The Beginning of the End
Spontaneous optimism and instability... AI spirits... Another 29-bagger ahead?... The narrative falters... The beginning of the end... 'The Edge of the Abyss'... Signs from gold prices... Fiscal vs. the Fed...
Editor's note: Since we published Part I of our annual Report Card on Friday, we're sharing Dan Ferris' terrific weekly essay today. But before we get to that, I (Corey McLaughlin) want to quickly report on the biggest market news from the past few days...
Over the weekend, President Donald Trump said he planned to impose 25% tariffs on goods from Mexico and some from Canada, with a 10% tariff on energy imports from Canada, starting on Tuesday. He also said he plans to slap an additional 10% tariff on all imports from China. The news sent stocks plummeting when the U.S. market opened this morning.
But the major U.S. indexes reclaimed a good chunk of those losses by midday after Trump said he's pausing tariffs on Mexico for one month after the country agreed to send 10,000 of its National Guard forces to the U.S. border to help prevent illegal immigration and drug trafficking.
All along, we've said Trump's threat of tariffs is a negotiating tactic to get concessions on other matters, and it's one that appears to be working in part.
Yet, a potential U.S. trade war with major trading partners could lead to further market volatility. As Dan explains today, it's just one reason he believes a "bill of ignorance" is coming due in what he describes as a speculative market bubble...
The global economy runs on animal spirits...
That's what economist John Maynard Keynes seemed to conclude about most investment decisions in his 1936 classic, The General Theory of Employment, Interest and Money...
Most, probably, of our decisions... can only be taken as a result of animal spirits – of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities...
Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die...
Keynes also discussed speculation as a source of economic instability and capital-allocation errors in financial markets. That's where the animal spirits come in. As he put it...
A large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic.
It has always struck me as odd that Keynes seemed to discuss speculation and animal spirits as different ways in which investors' decision-making can go wrong. Nowadays, animal spirits and speculation are practically synonyms.
You'll often hear mentions of animal spirits by talking heads, journalists, and investors during times when financial markets are clearly in the grip of a speculative fever. Digest editor Corey McLaughlin shared one recent example last month.
Economists George Akerlof and Robert Shiller took Keynes' idea and ran with it in their landmark 2009 book, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. The pair described five aspects of animal spirits that influence economic decision-making: confidence, fairness, corruption and antisocial behavior, money illusion, and stories.
Though the book is about economics... the list seems tailor-made for a discussion about financial speculation.
AI-related stocks have already soared on a wave of animal spirits...
The poster child of the AI frenzy – Nvidia (NVDA) – has recently been up as much as 2,900% from its March 2020 pandemic-panic lows. The stock trades today at around 26 times sales and 47 times earnings.
Such multiples are the market's way of saying, "We believe there is no way this company will have any trouble growing revenues by 185% per year," the average annualized revenue growth of its past four quarters, for some time. Investors believe their observations are rooted in hard reality: Nvidia's revenues are up 10-fold since 2020 and 22-fold since 2016.
Nvidia's big breakthrough is the adaptation of its graphics processing units ("GPUs") – once seen as primarily suited for video games – to do the heavy computational lifting required by artificial-intelligence ("AI") software. The company has an insanely great business right now, with tens of billions of dollars in free cash flow and net margins exceeding 50%. It's widely believed that Nvidia has no real competition and that there's no substitute for its chips.
Investors see the company's huge profits, apparently unassailable competitive position, a growing AI trend, and a 29-bagger return in the rearview mirror. You can hardly blame them for seeing another huge multibagger charging at them in the front windscreen.
It's a perfect example of recency bias (favoring recent events and information over historical ones) and standard "animal spirits" calculus.
In other words, for what might seem like very good reasons right now, investors are 100% confident – and 100% ignorant of the history of speculative bubbles.
It's possible that the bill for that ignorance is coming due...
The narrative faltered last Monday...
Nvidia's share price fell nearly 17%, erasing nearly $600 billion in market cap – the largest one-day market-cap loss in history.
The news that led to the rout was that Chinese AI company DeepSeek had launched its R1 AI model. DeepSeek famously claimed it spent just $5.6 million to train its AI model – rather than the billions of dollars that Western companies have spent – and that it needs a lot less computing power than rivals like ChatGPT.
Now, it's possible that DeepSeek's deeply discounted pricing is more about disrupting the AI market than covering the company's true costs... And I (Dan Ferris) certainly suspect the $5.6 million claim is exaggerated. Plus, according to researchers at Rand, it's nothing new for machine learning to fall in price as technology develops.
But one thing is clear... If AI needs less computing power, that makes the industry less reliant on Nvidia's powerful chips.
And unlike ChatGPT, DeepSeek developed its code under an open-source business model. That means other companies can quickly take advantage of its software, too. And more-efficient AI could spread rapidly through the market, bringing down computing-power needs faster than investors expected.
Also, never forget that the semiconductor industry is a highly cyclical, highly capital-intensive industry. Blistering rallies and brutal corrections are nothing new. Semiconductor stocks fell 84% in the dot-com bust – larger than the Nasdaq Composite Index's 78% decline.
No investor with a knowledge of semiconductor cycles or the effects of technological innovations on stock prices should be surprised if Nvidia were down 70% or 80% at some point in the next few years.
There's no predicting how or when a bubble will end...
But at least one person – trader/author Nassim Taleb – thinks Monday's Nvidia rout is the beginning of the end.
In an interview last week, Taleb said the widespread belief that Nvidia would be the one company to make money from AI "is completely at odds with our knowledge of history."
He said Monday's rout was the beginning of "an adjustment of people to reality," and to expect a drawdown two or three times larger than Monday's (which would be a drop of 34% to 51%).
While most of his comments focused on Nvidia, Taleb also implied that when markets concentrate wealth into too few stocks, they're ripe for a fall. With the "Magnificent Seven" dominating the big indexes... that's not an abstract fear.
Global macro investor Hugh Hendry also chimed in, though without mentioning animal spirits or AI...
In a note to subscribers last week titled "The Edge of the Abyss," Hendry wrote (bolding included):
The rules feel different this time, but then again, that's always the delusion before the crash.
The market is flying, risk-taking is rewarded, and the Fed stands at the same precipice it faced in 1928 and 1998: force to choose between the immediate demands of offshore liquidity and domestic stability. Twice before, the prioritized global liquidity concerns... Twice before, that decision accelerated financial excess into full-blown market bubbles, and both times, the crash was catastrophic.
Like me, Hendry is a survivor who would rather prepare than predict. So he's "not rushing" to say just how or when the latest bubble will burst...
Procrastination is the only honest position when history's echoes are so deafening. I've seen plenty of compelling sirens and I've survived to write the obituaries of all those men folk who couldn't resist.
Overall, I do think the AI craze will end like all speculative episodes – with a big crash.
But Hendry also pointed out that if investors take the speculative bit in their teeth, they can ride far longer than you'd ever imagine. And I agree with that, too.
In the meantime, it's hard to miss gold making new all-time highs...
The precious metal recently traded around $2,850 per ounce. I've seen more than one investor on social media claiming that gold is trying to tell us something.
Maybe it's trying to tell us that things are changing fast and that you'd better be prepared for the consequences, intended and otherwise. President Donald Trump sits at his desk for hours a day, signing executive order after executive order as his cabinet appointees survive (so far) congressional hostility. Federal employees have been offered the choice of returning to their offices or resigning.
It'll cost a lot of money to keep his promises to modernize and strengthen the military, build an "Iron Dome" missile shield over the entire country, rebuild our cities, seal the border, deport illegal immigrants, fight a trade war with our major trading partners, and carry out all the other promises in his official campaign platform (here).
Maybe the gold market sees all that spending coming and knows it'll require large fiscal deficits and lots of newly printed money.
The Federal Reserve may have contributed to fears of continued higher inflation when it chose to keep short-term interest rates steady on Wednesday...
According to Fed Chair Jerome Powell, the central bank believes the labor market is in balance and that its twin goals of maximum employment and price stability (a euphemism for low inflation) are in balance. According to gold, maybe the balance isn't as important as the Fed thinks.
And maybe the Fed isn't as powerful as so many seem to believe. Macro investor Lyn Alden talked about the shift from Fed dominance to fiscal dominance in her May 13, 2024 appearance on the Stansberry Investor Hour podcast. In that episode, she told us...
Fiscal dominance is when the fiscal deficit and federal debts... are large enough that they start reducing the options that a central bank has, that it kind of constrains their options and the fiscal side becomes a more important impact on the economy than the monetary side.
In recent years, Alden said, the federal deficit is larger than new bank loans and corporate-bond issuance combined. Raising interest rates as the Fed did starting in March 2022 won't have the dramatic effect it did in 1980 and 1981, when higher rates caused a nasty recession in the U.S. and a massive depression in Latin American countries loaded with dollar-denominated debt.
Simply put, the Fed's back is against the wall. It's not in the position of power it had in 1980, when most money was created through bank lending. Back then, the Fed stepped in, jacked rates up and crushed inflation.
So what happens next...?
Will the Fed choose global liquidity and lower short-term rates? And if it does, will inflation soar, and will "bond vigilantes" sell Treasurys and send long-term rates higher in protest?
Or does the Fed choose domestic stability, prioritizing fighting inflation when considering monetary-policy actions? And will its policy be enough to keep inflation at bay, given the era of fiscal dominance we're in today?
Or will something else that we can't fathom play out this year or next?
I'm not making any predictions, but maybe there are even more reasons to procrastinate in your risk-taking than Hendry let on.
In the pages of The Ferris Report and Extreme Value, I will continue to emphasize safe sources of income, alternative assets that perform well in difficult markets, value stocks, and high-quality stocks.
It's reasonable to expect plenty of volatility in the coming months (and perhaps years).
Just remember that volatility goes both ways and prepare for a wide variety of outcomes.
New 52-week highs (as of 1/31/25): Alpha Architect 1-3 Month Box Fund (BOXX), Blackstone Secured Lending Fund (BXSL), Viant Technology (DSP), SPDR Gold Shares (GLD), Alphabet (GOOGL), Grand Canyon Education (LOPE), Meta Platforms (META), Sprouts Farmers Market (SFM), and VeriSign (VRSN).
In today's mailbag, some feedback on tariffs... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.
"The idea of tariffs being paid by foreign governments is either pure nonsense, political jive or just plain ignorance... Countries do not pay tariffs. USA importers pay tariffs to U.S. Customs, now Homeland Security, on top of duty rates. It raises the cost of the products we import..." – Subscriber Harold N.
Good investing,
Dan Ferris
Medford, Oregon
February 3, 2025