Improvements in the state of the economy and the growing potential for interest rate cuts fueled a broad-based market rally.
There’s little doubt that one of the biggest contributors to the market rally that began early last year is the growing adoption of artificial intelligence (AI). Countering that bullish sentiment, however, are lingering concerns about the ongoing battle with inflation and its impact on the economy.
The Federal Reserve Bank has been resolute that it would not begin lowering interest rates until there has been a marked improvement in the rate of inflation. Consequently, interest rates remain at 22-year highs, but the latest read on inflation was better than expected, fueling hopes for a rate cut and sparking a broad-based market rally.
With that as a backdrop, chip designer Arm Holdings (ARM 3.57%) rose 3.2%, semiconductor giant Broadcom (AVGO 5.36%) rallied 4.9%, and memory and storage chipmaker Micron Technology (MU 7.06%) climbed 6.5%, as of 1:06 p.m. ET on Thursday.
A check of all the usual sources — regulatory filings, earnings results, and changes to analysts’ ratings and price targets — turned up very little in the way of company-specific news that helped drive these AI stocks higher (more on that in a moment). It seems the market bounce today was primarily driven by the improving state of the economy and what it signals for the future.
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Persistent and stubborn inflation
Yesterday’s monthly report on inflation, courtesy of the U.S. Bureau of Labor Statistics, provided good news on the inflationary front. Prices continued to cool, providing much-needed relief for price-weary consumers. The Consumer Price Index (CPI), the most widely watched measure of inflation, rose 2.9% in July compared to the year-ago period. Prices rose just 0.2% month over month. This marks the lowest rate since early 2021.
The monthly rate came in as predicted, but the yearly comp was better than expected, as economists predicted inflation to increase 3% year over year and 0.2% sequentially. The “core” data, which excludes volatile food and energy prices, was up 3.2% compared to this time last year and climbed 0.2% sequentially, both in line with expectations.
The Fed continues to push to achieve its 2% inflation goal. However, a growing chorus of economists are predicting the Fed will cut interest rates by 0.25% in September, while some even suggest rates could be cut by 0.5%.
While progress is being made, hotspots remain. Shelter prices — primarily made up of rental rates — were the largest contributor to the increases, as consumers continue to bear the burden of high housing-related costs.
Interest rates have been on the rise since March 2022, and investors and businesses alike are eager to see the first of many rate cuts, as this would spur additional business and consumer spending, ultimately boosting the economy. With inflation marking its lowest increase in more than three years, Wall Street is increasingly banking on rate cuts to begin sooner than later.
The only other catalyst
Yesterday marked the deadline for hedge funds to file their quarterly portfolio disclosures with the Securities and Exchange Commission (SEC). Revelations that notable investors have made changes to their holdings have been known to move stock prices.
To close out the second quarter, Paul Singer’s Elliott Investment Management disclosed in a regulatory filing that it had taken a stake in Arm Holdings, albeit a small one. The billionaire investor bought roughly 150,000 shares of Arm stock in a stake valued at $24.5 million. For context, that only amounts to 0.24% of Elliott’s overall portfolio, so it likely didn’t move the needle much.
AI has generated a lot of headlines since early last year, largely thanks to the heavy spending by hyperscale cloud providers and big tech companies that have been eager to profit from the technology. However, other companies have been reluctant to spend on new and, as yet, largely unproven technology, particularly in the face of higher borrowing costs. That said, many more may take the plunge as interest rates come down and generative AI proves its value.
To be clear, excitement about the potential of this groundbreaking technology has driven valuations in the space higher. Micron Technology, Arm Holdings, and Broadcom are selling for a whopping 332 times, 71 times, and 52 times earnings, respectively. That said, the price-to-earnings (P/E) ratio is virtually useless for valuing high-growth stocks. The more appropriate price/earnings-to-growth (PEG) ratio, which takes into account a high growth trajectory, reveals multiples of 0.1, 0.2, and 0.8, respectively, when anything less than 1 indicates an undervalued stock.
This suggests that for investors with an appropriate investing timeline and the stomach for volatility, these AI stocks might be worth a look.
