Don't Fret, It's Picks and Shovels Time in the AI Gold Rush

• Fears of a sharp economic slowdown, and worldwide heavy selling of stocks have hit U.S. stocks in recent weeks.

• Recent economic releases have shown that unemployment is rising, home sales are slowing, manufacturing production is softening, and wage gains are flattening out. These weaker economic data points have caused fears of a recession and a move out of stocks and into bonds. 

• This flight to safety has seen 10-year U.S. Treasuries to fall from near 4.75% a few months ago to 3.75% on Tuesday. The slowing economy fears have caused the S&P 500 to fall by nearly 10%. 

• The sell off in stocks and specifically in the tech stocks is hard to reconcile in the face of the solid second quarter earnings growth reports across almost all industry sectors, from AI leaders to banks and industrial companies.

• Does this big sell off mean the AI gold rush is already over? Moreover, does it mean the bull market in non-tech stocks, which was signaled in recent weeks, is also only a head fake?  

It is important to remember that gold rushes are driven by forces other than “there’s gold in them thar hills.”  At times, reality sneaks in to play a role in the pricing. The reality in this case is investors have become worried that the tech stocks have come too far too fast, and they no longer offer value at their inflated prices. There is nothing new about that worry. It’s very realistic and has been around as long as the tech stocks have been. The techs are trading at about 30-35 times earnings and projected to have earnings growth of 15-25% over the next 3-5 years. In an earlier post, I stated that if the current earnings projections for the techs and the S&P 500 prove correct for year-end 2024 and 2025, the market will go higher. My valuation model still says 5800 is the best guess of the current fair value of the S&P 500.

It is necessary to square the recent week economic news and sharp sell offs in worldwide stocksand interest rates with corporate earnings that are being reported every day. All these data

are being collected in the same time frame, and history tells us that earnings and dividend growth

have more predictive power in the long run than do changes in GDP and interest rates.

In my judgment, the billions of dollars that corporate America is investing in AI have not had nearly

enough time to find gold. We are in the “picks and shovels,” or early stages of the gold rush where

the miners are assembling the people and tools, and identifying where to mine. In short, nowthe big winners are the chip companies that manufacture the AI chips. The products

and services that will be forthcoming in the years ahead are still concepts. Yet, when giant sums

of capital are being placed in the hands and minds of the smartest tech people in the world,

life-changing products and services are assured.    

I believe an AI gold rush is underway. AI gold will be found and lead to huge stock gains in many existing, as well as start-up companies. My calling it a gold rush is not a total disparagement. The operative questions are: How much gold is there to be found, and who will find it? Almost certainly, too much money will ultimately join the gold rush, but it is far too early to declare AI dead. That being the case, the huge selloff in tech stocks is way overdone and offers a buying opportunity in the coming weeks and months.

Warren Buffett selling a huge chunk of Apple is probably the best news I have seen to assure us that AI has real merit. I am a great fan of Mr. Buffett, but he is anything but a gold rush player. He is strictly a “picks and shovels” guy. He did not sell out entirely. He just took some profits.   

In an earlier post, I said we are traversing a gold rush in AI, and almost all gold rushes end poorly for the average investor. However, for the recent sell off in AI and the stock market to be anywhere near correct, AI would have to be a complete bust. My bottom line is all gold rushes  are driven by periods of reality and illusion. AI has been called the driver of a new industrial revolution. That is big talk, but to say that AI is a bust is just as big an exaggeration.

Stay tuned.

It's Official: The AI Goldrush Is Underway

 

1. Near the end of the dot-com bubble in 2000, my business partner and I stumbled onto the notion that the techs were acting much like a gold rush. Gold was being found in the dot-com world and creating riches, but its passion was producing ever more gold miners with golden dreams.

2. Our company had traversed the dot-com craze during the late 1990s, chasing the gold like everyone else. But in early 2000, our valuation models simply could not justify the tech prices . .  . not by a mile.

3. A simple truth spoke to us: Never in the history of the US stock markets had an industry grown fast enough, long enough, to justify the prices of most tech and big consumer stocks.

4. We decided to cut back on the hottest of the highflyers. It changed our company and our lives forever.

This seemingly bold move was not based on something we were convinced we knew, but just the opposite. It was because we knew we did not know how to value the techs, and that being the case, we decided to stand aside. Even then, there was nothing bold about our decision to start cutting back on techs. In fact, we visited every client we had and admitted to them we believed the techs had reached the gold-rush state, but they might just keep going higher like they had over the last decade. The only thing we could say for sure was that our valuation models showed that many slower-growing companies were great values. We advised them we recommended placing sell orders 15% below the current prices on the six most overvalued tech stocks. Should any of these sell orders be triggered, we would invest the proceeds in undervalued dividend-paying stocks with dominant positions in their industries. 

During the year 2000, all six of the stocks' sell orders were triggered, and we bought financials, consumer staples, and industrial companies whose prices had gone flat in recent years because their sales and earnings were growing in the high single digits, much less than the 25-50% annual earnings growth of the techs. Interestingly, these undervalued dividend-paying stocks actually rose in 2000 when the overall market fell by over 10% and the dot-com gold rush ended. 

Why am I sharing this old tale? Am I predicting the AI gold rush is near its end? Indeed, are there other stocks that offer much better value with good prospects for future growth? No I’m not. I am announcing; however, that the gold rush in AI is now a reality and there are two truisms about gold rushes of the past. 1) When everyone, everywhere knows that an industry or a particular stock is the center of the investing universe, there is a good chance that everyone owns the stocks and the new money needed to push the stock higher will soon be tapped out. 2) The analysis at the end of gold rushes has always revealed that the companies that sold the picks and shovels for the miners were the best place to put your money, not in the gold miners themselves.

As one who is old enough to remember the dot-com collapse, my reason for writing this blog is to just give everyone a heads up that in my judgment, the AI phenomenon has officially reached the gold rush state. I said last time, my valuation models are showing that an S&P 500 level of 5700 is reasonable. If the AI world can produce overall sales and earning growth for corporate America of 11-12% over the next five years, the market is fairly priced. If earnings growth is higher than that, stocks still have a good run ahead of them. However, if the earnings growth falls back to a 7% or 8% handle, stocks will fall. Additionally, I do not see a long list of undervalued non-AI companies. Thus, I conclude the gold rush has room to run. I’ll keep you posted on what my models are saying as we go.

If you would like to communicate with me directly, email me at info@gregdonaldson.com  

Dividends and Earnings Say, The S&P's Current Price is About Right

The question I have been asked most in recent months is, "Is the current bull market in tech stocks signaling another dot-com massacre, or is it justified in light of the promise of AI?" 

1. Most of my questioners lived through the dot-com bubble of the 1990s and its subsequent crash in early 2000. In the late 1990s, the notion that computer and internet stocks could only go higher took hold, which proved dead wrong and devastating to many investors when some tech stocks fell by 90%. 

2. Nvidia and its artificial intelligence computer chips are skyrocketing in much the same way that Cisco and Intel did in the late 1990s, before crashing back to earth in 2000.

3. The Fed gives the impression that their rate hikes are finished, but inflation is still running near 3.5% and shows little signs of slowing on a month over month basis. 

3. If the Fed does not have inflation under control, a spike in long-term interest rates could cause another sell off in tech stocks just as it did in 2022. 

    One of the most disappointing aspects of modern day investing is we seem to have all become momentum investors. Find a winning stock, jump on board, and hope to sell out before it turns lower. Ben Graham's famous quote about how stocks operate is in full bloom today. He said, "In the short run, the market is a voting machine, but in the long run it is a weighing machine." The point being, stock prices can be driven to ridiculous levels by short-term projections of how high is the sky, but ultimately, stock prices find their correct value. 

    Over the years, I have developed two stock market valuation tools. One looks back and is primarly earnings driven. The other looks forward and is dividend and interest rate driven. Dividends would seem to be a very pedestrian way to value a gold rush, but over the years, I have found the growth of S&P 500 dividends in combination with changes in long-term interest rates have been the best risk-adjusted predictor of S&P 500 prices. At present, my dividend discount model predicts that the fair value of the S&P 500 is approximately 5800. At 5300, that would mean stocks are modestly undervalued. However, one has to realize that the forward dividends and earnings estimates are heavily influenced by Wall Street's 3-5 year forward estimates for tech stocks. 

    My answer to the questions I have been receiving about the risks in the markets is a familiar one: "It depends." It depends on whether the AI and other high-flying tech stocks can deliver the dividends and earning growth Wall Street is now projecting. If the overall S&P 500 can deliver numbers reasonably close to the current estimates, the market is modestly undervalued and vice versa. I'll keep you posted in the weeks and months ahead how the estimates are holding up and measuring up, as well report on how interest rates are impacting my model.    

  

Paul Volcker Taught Us How to Tame Inflation

I started writing a monthly investment update for the investment firm I was with in 1975. I didn't know what I was doing at first, so the older people in the firm would feed me what to say, and I would write the update.  This was just a few years after the OPEC oil embargo and inflation had shot higher. As the months rolled on and inflation continued to rise, I found fewer and fewer of the old-timers were stepping up to tell me what to say, so I became a student of the Federal Reserve in order to have something halfway intelligent to say. That was no help for several years.  Inflation remained persistently high. At times, prices changed on grocery shelves and gas pumps while I was standing in front of them, ready to make a purchase.  Interest rates kept going higher and higher, and none of the Federal Reserve's rate hikes seemed to make any difference.  

An inflation mentality set in on Wall Street, Main Street, and Ivy Street. Inflation became a way of life. We had silly government programs such as Whip Inflation Now (WIN) and a lot of other kinds of cute sloganeering that was not rooted in any economic truth because very few people really understood inflation and how it worked. 

We all became followers of the money supply.  M1, M2, and M3 discussions went on at social gatherings like somebody somewhere knew what it all meant.  "Too many dollars chasing too few goods" became the wink and a nod answer to all things inflation.

There was one man who did understand what drove inflation and how to control it. His name was Paul Volcker. Volcker was promoted to chair of the Federal Reserve in 1979. He immediately began a series of rate hikes that would drive the Fed Funds rate up from around 11% in September 1979 to 20% in March 1981. The 6’7”, cigar-chopping man taught us all that in dealing with inflation, the right course of action was to use a leading interest rate strategy instead of a lagging strategy.  In effect, Volcker made it clear verbally and by his actions that wherever inflation went, he would push interest rates even higher. His leading strategy was truly remarkable, and it broke the back of the inflation panic that had been raging through the economy for years. Inflation peaked at 14.8% in March of 1980 and by 1983 had fallen below to near 3 %. 

Today, we face another inflation crisis and the same 'we got this thing under control' illusion that I watched play out for years in the late 1970s.  Modern Monetary Theorists, who spoke so boldly of 'we got this economic thing' and advocated dumping huge quantities of dollars onto anyone who could breathe, have become silent. They should have done so much sooner.

Inflation is as much of a psychological phenomenon as it is a monetary phenomenon. The present Fed has been saying 'we got this thing' for too long.  They are losing both the psychological battle as well as the monetary battle. They must come out of today's meeting with two huge changes in what they say and what they do.  First,  they must say "Paul Volcker taught how to tame inflation, and we are now following his playbook." Second, they must raise Fed Funds by at least 1% and promise even more 1% hikes in the future. Jerome Powell must ignore the politicians, jump straddle inflation, and fight it with tools history shows us have worked.  If he continues to bow down to the politicians and make small interest rate hikes, we may be fighting inflation four years from now.

I believe the stock market understands what needs to be done and will soon find a bottom if the Fed takes a tougher stance. If the Fed keeps nickleing and diming us along, stocks will likely keep falling because big investors know that the longer we allow the current lagging interest rate strategy to prevail, the worse will be the ultimate recession.

The illusion of 'we got this thing" should end today."         

Dividend Watch: Divi-Do Land

• Media headlines have growled that dividends were dying or dead for most of the last three months 

• Yet, few in the crowd of 'Divi-Don'ters' have bothered to chronicle the 'Divi-Doers.'

•  That's a shame because there is a splendid story in Divi-Do land.  

On April 7, we made the following statement:

    "We have long believed that dividends are the linchpin tying individual investors                   
      and corporations together.  With stocks careening all over the place, it would appear 
      that traders and speculators are betting that companies will break this bond.  
      We believe the bond will hold and provide an undergirding to the overall stock market."

Early on, over 20 S&P 500 companies announced dividend cuts, mostly in retail, energy, and travel and entertainment. In late March, estimates of dividend cuts by some observers for S&P 500 companies were as high as 35%.  But soon company after company began announcing that they intended to pay their dividends.  But that wasn't all; a surprising number of companies announced dividend hikes.  The table below shows the dividend actions of S&P 500 companies made from January through June 6, 2020. 

S&P 500 Company Dividend Actions 

Through June 6, 2020

Companies Paying Dividends Paid	Companies Cutting Dividendsd	Companies Raising Dividends
363	47	146

So far 47 companies have cut, suspended, or omitted their dividends.  That represents about 10% of the Index, but only about 3% of total dividend payments.  Wall Street now estimates that total S&P dividends for calendar year 2020 will fall approximately 2.5%.
        The reason the percentage total dividend cuts for the Index will be small is the 146 offsetting companies that are hiking dividends.  In addition, some of the dividend cutters, such as TJ Maxx, have announced they will reinstate payouts once they have assessed the damage from the quarantine. The dividend hikes have a median growth rate of almost 8%. 
        In analyzing the cash flows of hundreds of dividend-paying companies, it is clear many will be borrowing to pay their dividends.  That would have seemed like folly in a time of such great uncertainty.  We believe this commitment to paying a dividend is not well understood by many investors.  Companies know that many of their shareholders count on dividend payments to pay their bills.  They also know that millions of individual investors and thousands of dividend etfs and mutual funds will sell any stock that cuts their dividends.  Finally, these companies have experts advising them on the effects of the coronavirus and its impact on the economy both in the short run and in the long run.  These companies would not borrow to pay dividends if such an action would imperil their firm.  They are taking such actions because they have concluded that the doomsday scenarios spun by many politicians, media, financial analysts, and so-called scientists are far too pessimistic.  Life will go on, and as people return to the streets, business will come alive again.
        Think of it--almost 90% of S&P 500 companies that were paying a dividend before the coronavirus struck are still doing so in the face of the most horrific headlines since the 1930s.  Of this number, over 40% raised their dividends.  That's actual money going out the door.  Either these Divi-Do companies are daft or prescient.  We vote prescient.  

Sources: Bloomberg, Marketbeat, Seeking Alpha           

Dividend Watch: A Bar Bet You Will Win

• Here's a bar bet you can win:  What is the ratio of S&P 500 company dividend hikes to cuts year to date?
• Oops, I forgot the coronavirus has made bars and bar betting taboo for most of us.  Save this one until they open.
• While the dividend news has been much better than almost any of your bar buddies would guess, there is some not-so-good news creeping in. 

First the good news: Through last Friday, 369 companies have paid a dividend in 2020.  Of these dividend payers, 124 increased their dividends at a median rate of 8%.  

Now, the bad news: 39 S&P 500 companies have suspended, cut, or eliminated their dividends since the first of the year.  More on this later.  

Back to the good news: Dividend hikes have outnumbered cuts by over three to one.  That tidbit of dividend news will win you the drink of your choice at a time and place when you once again can have social distance with friends and colleagues.  The financial media has been so full of bad dividend news that most people will bet just the opposite of what has actually happened.

Back to the bit of bad news: Bloomberg now estimates that cumulative S&P 500 second quarter dividends will fall by approximately 2% from last year.  Bloomberg also is now forecasting that total dividends for the S&P 500 in 2020 will be slightly less than 2019.  I'll keep you posted on changes in the estimates as we traverse the rest of the year.  

We look for dividend news to calm down for a few weeks.  Dividend news is often announced at regular quarterly earnings reporting intervals.  These meetings will not return to full throttle until July.

As the country opens and people begin to move toward some level of normalcy, the economic picture will either become clearer or even more opaque than it has been for the last three months.  We said early on that the dividend actions of major American corporations would tell us a lot about how destructive the coronavirus would likely be to the economy for the long-term.  We believe the dividend actions year to date by major American companies are telling a much more positive story than the "things will never be the same again" crowd who know very little about economics and even less about the truth. 

Sources: Marketbeat, Simply Safe Dividends, Seeking Alpha, Bloomberg, Value-Line

       

Dividend Watch: New Data Show S&P 500 Dividend Payments Still Rising

• The percentage of S&P 500 companies paying dividends continues to be much better than was predicted two months ago.
• Dividend increases are running almost 3 times that of dividend cuts.
• Many companies are specifically committing themselves to honoring their dividends.

The news on dividend payments by S&P 500 companies continues to be better than many experts predicted in the early days of the coronavirus outbreak.  The table below shows the dividend actions of companies that either made a dividend announcement from March 1 through today, or paid a dividend during this time.

Dividend Actions by S&P 500 Companies 
March-May 4, 2020

Dividend Paid	Dividend Increased	Dividend Decreased
361	98	35

We are approaching the end of the initial round of dividend actions by S&P 500 companies since the onset of the virus, and so far the news is good for the overall stock market and income investors.  We are awaiting only nine companies that pay irregular dividends, usually annual or semi-annual payers, and 16 companies that did not make dividend payments or declarations in March or April.  We should be able to log the remaining companies over the next six weeks.  Remember, seventy-nine companies do not pay a dividend. 

        Even though the number of companies cutting dividends are the most in many years, we are not even close to the number of cuts in the 2008-2009 Great Recession.  This has surprised many observers because the economic impact of the massive country-wide shutdown is having a more negative effect on the overall U.S. economy than did the Great Recession.  Of even more interest, many companies are taking the unusual step of promising their shareholders that they are committed to paying their dividends and will cut them only as a last resort. The following are statements from some of the largest companies making these types of public statements:

United Parcel (UPS): Our dividend remains a high priority and is a hallmark of our financial strength. We are confident our actions will continue to enable us to fund the business and support shareowner interest.

Coke (KO): We will of course continue to focus on protecting the progress we made on working capital and free cash flow in 2019. And in this context, our capital allocation priorities remain very much focused on investing wisely to support our business operations and continuing to prioritize our dividend. Specifically, with regard to the dividend, we currently have no intentions to change our approach.

IBM (IBM): The key here for investors I think are two questions. One, in any of these scenarios, do you still have the strength of your cash, your liquidity position to ensure that you can, one, invest in your business to make sure as you come out of this—that you can emerge stronger. And two, can you maintain your capital allocation and your commitment to our investors with regards to the dividend, and both of these [we answer] emphatically, yes.         

Starbucks (SBUX): To further enhance our financial flexibility, we have also temporarily suspended our share repurchase program and are taking steps to defer capital expenditures and reduce discretionary spending. We do not expect to reduce our quarterly dividend.

Caterpillar (CAT): "We continue to expect our strong financial position to support the dividend. As a reminder, Caterpillar has paid a quarterly dividend every year since 1933 through a variety of challenging business conditions. We remain committed to returning substantially all our free cash flow to shareholders through the cycles." – CEO Jim Umpleby

Exxon Mobil (XOM):  After all, Exxon and its predecessors have paid uninterrupted dividends since 1882, and management continues to emphasize that "a reliable growing dividend" 

remains a priority.

Chevron (CVX): “Chevron’s financial priorities remain unchanged. Our focus is on protecting the dividend, prioritizing capital that drives long-term value, and supporting the balance sheet.” – Chevron CFO Pierre Breber

        Some of these companies, such as the oil companies, would almost certainly have to borrow to pay their dividends.  That might seem risky, but Exxon recently reaffirmed their continued dividend payments, indicating that nearly 70% of their shareholders were either individuals who count on the dividend income or long-term investors who seek stable growing income. 

        The dividend story of 2020 is still in the early stages, and the recent positive trends could change if the country's economy takes too big a hit from the shutdown and the virus, but the story thus far has been much brighter than observers were predicting.  We believe this is an indication that stocks have seen their lows and will continue to push higher.
        The other bit of good news is that total dividends paid by S&P 500 companies is still higher than it was a year ago.  With few exceptions, the companies cutting dividends have not been big dividend payers compared to the average S&P 500 company.  Thus the cumulative dividend increases from companies hiking their dividends has more than offset the dividends lost resulting from the cuts, even though the cuts on a percentage basis have been higher.