Steroid Era With Spencer Jakab, the F***’s Going on With Strategy?, Margin Debt

The Compound and Friends - The Compound

The podcast explores the current stock market's inflated earnings growth, attributing it to accounting quirks like revalued AI stakes and slow depreciation of tech assets. Spencer Jakab from the Wall Street Journal joins

Key takeaways

• Earnings growth is artificially inflated by non-cash accounting adjustments

Transcript preview

Michael the chat is booming right now I have to say so it's a stock market yeah all the gangsters are here up 4%. I would be insufferable right now. All right. We're gonna get to Nike later in the show. I want to say a quick couple of hellos to the chat. A lot of our, a lot of our OGs are here. Matt Stevick in the house, see Paul Breezy, what up. Just Dave is here. Have you seen Michael Jordan lately? He's gained a few pounds. I think he's earned that, Dave, to be honest. Georgie D says squawk and friends, okay. Not sure where we're going with that. Shapiro full-time pounder. We appreciate you brother Thanks for being here All right, and everyone I don't I don't get a chance to say hi to I do I see you I'm thrilled to have you here All right one more Jackie Jamirad is back from the greatest city on earth Philadelphia Debatable Jackie, but we love you. Thank you for being here All right tonight show is brought to you by I AM GP. Wait What is it? DBFF? E. T. T. F. 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W. W. W. W. W. W. W. W. W. W. W. W. W. W. W. W. W. W. W. W. W earnings, which obviously is the main story in the market this year. It's a bonanza. Earnings growth is significantly better than economic growth. Earnings growth is the reason why we are where we are in the market. We are not getting here. Thanks. Oh, who the what? Who could that be? Dad? Oh my God, it's Spencer Jacob. From the Wall Street Journal, ladies and gentlemen. What brings you to the neighborhood tonight? So I jumped into the discussion, man. You overheard us talking about earnings growth and you decided to come by. Well, we appreciate it. It's, you know, it's such a coincidence that you're here because we were literally about to talk about your excellent piece in your newsletter for the Wall Street Journal this morning. It's just like one of those serendipitous things. It's hard to explain even. So. All right, we're super happy. We're both on the call. Thank you. We're super happy to hear. We're super happy to hear. I want to quote you and then I want you to react to it. You did this really as I mentioned really good piece about the earnings growth this year and your title was earnings forecasts are on steroids and it's clever it's a it's a good way of thinking about it I think it's exactly right there are a lot of asterisks to what's happening to produce the sort of earnings growth that we're getting this year and then this is exactly what you said the first clue about how unusually profitable the quarter has been. is that analysts raise their earnings per share forecast for the S&P 500 by 3.4% since the end of March. And you note, analysts typically lower their earnings expectations during the quarter, which that's how we get all these surprises in the next quarter. But the average reduction has been 2.7% over the last 40 quarters. Okay, so right off the bat, this is a very unusual situation where we're actually raising the ante in the midst of the quarter itself. Tell us more. Well you got a couple of things going on you know one is that You know what's what's holding up earnings is that You have these hyperscalers spending a lot of money But it's only going through the P and L pretty slowly because they've extended the depreciation of all these chips and equipment servers that they're buying and it's revenue it's it's immediate revenue and profit for other people in the market So that that's kind of charging the earnings, but there's going to be a, you know, held to pay for that later on when it goes into reverse. Another thing though is very interesting is that the stakes in these still private AI companies, I mean, entropic, open AI, but also other companies you haven't heard of. A lot of them are stakes held by companies like NVIDIA, Alphabet, those stakes have to be revalued according to accounting rules, according to accounting rules. They get the stake in and through a public company that's got a stake in anthropic and there are many but just hypothetically the valuation of anthropic during the course of the quarter has an event meaning they raise a round of financing which raises the value of the company a public company that's got that on their books has to then in their earnings statement write up the value and we know it's not actual earnings but for the intense and purposes of what we calculate on the S&P 500, it counts. And there's a lot of it happening. Yeah, like you know how you listen to, or you don't listen to, because they don't have earnings calls, but you see Berkshire Hathaway's quarterly statements. And they don't mean anything anymore, because they have stakes and all these companies and they're going up, they're going down, and you know, they tell you not to focus on that. And it's not like Alphabet's telling you to focus on it, but those are such big companies and these that it's moving the needle for the entire stock market is creating this illusion of more rapid earnings growth. This professor at the University of Florida, by Llan Wang, looked at it and he said it about the two, it was equivalent to let's say about 12% of the first quarters in that profit and his preliminary numbers say it's going to be two or three times as large for the second quarter. So you know these are big numbers and so it creates the impression I mean earnings already is rapid is rapid, but it's It creates the impression of even faster earnings growth. And these are not cash gains. These are not things that are being sold and cashed in on. They might be one day. But it's just an accounting thing that you have to do. And just to perspective, the first quarter, the earnings growth was very rapid. The kind of thing that you see coming out of a crisis, not the thing you see year six of an expansion. ever have been 14.8% for the S&P 500. And that actually does not include these gains. So that's on an operating basis. And it's likely to surpass that during the second quarter, which is great. I mean, you can look at that as glass half full or glass half empty. I'm a pessimist, so I find it a bit alarming because you know, you're valuing the market on these and your people are saying, well, stock market is not that expensive based on that. the Wall Street Journal's dirty laundry. It's just two interpretations of the same thing, but there was a news article that appeared the same day based on the same numbers, not the extraordinary numbers on Anthropic and things like that, but just that 14.8%, and I'll somebody just read the headline to you, why Wall Street Bulls aren't worried about sky high stock prices. So I am worried about sky stock prices. I think that, you know, if once you strip out all these abnormal things, the stock market is pretty expensive, and And margins are unlikely to stay this high for that long. But forecasts for the next the rest of this year and the next couple of years call for them to go even higher, which is would be pretty unusual. You talk about this as sort of a virtuous cycle where we write up the value of things, and then that gives us cover to take stock prices even higher. And then you've got, all right, so if we're saying 12% in Q1 is coming from this right up issue of startup. and assuming the professor is right, that's going to go to 25 to 36% in the next quarter and no one's going to look at that and say, no, we're not giving these companies credit. Yeah, to be clear, you know, that the operating earnings that you see that like S&P puts out, they then strip that back out. Right, of course. But the numbers that you see when you look at the companies, you see it and people are getting optimistic about it. And it's kind of a really. choice circle because then people see these big profit numbers for the hyperscalers and invidia, you know, that own big stakes in these things. And then they say, well, Anthropic must be worth even more, right? And then the next round of funding is even higher, right? So where does it stop? I mean, how many trillion does it stop at some point? But just more broadly, I mean, it's an interesting quirk, but the fact that margins even without that are so high is, is, is is really unusual. Let's put up Spencer's chart. So you say for perspective the first quarter's net profit margin of 14.8% was about twice the post-war average. Some of that has to do with the types of companies that dominate the market. You know, we've made that point, you have made that point. Companies selling each other lots of AI gear, but depreciating it slowly is another temporary accounting boost. This chart is remarkable. So this is what you guys are looking at is the net profit margin of the P500 since the release of chat, so I guess three almost four years, three and a half years ago. This, look I'm not saying it's gonna mean revert immediately and be back at 11, but this obviously seems unsustainable or unlikely to be sustained. Is that one of your, is that one of your bigger asterisks here? Yeah, absolutely. I mean, look, I mean, and just do the math on that, right. I mean, let's let's say net margins are 15% make a nice round number this quarter and that people are saying look the market's not that expensive you know if you look at this incredible profitability and then it'll you know analysts actually expect that to get better which is not I mean it could for a quarter or two but it's pretty unusual for the whole stock market to be that profitable you can't compare it to the 1970s obviously so you know you you have different kinds of companies and different companies different private margins that's that's obvious but this is high even for a tech heavy market market but this is high even for a tech heavy market market market market market market market. It's really unusual and we know that some of it is artificial because you buy a chip from NVIDIA, you know, it's immediate profit to them, but the chip they sold you is to appreciate it over three, five, six years, right? And so that goes through the P&L more slowly. And you know, once this slows down, those margins are kind of kind of roll over it, be a little lower than... Is that the hell to pay part? Is that what you meant by that when it goes into reverse? And not just that, but just do the math on 15% versus 11% where you were just a few years ago. So you go, let's say, let's not end of the world, you're going from 15% that margin to 11% that margin. Well, that's a lot lower. That's 25% reduction. That's huge. Right. So if you say, let's keep the market's, let's keep the market's key ratio constantly. Let's say, well, we're comfortable paying 21 times forward earnings for the stock market. Well, then, then that's, that's, that's, that's, that's, that's, that's huge, that's huge. That's huge. That's huge. That's huge. That's huge. That's huge. That's huge. That's huge. So, that's huge. So, let's huge. So, let's huge. So if you're. So, let's huge. So if you're. So if you're. So if you're. So if you're. stocks get that much more expensive. So if you hold the PE ratio constant and things aren't constant, things tend to go lower when profitability is declining. But let's say that people don't get skittish about that, then the market should be 25% lower if you're justifying it based on those earnings. So it is of some concern. Things don't move and align that way, but that's a useful way to think about it. So think about where we are. To get a potential get out of jail free cards. Tell me which, or maybe, or maybe neither, these are likely. One get out of jail free card is, GPUs do not depreciate at the rate the bears say they will. And we turn around 10 years from now and there are still Grace Blackwell chips and Vera chips that were sold in 2026 operating in data centers in a decade. That's, I mean I don't know if that helps or not, but that's part of that depreciation debate. The other get out of jail free card, this is a little bit more ephemeral is is. profit margins remain closer to 15 than 11 because all the customers of all this of all this AI are more efficient businesses now and have margins that appear to be abnormal but maybe are the new normal and not subject to the 1970s 1980s type of mean reversion and profit margins we just sort of go into a new age of profitability I know I know that maybe those are both reaches but could either of those be true us out of this paradigm that we're in. Yeah, I mean, what's the famous last words? It's different this time. I mean, there's always, look, any time that you, and maybe this technology is just so amazing that the productivity gains in the economy will justify it. But we're talking about revenue growth, right? Revenue growth is pretty good this year, but it's supposed to slow down in the future. And obviously it's going to slow down because revenue growth is just nominal GDP growth, right. It's the GDP number that you hear plus inflation. And then. And then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, and then, little bit on top of that as companies, you know, gain share and become more profitable. It doesn't grow at 11%. You know, it's going to go to 11% if you have very rapid inflation, which you really don't want. Every kind of boom, whether it was the late 20s or the tech boom, you always have someone saying, okay, but we're in a new era. I think Irving Fisher like the famous, you know, you know, won't is like permanently high plateau. I mean, this could be the time, like the time, like the last 25 time, like, like, work out and this could be the time. Obviously, railroads, electricity, the internet, man flight, cars, all those things were really big and maybe this is like all of those wrapped together. The amount of money being invested in it relative to the size of the economy is like a few of those wrapped together too. So, you know, if AI is really just going to be so revolutionary that, you know, we're like being like in start, post-scarcocity Star Trek world, yeah, then it's great, it's great, great, then. We only have one more question because then you'll have like you know go into the holodec and no one will need stocks anymore we only have one more question which company is which company is Barry Bonds which is Sammy Sosa which is Mark McGuire in the in the earning steroid era you know I don't know what Mark McGuire you know I don't know what Mark McGuire came out like a lot later he was very kind of trite and humble about it Barry Bonds not so much talked about it too much. We won't make. I don't know.