AI Stocks VS The Federal Reserve System (Fed): Navigating The Distorted Stock Market Reality
Despite the fastest interest rate hike in history and the highest inflation in 40+ years, it is remarkable to witness the current unshakable market optimism. The systemic risk in the U.S. banking system continues to persist, elevating the concerns about an imminent downturn in the U.S. economy. However, investors are mesmerized by AI stocks, and they are underestimating the current risks involved. Some have even started to wonder if the next bull market has already begun.
In this article, we will explore the divergence between seven AI stocks and the rest of the market, along with the existing risks, and why it is important for investors to be aware of them, even in the current AI boom.
The Distorted Stock Market
AI hype has taken over the market. Investors have become increasingly bullish on the future of this new technology, and they have forgotten about the rest of the market sectors. The seven AI stocks mentioned above have all seen historic gains in recent months. Meta Platforms, for example, has seen its stock price more than doubled since the beginning of the year. However, in this same period, most of the S&P 500 companies lacked any kind of momentum.
This dissonance between AI stocks and the rest of the market could be a big red flag that investors are quickly brushing off in favor of making potential quick profits.
FOMO (fear of missing out) is a real psychological phenomenon that can impact individual investors’ perception and ultimately the overall market. When investors see other people profiting in a particular sector, they may feel the need to get in on the action and not feel left out, even if they don’t fully understand the sector and the risks involved.
This herd mentality could be driving the recent volatility in AI stock prices. However, the problem is that excessive impulsive investing can create a speculative bubble, which is a situation where the prices of stocks are far higher than their intrinsic value. When the bubble eventually bursts, the reversal could be very fast and severe for investors, causing them to freeze and lose money.
Having said that, investors should remember that AI stocks can still have a long way to go before reaching the ‘bubble danger territory’. However, having the right tools and the right knowledge of when the market sentiment might get sour is key in investing.
The FED Facing A Difficult Decision
As Inflation seems to be stuck around 5% for the past few months, this led the Federal Reserve to reconsider its recent plans to ‘pause rate hikes’. Chairman Powell reiterated the Fed’s 2% inflation goal and expects more rate hikes ahead as the inflation fight “has a long way to go”. Right after his speech, the odds of a 25-basis point rate hike in July hit 80%, and a 15% chance of 2 more rate hikes by September. Looks like the Fed is not backing down.
Why is this a problem?
The Fed’s decision to reverse course on the rate hike pause is a sign that the central bank is serious about tackling inflation. However, it also raises the risk of a recession. Higher interest rates can lead to slow economic growth, reduce consumer spending and make it harder to borrow money and invest. This is why the Fed is in a quiet predicament. The only strong economic indicator that the Fed is relying on is the unemployment data, which was very stable at 3.7% in May. If Powell raises rates too quickly, it could choke off economic growth and put a dent in the only positive economic indicator.
Therefore, the ultimate challenge for the Chairman is to raise rates just enough to cool down inflation, but he also needs to avoid raising rates so much that it causes a recession.
The next few months will be critical for the Fed as it tries to navigate this difficult trade-off.
However, the Fed’s track record of avoiding recessions in the past is not quite impressive.
Why Interest Rates Matter?
Understanding interest rate cycles is a key macro component that can help investors navigate through the market cycles more effectively.
Whether the Fed decides to tighten or ease the monetary policy, both have a huge impact on the overall market cycles. Understanding the difference between the two and the impact that it has on the market is crucial for any investor.
In this current environment, the Fed keeps tightening the monetary policy to fight this stubborn high inflation. However, the downside of higher rates is that it can lead to a slowdown in economic growth, a decline in risky asset prices such as stocks, and poses systemic risks in the banking sector.
Why does the banking sector get hurt?
Higher rates make it more expensive for banks to borrow money, which can reduce their profitability and can lead to a number of problems such as increased loan defaults and reduced lending.
We already had three banks liquidated and collapsed this year, Silicon Valley Bank, Signature Bank, and First Republic Bank. If rates keep going higher, we might see some more.
Do you remember how the 2008 financial crisis began? It was with the collapse of the Lehmann Brothers investment bank.
The chart above suggests that we may be in a late market cycle with interest rates keeping on rising. Additionally, History shows us that the potential consequences of a hawkish Federal Reserve are not to be taken lightly. If that’s our case right now, then it could be only a matter of time before something “breaks” in the economy and triggers a recession.
What To Expect With This Market Cycle
Having said all of that, recessions are a natural and necessary part of every market cycle to remove excess, reprice assets, and tame risky behavior. Therefore, if the alarm bells start ringing in the next 6 to 12 months, investors should recognize that it is a natural part of the market cycle and that it can be beneficial in the long run.
After every recession, there is always a new bull market arising with new opportunities. A lot of investors believe that the AI bull market has already started, but a lot of data suggest otherwise. It is crucial to remain cautious, consider broader market sectors, and understand the impact of the interest rate cycles to navigate the market effectively.
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