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#59 Nvidia's Roller Coaster: Soaring Revenues, Global Tensions, and the Tech Sector's Future

Nvidia entered its earning day on a hot streak, with its share already up 240% year-to-date. Options trading implied an 8% swing in share price, either up or down, for Nvidia after the earnings report dropped. The chipmaker giant reported another quarter of blockbuster earnings on Tuesday as demand for AI chips continued to grow, with companies worldwide racing to build next-generation artificial intelligence-powered products.

California-based Nvidia reported a record $18.12 billion in revenue, up 206% from the previous year. The company's main revenue driver, data centre products, logged a record-high $14.5 billion, up 279%. However, Nvidia now expects a drop in sales to China for the next quarter; these sales have consistently accounted for approximately 20% to 25% of its data centre revenue.

On the day of the announcement, Nvidia shares were down about 1.5% around 7 p.m. New York time during extended trading. The performance on the day after the announcement was similarly lacklustre, seemingly contrary to the quality of the announced figures. Possible contributing factors to the underwhelming market reaction include structural pressures from an upcoming long weekend, updated US AI chip export restrictions to China from October 18th, and Microsoft's announcement that it has developed its own in-house AI chips to power its Azure cloud services, starting in 2024.

Overall, while Nvidia delivered impressive financial results, external factors such as geopolitical tensions and increased competition from Microsoft may have contributed to the cautious market response. Investors and analysts are likely closely monitoring the situation to assess the potential impact on Nvidia's future performance.

The results of Nvidia and other prominent tech stocks significantly influence the broader market, especially considering that most of the S&P 500's gains this year stem from the AI-driven rally in these companies. As AI represents the last pillar of growth, and given its critical importance, a weaker announcement could have triggered a substantial correction in the market. However, this did not occur.

We find ourselves in a period of heightened market volatility and shorter-term investment horizons. In such an environment, long-term structural trends with near-term catalysts can be a defining edge in generating outperformance. Macroeconomic and geopolitical uncertainties have led to sentiment swings, which in turn have resulted in rotations across various sectors and countries.

Certain sectors are currently undervalued, with insufficient recognition of constituent firms leading innovation or driving structural change. The market's underappreciation is exacerbated by tight liquidity conditions, which amplify market movements. Consequently, we anticipate increased macro volatility translating into divergence in securities' performance.

Approximately $6 trillion is currently sitting in cash on the sidelines, driven by record-high short-term rates and investor hesitancy to acquire equities. However, with a granular and nimble approach, specific themes and subsectors are expected to outperform cash and other assets. Given the enhanced complexity of work, investors should demand greater compensation for taking on equity risk and target specific outcomes more attainable in this market regime.

Examining the divergence within the Tech sector, one can evaluate the impact of pronounced tech stock valuations on broad index/ETF performance in the SPX versus the S&P 500 Equal Weight Index (SPXEW cancels the effects of market capitalization). From January 2007 (the start of the Global Financial Crisis) until August of this year, both indices delivered over 300% in returns, with the Equally-Weighted Index marginally leading by 3%.

The performance graph strongly suggests that the notion of tech overvaluation and its contributing performance only became prominent in the final week of March 2020. The pronounced valuation in Tech stocks is evident: from the "market bottom" of March 24, 2020, until the end of August, the S&P 500 is up 17.5%, while the Equally-Weighted Index is up 12%. This 5.5% "spread" is significant and could catalyse a fresh period of divergence. The tech overvaluation is expected to cool off, primarily through divergent valuations, especially moving away from the 'magnificent seven.'

The strategists at @MACROMETR see this potentially happening as:

-        Fading interest in NVIDIA to bolster valuations in AMD and Microsoft.

-        Intrinsic AI rotation expressed through investor interest transitioning from AI chips/semiconductors to AI healthcare.

-        A rewiring of globalization due to heightened geopolitical fragmentation pushing supply chain reorientation, along with 'isolating' China from the emerging markets pool.

Another point worth noting is that exposure to the "Magnificent Seven" doesn't necessarily equate to relevant exposure to thematic growth. Blackrock analysed a portfolio representative of US wealth investors' broad allocations to equities based on a study of 21K portfolios over a 12-month trailing period.

The chart below illustrates the theme exposure of these portfolios, breaking down total theme exposure into two categories: mega-cap exposure (dilutive) and non-mega-cap exposure (pure play). The results indicate low exposure to key themes, particularly concerning pure-play names or companies that specifically focus on products or services related to a theme.

Source: BlackRock, Morningstar, BlackRock Portfolio Solutions as of June 30, 2022.

Only 1.5% of the average robotics and AI allocation originates from firms with high sensitivity to the theme; the remainder comes from US-based mega-cap firms in the technology and communication services sectors.

Bottom Line:

NVIDIA and the rest of the "magnificent seven" can be expected to continue sliding in valuation through the end of the year, supported only by modest buy-ins in a shallow market. Regarding the Tech sector, although the market outlook is positive, there is not substantial support for a major price jump. The sector may undergo a selling period to cool off, mainly manifested through a rotation out of mega-tech into other tech and AI alternatives (as mentioned earlier).

While NVIDIA might experience near-term weakness after its 240% year-to-date run, the valuation at 24x CY24E PE is considered sustainable (especially relative to 30-35% CY23-27E sales), given its best-in-class 65%+ EBITDA and 40%+ FCF margins. With price targets ranging from $575 to $1,100, the long-term expectations are supportive of a positive trend. Alternatively, many artificial intelligence stocks beyond the already anointed "magnificent" ones are perceived as undervalued relative to mega caps and the broader technology sector. A brief look at broader valuations reveals the NYSE FactSet Global Robotics and AI Index trading at a P/E multiple of 19.7, which is less than the S&P 500 Information Technology Index's respective one of 29.0.


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