vanguard, the retirement of Schwab’s RIA boss Bernie Clark and the current state of the brokerage industry. He’s never said the words “no comment” in his life, so we really got an insider’s take that I think you’re going to love.

The audio version is on our podcast feed here.

Okay, that’s it from me - I want to wish you an awesome MDW, talk soon! - Josh