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The AI Payoff (and a Cautionary Tale)

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Smooth sailing, they say... Big Tech earnings are underway... AI is paying off for Alphabet... Down goes Super Micro Computer... Rick Perry on the nuclear option... Mailbag: More on the market and the election...


The economy has still been growing, they say...

Today, Uncle Sam released the first estimate of third-quarter U.S. GDP, and it showed 2.8% annualized growth. That's a little slower than the 3% rate of the second quarter, but it's above mainstream economists' expectations... and far from contraction territory.

So the Federal Reserve's promised "soft landing" – engineering the economy off a 40-year inflation high without hurting growth or employment – remains in progress without obvious alarm. On the surface, at least.

In the third quarter, consumer spending increased by 3.7%, a good sign for the plumbing of the economy. Of course, many things today cost a lot more than they did a few years ago, but the pace of inflation checked in at 2.2% according to the Fed's preferred measure.

That's the good news... But then there's this reality as well: Federal government spending rose by nearly 10%, with about 15% growth in defense spending for the quarter. That made for 0.6 of a percentage point in the headline GDP growth.

Private investment increased a paltry 0.3%, down from an 8.3% rate in the second quarter. To me (Corey McLaughlin), that's not an encouraging sign.

Today, the major U.S. indexes absorbed this information, and everything else, and finished slightly lower. The Dow Jones Industrial Average and Russell 2000 Index lost 0.2%, the benchmark S&P 500 Index was off 0.3%, and tech-heavy Nasdaq Composite Index closed down 0.8%.

In other news, Big Tech companies have started reporting their latest earnings...

This week, 20% of S&P 500 companies are scheduled to release quarterly results. And that includes multiple "Magnificent Seven" names, as well as other tech giants. First up was Alphabet (GOOGL), which reported after yesterday's close.

Alphabet beat Wall Street's estimates for both top and bottom line, and shares popped roughly 3% higher today...

As our Stansberry's Investment Advisory lead editor Whitney Tilson wrote in his free daily newsletter today, "it's hard to find any flaws with this earnings report." As Whitney wrote...

Year over year, revenue rose 15.1% to $88.3 billion (above expectations of $86.4 billion), led by 35% growth of cloud revenue to $11.4 billion (above expectations of $10.8 billion) and 10.4% growth in ad revenue (slightly surpassing expectations).

Meanwhile, expenses only rose 7.9% year over year. As a result, operating margin – already a mouth-watering 27.8% last year – expanded to 32.3% and earnings per share soared 36.8% year over year from $1.55 to $2.12, handily beating expectations of $1.83.

During the quarter, Alphabet repurchased $15.3 billion of its stock and reduced its share count by 2.2% year over year. It also paid out $2.5 billion in dividends, giving the stock a dividend yield of 0.5%...

Artificial intelligence was a big part of the company's report. Alphabet said that growth in AI infrastructure and generative AI helped fuel the cloud revenue in the quarter.

And Alphabet is still investing heavily in AI...

Chief Financial Officer Anat Ashkenazi said that the majority of the $13 billion in the company's capital expenditures in the third quarter went to things like servers and data center equipment for AI programs. And Alphabet expects similar capex in the fourth quarter.

In 2021, Alphabet spent $25 billion on capex. Thanks to AI, that number has almost doubled to $44 billion over the past 12 months. It will take a while for the results to show up in full, but one thing is for sure – companies like Alphabet are betting big on AI, and it's already paying off.

As Whitney noted...

It's simply astounding that a company of this size – it now has trailing 12-month revenue of $340 billion – can still be growing this quickly and this profitably.

Moving on, bad news for a big chipmaker...

Aside from Nvidia (NVDA), chipmaker Advanced Micro Devices (AMD) has been one of the biggest beneficiaries from the AI boom. The stock is up more than 70% over the past year, and the company expects more than $5 billion in AI chip sales this year.

But even though its data-center revenue more than doubled in the quarter, driven by demand for the company's AI chips, investors didn't like AMD's outlook – sending shares down by more than 10% today.

For the fourth quarter, AMD projected revenue of $7.5 billion, slightly below Wall Street estimates.

This is the other side of the AI story. AI companies like AMD face sky-high expectations. So any sort of disappointment like today's from AMD is going to take the wind out of the stock.

Down goes Super Micro Computer...

Then there are the cautionary tales in a euphoric trend, like the story of Super Micro Computer (SMCI), a stock linked to the AI boom that made a parabolic move earlier this year.

Today, the company's auditor – Ernst & Young – resigned because it is "unwilling to be associated with the financial statements prepared by" SMCI anymore. Yes, that's as bad a signal about a business as it sounds.

SMCI shares dropped by 32% today.

Kudos to Whitney, again, for sounding the alarm on SMCI back in August in an edition of his free daily...

I'm highly wary of Super Micro Computer (SMCI), which makes servers that contain chips made by Nvidia and others. SMCI has also been riding the AI boom, but the stock looks like it is now busting.

That was after the stock crashed by nearly 20% upon the company's announcement that it wouldn't be filing routine annual 10-K paperwork on time. It was also in the news after a damning report from activist short seller Nate Anderson of Hindenburg Research.

Whitney thought there was something to it and questioned the company's financials in his free daily letter...

Is it a coincidence? I'm not so sure...

There's a possibility that the delay is because the board and/or auditors aren't willing to take the risk of signing off on SMCI's numbers without thoroughly investigating what Anderson has uncovered.

Will he be proved correct that the company is once again cooking the books? Based on a quick look at SMCI's income and cash-flow statements, I suspect Anderson might be on to something...

Normally, these two statements move in the same direction: If a company is reporting growing sales and profits, its operating cash flows should also be growing.

For example, here's Nvidia's operating cash flow over the same time period (the past 14 quarters) as the earlier chart with revenue and net income:

This is exactly what I would expect to see – the cash-flow statement closely tracks the income statement.

Then Whitney looked at SMCI...

Here's a chart of the company's revenue and net income over the past 14 quarters – showing the explosive growth that drove the stock price:

But look at operating cash flow:

Put simply, that's just weird.

And it's hard to pin down exactly what's causing it because the company failed to include a full cash-flow statement – another red flag – when it reported earnings results earlier this month...

Remarkably, SMCI stock actually had been churning higher since that August sell-off, but not today... and I suspect this story will get worse before it gets better.

Where there was smoke, there was fire... And it's a reminder to do the research, that financial statements and management do matter, and to separate the real long-term winning trends and businesses from short-term plays that appear too good to be true.

I'm sure Whitney will have more on this story soon.

A lot more to come...

Apple (AAPL), Meta Platforms (META), and Microsoft (MSFT) are also reporting this week, the latter two today after the closing bell as we near our press time. These three companies, plus Alphabet and AMD, represent more than 20% of the S&P 500's market cap. So the results will influence headline activity...

What's more, they're all big names in the AI trend. So these quarterly releases can serve as a huge catalyst for the market and the AI bubble in the near term – and more of an indication of what's really going on with the trend.

As we saw with Alphabet and AMD, we could see huge swings in stock prices if any of these companies miss (or beat) Wall Street's expectations... We'll keep you updated on any more market-moving developments in the coming days.

The Nuclear Option

During our Stansberry Research conference in Las Vegas last week, I had the chance to sit down with Rick Perry, the former Texas governor and secretary of energy under Donald Trump, to talk about the future of energy in America... and why he's bullish on nuclear...

Check out the full interview on our YouTube page... and stay tuned here for more information on our 2025 conference. We'll be sharing details and offering early-bird presale tickets soon.

New 52-week highs (as of 10/29/24): Agnico Eagle Mines (AEM), Maplebear (CART), Commvault Systems (CVLT), Franco-Nevada (FNV), SPDR Gold Shares (GLD), Omega Healthcare Investors (OHI), Sprott Physical Gold Trust (PHYS), Snap-on (SNA), Spotify Technology (SPOT), Summit Materials (SUM), Texas Pacific Land (TPL), The Trade Desk (TTD), Tyler Technologies (TYL), ProShares Ultra Gold (UGL), Zebra Technologies (ZBRA), and Zoom Video Communications (ZM).

In today's mailbag, more feedback on Monday's edition that discussed the market's take on the presidential election... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"In your 10/28 daily Digest, you note that the consensus on the recent rise in the stock market indicates that the markets are predicting a victory for Trump in the upcoming election. I'm questioning whether that is true in this case. When 23 Nobel Laureates evaluated and compared Trump's economic plans with [Kamala] Harris's, they concluded that Trump's plan would create much economic uncertainty and much higher inflation than Harris's plan. And these concerns are shared by many other economists. Given that the markets hate both uncertainty and high inflation, wouldn't that indicate that a rising stock market is calling the race for Harris? Your thoughts?" – Subscriber Michael S.

Corey McLaughlin comment: Thanks for the note, Michael. There's a lot going on in that logic, so I'll do my best to answer.

First off, without having read the full evaluations of those prize-winning economists, I won't comment on them other than to say that what mainstream economists believe should not be taken as gospel. As a group, they are wrong about a lot of things a lot of the time. Plus, the market is made up of a lot more than those 23 people or just economists.

I also don't think many people, economists or not, will accurately predict how the market will perform under a particular president. Often, things turn out the opposite of what the mainstream "consensus" is.

For example, during Trump's first term, which brought with it uncertainty about trade policy with China and a pandemic, the Dow Jones Industrial Average returned about 12% annualized. Under Barack Obama, who came aboard amid the financial crisis and ushered in major financial policy we're still feeling the effect of today, the Dow went on to return... about 12% annualized.

Lastly, while I agree that uncertainty tends to lead to volatility, I wouldn't say markets always hate high inflation... at least in the short term.

Stock prices can go much higher than you might ever imagine as high(er) inflation builds, as we saw in late 2020 and in 2021. That doesn't mean it's "right," though. It comes with consequences, like the continued devaluing of the U.S. dollar, and then higher interest rates to "fight" said inflation (2022) and consequences from that. (These are all reasons to be bullish on inflation hedges and own stocks.)

I noted that sentiment in the market appears to suggest expectations for a Trump win because of all the headlines – and betting odds – we've seen about it. What most stands out to me right now is we're seeing Melt Up-like "euphoric" behavior in speculative bets directly tied to Trump winning, like Trump Media & Technology (DJT) shares, which are up 250% in a month. Moves like these don't typically end well, and the stock was down 20% today.

Now, all that said, I've reached your same conclusion about what a rising market indicates about the potential election outcome – but for a different reason. Repeating what we wrote on Monday, an up market in the months leading up to an election, without an "official" recession in the prior four years – bodes well for the incumbent or incumbent party, according to history.

Since 1928, if the U.S. benchmark stock index has been up from July 31 to October 31, the incumbent president or party has won the White House more than 85% of the time. Since 1932, the incumbent or incumbent party has never failed to win reelection unless a recession occurred during the current presidential term. The idea to me is that in this scenario, people have fewer reasons to kick out the current president or his party.

That's the situation today (though I personally contend a recession did happen during Joe Biden's term in late 2021 and early 2022 with negative GDP growth in two straight quarters). But we'll see if history rhymes or not soon enough. And whichever way the election goes, I'm betting on more debt and inflation.

All the best,

Corey McLaughlin with Nick Koziol
Baltimore, Maryland
October 30, 2024

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