Hello my friends. Today is November 15th and this is Markets Weekly. So this past week was another exciting week in markets. We had finally the end of the government shutdown, the longest in US history.

And we also learned that some of the data that uh releases that we missed we may never see. So we are probably never going to find out what happened to the jobs market in October nor will we have an October CPI. Um

looking at the equity markets, it was also a volatile week. We rallied earlier in the week, but towards the end of the week, you know, we we kind of um had a lot of volatility, big declines on Thursday. On Friday, we once again tested the 50-day moving average on the S&P 500, bounced off of it,

and remember, we are in a seasonally positive part of the year, and that Christmas Santa rally is a real thing.

Now it seems like the S&P 500 and broader markets were upset by two things. First off, of course, was that it looks like a Fed December cut is becoming less likely. And secondly, there are cracks emerging in the AI narrative, which has been a big driver in the equity market.

So today, let's talk about two things. First off, let's talk about why the market is uh pricing in only a 50% chance of a December rate cut and what the cracks are in the AI narrative.

Starting with the Fed. Now, let's rewind a little bit. Now, after the September FOMC meeting, the markets were pricing in a 100% chance of a December rate cut. Why?

Well, it's because the the Fed basically guided towards that in September. Remember, in September, we got a dot plot. And if you look at the dots on the dot plot where each dot shows where a Fed official thinks rates would be at the end of the year, you'll see that a majority were guiding towards a December rate cut.

But not all. It was uh you know, it wasn't a very big majority. You had a sizable uh plurality that thought that maybe we just need one or two cuts this year. But in any case, the market saw the dot block and was basically thinking that yeah, we're going to get a December rate cut.

Moving on to the most recent October meeting, Pawa had very, very memorable and strong words. Here's what he said. In the committee's discussions at this meeting, there were strongly differing views about how to proceed in December. A further reduction in the policy rate at the December meeting is not a foregone conclusion. Far from it.

So Powell was basically strongly telegraphing to the market that he did not have uh enough support at least at that time uh to guide towards a December rate cut. There seems to be a lot of vocal opposition to a December rate cut and so he basically pushed back against it and so December rate cut odds gradually faded.

Now, this past week, we got a lot more Fed speakers, specifically a lot more Fed presence speaking, who were sounding a very hawkish note. Now, what they were saying is basically that, you know, I don't think we should cut rates. We should basically wait and see.

From their perspective, they were worried about inflation and they felt that the labor market was was okay. Now if you look at uh this the data again this is going to be out of data a little bit but it's the most recent official data we get from uh from the government you can see that the Fed is in kind of a difficult situation.

On the one hand inflation has been stuck around say 2.7% for some time. It really hasn't been going anywhere. On the other hand you see the unemployment rate gradually creep up. So they are at a time where things are moving in opposite directions and they're not really sure um where inflation will be because some of them are afraid that tariffs will actually move inflation higher

and they're not really sure how the labor market will perform because you know we have this changes in population growth whereas the weak job numbers we saw earlier in the year could be in part due to just slower population growth.

And a third dimension that they're really not afraid of, not sure of is how restrictive is monetary policy is say a 4% 3.8% Fed funds rate. Is that restrictive today? Some people uh will will say that you know the economy has changed between now and the preandemic world and so where we are now not super restrictive

and you have other people who would say that you know the structural forces that kept u the neutral rate low are still there. And so uh we are still pretty restrictive. So we have all sorts of uncertainty and on top of that different risk tolerances.

Some people are just have a a lot more sensitive to inflation um being above target since it has been above target for uh a number of years. So all this confusion is ending up to the market just saying that hey 50/50% of a Fed December rate cut

and a lot it seems at least part of the enthusiasm in equity markets has been due to the fact that hey markets are kind of in a mania fed's actually going to be cutting into it and for sure expanding their balance sheet so let's party on.

Now this is actually historically quite strange. Uh usually when we have these big mania, let's say during the.com or during the 1920s, we have the central bank actually raising rates. Not so much to try to pop the bubble, although that may play a role in it.

But usually when you have strong stock markets, you also have a strong economy. Uh it just doesn't seem to be the case at the moment. Now, from my perspective, I think all this hawkish talk is really, really strange because, you know, if you were kind of dovish in September, between then and now, we really haven't had a lot of official data.

So, you know, you haven't had good data to change your mind. And I think just as importantly, the government shutdown itself is a headwind, right? You had, you know, all these government workers who weren't doing anything, industries that were reliant upon their patronage, not doing anything and all these flight disruptions that are, you know, impacting airlines and so forth.

Now, a lot of the economic slowdowns from the government shutdown will reverse as uh government workers get back pay and spend that money, but some of that will will be lost and never come back, right?

And if you were a government worker, let's say buying a sandwich at a local restaurant by your office every day, uh you're not going to go back and buy two sandwiches instead. That restaurant owner is just never going to get that lost revenue back.

So if you had these headwinds, it would seem that you would, you know, at least continue your doubbish bias. There's certainly no reason to to um switch to hawkishness. And and yet we do have some Fed presence who seem to have switched.

Now, at the end of the day though, the most vocal uh hawks are Fed presidents and many of them don't even vote at the moment. The more important people, the Fed governors, there's still a very strong contingency there that are leaning doubbish.

Governor Moran, I would assume that um the other Trump appointees are also leaning towards a cut a cut in December. I suspect that John Williams, president of the New York Fed, is as well. And I think that Pablo probably is leaning towards a cut as well.

So at the end of the day, I I think it's still it's still likely that we would get a U December cut, especially if the data that comes in uh is weaker than than expected.

One thing I'll also highlight is that we have this brand new research out of the San Francisco Fed that Nick Turos of the Wall Street Journal highlighted and that's showing that tariffs are actually uh disinflationary and raise unemployment rates looking through 150 years of history

and the reason of course is really simple. Tariffs are basically a tax and when you increase taxes that slows down the economy which of course you have less demand that means unemployment rate goes up and inflation goes down which usually combination would lead to um more monetary policy easing.

So all these talk about tariffs pushing up inflation so that the Fed should stay more hawkish that's you know just not supported in in data and so far I think more of more and more people on the FOMC are becoming to realize that the hawks not really sure what they're looking at but uh a lot of time in the data for them to change their mind.

All right the second thing I want to talk about is cracks in the AI narrative. So again, as we've talked about before, AI is the thing that's driving markets higher. Companies spending hundreds and hundreds of billions on it. Not really clear how they're going to make money off of it, but you know, that doesn't stop the equity market.

Now, the two cracks emerging in the equity market this year are increases in the CDS, so credit default swaps for certain AI companies, suggesting some concern from bond investors about the AI narrative. And secondly, you have um I guess more concern from the earnings perspective uh due to uh depreciation charges.

And this was raised by famed shortseller Michael Blurry who was of course famous for calling the uh mortgage bust in the 2008 financial crisis. There's a movie made about it as well. Uh Christian Bale plays Michael Bry there. It's a good movie.

Now, first let's talk about the cracks in the AI from the bond market. So over the past uh few weeks we see that the CDS spreads for Oracle and for Coreweave which are two companies that are engaged in the AI buildup boom basically widen significantly

and what that what a CDS is it's basically uh insurance premium for default on their bonds and so when CDS spreads widen that means investors are demanding uh that means insurance premium agreements are going higher. That means investors are getting more concerned about uh these companies defaulting on their debt.

Now, Oracle, we've talked about before, they had a just a tremendous mind-blowing rally from their most recent earnings report. At that earnings report, they guided towards tremendous amounts of u AI related buildout. They were going to build all these data centers and, you know, sell this compute that they had contracted out with AI companies.

And so massive AI buildout, massive AI contracts for compute and you know their stock basically went to the moon and uh these are all promises in the future and and if you were to uh find to be a bit skeptical I think it'd be understandable

but in anyway in order to provide all that compute obviously they have to spend a lot of money and build out data centers. Part of that money was financed in the debt market. So they went and borrowed some money and started are starting to build data centers.

Now if you are a bond market investor financing that debt again you're going to be a bit more spec skeptical uh because in order for you to be repaid that data center spending actually has to generate revenue that covers its financing costs.

So you know bond market investors they really cared about being repaid. They don't have that to the moon upside that equity investors would have. And so it seems like some of the bond market investors are becoming concerned that hey maybe these AI data centers might not generate enough cash flow to repay me and so I'm getting a bit concerned.

Again that's a crack in the belief that AI is just going to be this huge thing that's going to change the world. A similar company Core which also of course is in in the business of building data centers also saw their credit spot swaps widen.

So that is some crack in the AI narrative but I have to remind everyone that uh the bulk of the AI spending is financed from the hyperscalers like Meta, Google, Amazon and so forth, Facebook and these guys are paying for most of their AI spending from their cash flows and they generate enormous amounts of cash.

They are the uh actually some of the world's most successful companies generate huge amounts of cash. They're taking that cash and uh building AI stuff. Some of it, you know, they have some debt as well, but of course they generate so much cash and such successful businesses, not something to worry about.

So the bigger picture is that, you know, you have some cracks on the periphery, but really the big part of the sorry uh the Mac 7, the hyperscalers, these guys, uh they're still fine. Um, you can make an argument that if you spend cash on data centers, you don't have cash for stock buybacks, but it seems like they are saving money by cutting headcount so far anyway.

And of course, we get to hear from Nvidia this week, which will really help us understand the narrative better.

Um, the second crack that's emerging has to do with um whether or not these tech companies are properly accounting for their depreciation expense and this was raised by Michael Blurry.

So, what is depreciation expense? So, if you buy a physical asset, let's say that actually you buy a rental home, it costs $500,000 to buy it. And every year you get rental income, let's say uh $50,000 in rental income.

So, when you for tax purposes, that 50,000 in rental income isn't pure income because you have cost you have costs to uh obtain it. you you actually you bought a house and that housing cost has to be spent over uh the lifespan the useful life of the house.

Now the useful life of the house you it's you know it's it's going to be but from accounting purposes let's say that it's um you know let's say it's 20 years 25 years in any in any case you divide the depreciation lifespan and that is your annual depreciation cost.

That's costs that you incurred in order to generate that $50,000 in rental income. And so when you have higher depreciation, you have lower income uh because uh you're allocating more of that real asset cost uh to the income to against the income.

Now at the moment, a lot of these guys are buying a tremendous amounts of GPUs and are giving them a depreciation schedule of about five years. So, if you spend $100 on your GPU, let's say that every year you're recording $25 uh $20 of cost against that.

So, uh let's say you made $100 in revenue from your AI data center. Your only cost is your GPU. Now, you record $20 of GPU cost depreciation against that. That's basically saying that you had to buy a GPU to get that revenue. That's a cost.

the GPU has a useful lifespan about five years. And so you're just saying that, hey, let's do a $20 cost a year. The longer the lifespan of the GPU, the smaller the depreciation you get each year, and so the bigger your earnings look.

Now, what Michael Blurry is suggesting is that the GPU lifespans that are being proposed or being used by these big tech companies are too long. And because they're too long, the depreciation charge is too low. So they're not properly accounting for the expenses they are incurring in getting their revenue and artificially boosting their profits.

Now that's a logical argument. So when I look at computers, when I look at GPUs, you know, usually technology progresses pretty quickly. So a 5year lifespan probably not super reasonable. Maybe it's 3 years, maybe it's four years. It's hard to say

um Nvidia is going to come up with a new GPU say every year and so maybe your old GPU becomes obsolete faster. Now other people would say that even old GPUs are still used at a 100% because they can do you know simpler tasks and so a 5year lifespan is appropriate.

Again this is all hard to say. Uh but if you think that depreciation is too long then you would assume that they are overstating their profits and then the stock uh you know if the profits are overstated that should be negative for their stocks.

Uh but of course we all know better right uh stocks can have no earnings and still go to the roof. But if you're a fundamental investor like Michael Blurry again uh you would point towards things like that and that is totally legitimate, totally valid.

But uh earnings don't really seem to matter all that much at the moment. And so these concerns about the overstating of the GPUs and of the um credit concerns in the AI narrative seem to have shaken confidence a little bit as well.

So that seems to be what's happening. Now next week we have a lot to look forward to. We have data that um was supposed to be released. We're going to get the September NFP data and we're going to get Nvidia earnings.

Now before we get too bearish on the market, we do seem to be losing a little bit of momentum. You know, you could have a very clear path where say that Nvidia is totally okay, as it usually is, reaffirming the AI narrative.

and you could have data come in weaker than expected going forward. that puts a December rate cut back on the table and then you know you could easily see uh the seasonal effects kick in and uh see us at 7,000 by the end of the year.

That is in my personal view probably a pretty likely path and of course we could also go down. So in any case next week will be very important. Let's watch Nvidia and let's see what the data brings. All right, talk to you guys next week.