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Good morning. After a few months of risk-on, the market is getting jittery again. The S&P 500 is down 3 percent from its recent peak as investors fear the timid price response to earnings hits. Tech looks shakiest. With long-term interest rates rising, Microsoft is down 11 percent from mid-July and Nvidia is down 14 percent. More about the latter below. Email us: [email protected] and [email protected].
Nvidia 2023 = Cisco 2000?
Here’s a chart I’ve carefully designed to make it as terrifying as possible:
That’s Nvidia’s percentage gain over the past four years, compared to Cisco’s share price gain in the four years leading up to August 11, 2000. The reason the chart is scary isn’t simply because of the staggering rise of the two technology companies. It’s scary because the stories driving the two stocks in the two time periods depicted are remarkably similar. Cisco was pitched as the critical infrastructure provider for the internet revolution – whatever the internet became, we were told in the late last century, it would use Cisco switches and routers to become it. Nvidia is being pitched as the critical infrastructure provider for the artificial intelligence revolution – whatever AI becomes, we’re told, will use Nvidia chips to become it.
What makes this similarity troubling is Cisco’s price return since August 2000:
The stock has gone from $64 to $54 in the intervening 23 years; including dividends, and investors are almost even. It’s been a terrible couple of decades, and the crucial point of its terribleness is that Cisco’s underlying results over that period have been very good. Cisco’s earnings per share have grown at just under 10 percent annually since 2000. But the stock was so expensive to begin with that growth couldn’t save it.
How expensive was Cisco? Here’s the trailing P/E ratios of the two companies over the same time periods in the first chart:
I could have chosen a different time period to make the run-up in the share price of Cisco and/or Nvidia more or less extreme. But the lagging P/E ratios are what they are, and Nvidia is even more expensive than Cisco in 2000 on this metric.
Nvidia management suggests investors should use a non-GAAP earnings per share calculation, and Wall Street analysts obediently do so. By Nvidia’s calculation, the stock looks cheaper — 133 times trailing earnings instead of 212 times, a bit cheaper than Cisco was. But non-GAAP revenue at Nvidia excludes equity compensation and merger-related expenses, which should absolutely never, almost never, be excluded from revenue. GAAP is clearly the better measure.
That said, revenue in the current fiscal year is expected to skyrocket at Nvidia, to nearly $8 per share from $3.43 last year, on a non-GAAP basis. So flip the false non-GAAP adjustments and assume Nvidia makes $6.50 on a GAAP basis this year. Then the chipmaker would have about 60 times earnings, much cheaper than Cisco in 2000 (though hardly a bargain!).
However, it’s not that simple. Is the current fiscal year an exceptionally good year, a business cycle peak or a near peak in earnings? Or is it instead a new revenue plateau that Nvidia will only build on? On the one hand, the chip industry is cyclical and hyper-competitive; on the other hand, by all accounts, Nvidia has a major technological edge over its peers. I have no opinion on this, but the market is betting strongly that this year is just the beginning. The Wall Street consensus is that Nvidia will earn $19 per share in GAAP terms by 2028.
What if bonds are no longer the safe haven?
Bonds were slammed in 2022, but the worst is behind us. After a one-off valuation reset from extremely low interest rates, bonds are re-emerging as the “safe” asset class. As inflation eases, punchy 10-year Treasury yields look attractive. Investors would do well to lock them in now.
This thinking is common enough, represented in the financial press and in this column. Is it wrong? Over the weekend, two astute financial writers, John Plender of the FT and Spencer Jakab of the WSJ, published pieces arguing that the risks of bonds need to be reconsidered. They join a growing number and make some form of this case, notably including Charles Goodhart’s demographic-focused argument and Nouriel Roubini’s doomsday prophecies.
Together, Plender and Jakab highlight four risks to bonds, which we have distilled:
The bond bull market is over. In Unhedged last month, Jenn Hughes wrote about the five long-term shifts in interest rates since the mid-1800s. One seems to have just ended. The tailwind of bond appreciation after 40 years of falling interest rates has dissipated:
An environment in which inflation and interest rates are higher and more volatile will negate the short-term volatility mitigating benefits of bonds.
In the longer term, higher inflation and the frightening fiscal outlook in the US are raising the specter of downright negative real returns.
The 2022 episode illustrated that the correlation between bonds and stocks can skyrocket at painful moments. This calls into question the main long-term benefit of bonds, which is the ability to rebalance bond market gains in favor of worn-out stocks in a recession.
There’s plenty here that you could object to, but take it for granted. Leaving aside fringe issues such as insurers and pension funds, if Plender is right about bonds being “unsafe and highly risky”, then what?
First and foremost, cash looks better. Jakab quotes Ray Dalio: “Cash used to be worthless. Cash is now quite attractive. It is attractive relative to bonds. It’s actually attractive relative to stocks.” A six-month bill currently yields 5.5 percent, well above the 4-ish percent available on a long bond and without any equity risk. You also get some optionality value. When stocks fall from their high valuations, a convenient source of funding is at your disposal. In an environment of higher inflation and rising interest rates, there is a risk that a similar rebalancing from bonds to equities could result in paper losses on the bonds. In other words, holding bonds to maturity has an opportunity cost.
Bonds are still a different asset class than equities, likely with some diversification benefit to both. But if bonds have lost their safe, bland status to a volatile inflationary world – that is, if true returns are not guaranteed even if held to maturity – the investment approach needs to change. A bond investor may need the discipline and risk management of a stock picker.
Of course, it’s a different story if fears of longer inflation are exaggerated. Bond bulls like JPMorgan’s David Kelly tend to think the economy will cautiously return to 2% inflation next year. Now that inflation has been driven out, interest rates could return to neutral, which is about 2.5 percent, according to the Fed. Falling interest rates would lower returns on cash, which would make those bond investors who locked in returns above 4 percent feel pretty good. It would also provide bond investors with some meaningful capital appreciation.
There’s a lot more to say about this, and we’d love to hear what you think. (Ethan Wu)
A good read
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