Giving Thanks for a Correction

This has been a tough month for investing as a couple of big questions muddled the rally narrative. First, despite strong third-quarter earnings reports, has the AI trade become a bubble? Second, did the government shutdown gut-punch the economy?

The AI Trade
I see two good arguments for some caution regarding the AI trade. First, it is increasingly clear that the rush to invest in AI infrastructure and products has resulted in a tangled web of complex financial transactions that may mask actual market demand and compound losses if the expected returns don’t materialize. And there is a lot of money riding on these bets.

For example, Nvidia (NVDA) has invested in small AI companies, which then use that money to purchase Nvidia chips. The arrangement ends up boosting Nvidia’s sales, although in a way the company is no richer than it was before. In this resource-constrained environment, AI companies are desperate to tie up suppliers, leading to interlocking investments between competitors. For instance, Nvidia has invested in OpenAI, which has in turn invested in AMD (AMD), a competitor of Nvidia. Off-balance-sheet financing is gaining popularity as well. For example, Meta (META) has partnered with private-equity/credit firm Blue Owl to build a new data center, partly financed with debt. That debt is backed by Meta’s lease payments on the facility, and Meta is on the hook for the balance if it fails to renew the lease in the future. The thing is, Meta isn’t required to show that debt on its balance sheet. Some, like Michael Burry of “The Big Short” fame, say these complex deals artificially inflate demand and hide financial frailties.

Second, valuations in parts of the AI complex have outrun fundamentals. Alphabet (GOOGL) is up 70% so far this year. Over the preceding decade the stock averaged just 22% per year. The stock’s P/E multiple has risen from 22x to 28x—its richest valuation since 2021. The company’s financial strength and emerging AI chip capabilities justify optimism, but the stock has become meaningfully more expensive.

More speculative AI plays have moved even further. Palantir (PLTR) is up more than 100% and trades around 170x earnings. Oklo (OKLO) is up over 300% with no profits at all.

I draw a couple of conclusions from this analysis. First, the recent pullback in AI leaders—many down 20% or more—reflects a shift from fear-of-missing-out to a more realistic assessment of risks. This is healthy; corrections help keep us out of bubble territory. Second, the “AI trade” is no longer a monolith. The market is starting to differentiate between companies with real financial flexibility and those relying on hype and aggressive financing. By 2026, the burden will be on companies to show actual returns on their AI investments.

Government Shutdown
The shutdown ended earlier this month, but the lapse in data releases has made it harder to gauge the economy’s real momentum. Here’s what we can glean so far.

Consumer sentiment has weakened significantly. The University of Michigan’s sentiment index fell to the lowest level since mid-2022. The Conference Board’s survey is especially anemic, hovering around Covid-era lows. Additionally, AAII’s survey of individual investors has deteriorated to the point that only about 32% are bullish on stocks in the near term. Bloomberg ran an article today titled, “Crypto Crash Ruins Thanksgiving for Retail Traders Once Again.” Penny stocks, crypto, and other ultra-speculative plays have come undone, suggesting a shift toward caution among retail investors.

The job market is hanging in there. First-time filings for unemployment benefits held steady throughout the shutdown period at benign levels. This is very good news, but it’s only part of the story. The JOLTS survey found that planned corporate layoffs increased by about 150k in October, which is a lot for one month. And the cumulative year-to-date figure is now over 1 million. That said, the overall rate of layoffs is certainly not alarming, having returned to pre-pandemic levels. It seems we’re still in a slow-hire, slow-fire environment.

Government data on consumer incomes and spending—critical in gauging the economy’s health—are either delayed or missing. Banks and credit card companies confirmed strong spending growth during the third quarter. Visa noted debit-card payments volume rose 10% y/y in September. And even as the shutdown took hold in October, spending rose nearly 6% from the prior month. JPMorgan Chase CEO Jamie Dimon says consumers and small businesses “remain resilient.” But he also noted increased stress on lower-income households due to persistent inflation and slowing income growth.

Business-activity surveys are decidedly mixed. Regional surveys conducted by the Federal Reserve were pretty weak in the Northeast this month. And in general the U.S. manufacturing sector has struggled for the past three years. But ISM’s nationwide survey of service-sector businesses actually improved quite a bit last month. And services comprise a much bigger portion of the economy.

The shutdown will obviously drag on fourth-quarter growth, likely subtracting 1 to 2 percentage points, but history shows the impact is temporary. The more important issue for investors is the data gap. Without clean inflation readings, the Federal Reserve’s December policy path is harder to assess.