The market is celebrating, but investors should ask whether they are being paid enough for the risks in front of them.
KEY TAKEAWAYS
Markets are making new highs, led by AI, strong earnings, and renewed investor optimism. The S&P 500, Nasdaq, and Dow are all showing impressive strength.
Risk management remains the central discipline. Investors should start by asking what can go wrong before chasing what looks like easy upside.
The Fed is a major risk with Kevin Warsh taking over as chair. Inflation remains hot enough that the market may be underpricing the possibility of a hawkish surprise.
Oil remains a serious macro threat. The Strait of Hormuz disruption is keeping crude elevated, feeding inflation, and pressuring consumers and corporate margins.
China headlines may be helping sentiment, but the actual trade framework remains fragile. A photo op is not the same thing as a durable grand bargain.
MY HOT TAKES
There is no free lunch on Wall Street. Any return that looks unusually attractive has risk hiding somewhere, even if the pitch deck forgot to mention it.
The rally is not fake, but it is not risk-free. Strong earnings and AI capex can coexist with serious macro landmines.
Investors are getting too comfortable calling major risks “edge cases.” Warsh, oil, inflation, and China are not edge cases; they are the main event.
The AI trade is powerful enough to keep markets levitating. But at current levels, investors need to ask whether they are being paid enough to own the downside.
The best investors are not pessimists. They are people who ask uncomfortable questions before the market forces everyone else to ask them. 😉
You can quote me: “...the last few inflation numbers are so ugly, even doves would have to hold their noses–er, beaks–to vote for rate cuts.”
Don’t look down. Everyone has their own way of looking at things. Some folks look at the markets with filtered glasses. That is to say that they only factor in what is convenient for them–facts that support their thesis. Of course, we know that strategy is a dangerous one. To be successful, an investor must factor in as much data as possible when making choices. The good news is that–these days–there is lots of data available.
But still, if investors are only paying attention to data that supports their choice, they are setting themselves up for painful disappointment. For me, it has always been about risk management. It sounds simple in theory and–I am sure–that you are already nodding your head thinking, “obviously Mark.” But, my friends, saying it and doing it are two different things. What am I getting at?
Well, using my preferred approach is not exactly exciting. In fact, it can get scary and depressing sometimes. The relationship between risk and reward is such an elemental concept in life, it often surprises me that even some of the most prolific investors seem to forget it. I understand that when hard-earned capital is on the line, emotions can get intense, and those emotions can flummox up even the most disciplined among us.
I am going to give you an example that I encountered in my recent travels and then get to the heart of this matter. Stick with me.
I recently ran into a friend who has many years of investing experience, and he was going over an investment that he was considering. His pitch was perfect. Amazing returns on an asset class that typically didn’t offer such returns. It was sexy, elegant, and best of all, it offered great returns. Sign me up! I asked my friend what the risks were, and he said something to the extent of “there are none.” Now, he probably sensed by the look on my face that he lost me, so he quickly amended his initial statement by saying “insignificant!” Now my hackles were up, I couldn’t just leave it there, I needed to teach him a lesson in finance.
I asked him one simple question: “what risk am I taking to get the additional return for his investment over the traditional form of the investment.” He struggled to find an answer. He was literally convinced that the premium on his investment was some sort of divine gift–that he alone discovered. IT WAS FREE–in his mind at least.
I decided to ask him questions to help him out. I ran through a laundry list of what I thought could go wrong and result in…well, losing all my capital. I could tell that he was not happy with my questions, but he had an answer: “that’s not gonna happen, he explained.” Well, that might have been good enough for his money, but mine was not getting anywhere near it.
You see, I always start with the risks first. What are the risks–what are the chances of those “bad” things happening? Once I fully understand the risks which, by the way, include not just investment-specific risks, but also environmental risks–macro risks. Once I know the risk, then I can ask myself what I need to get paid to take on those risks. Rather than saying, an additional 2% is awesome, sign me up. I deeply ponder the worst case scenario to come up with a probability of loss, and end up with: how much additional return do I need to take on a 50% chance of losing my invested capital? Side note: there is math for all this–but that is for another blogpost. 😉🤓 Once I come up with a number, I compare it to what is on offer. Is it more or less? It’s usually less, so I often pass–my family calls me Dr. No because I say no more than I say yes. 🤣 If it’s more, I recalculate. If it’s close after recalculating, it makes it onto my watch list.
Walking around and constantly dreaming about what can go wrong, as I intimated earlier, can make one well…jittery. However, to be successful, there is no way around it, you have to start with the risks–deeply understand the potential painful realities that await you enroute to investing glory. None of this should shock my long-time followers who know that I spend an inordinate amount of time highlighting risks.
Lately, in case you missed it, there are quite a few risks to consider when pondering investments. If you have been reading my notes or watching my videos regularly, you are probably expecting me to be hoarding cash, gold, and canned foods in a bunker beneath my garden. Not at all! I highlight these risks for you because…wait for it…you have to understand the risks before you can ponder the reward. Now, the S&P and the Nasdaq both closed at all-time highs yesterday. The Dow is not far behind. Some stocks are posting double-digit daily returns while super-hot IPOs dominate the water cooler banter. AI is huge and going to be even more huge (is that even grammatically correct) yet. We know that. It takes a lot of spending to get it there. There are chips, software, power, servers–even bull dozers. Any company that is credibly in that space has benefited and is likely to benefit more in the future. Many of those companies have pushed the indexes to these fabulous heights. So, just buy…right?
There is war right in the middle of a sea lane that carries 20% of the world’s crude oil, amongst many other equally important commodities. That has caused inflation to spike which has begun to affect consumer behavior. Leading indicators of inflation have also spiked, meaning there is more to come. The labor market looks healthy on the surface, but one layer below the surface reveals serious structural problems–people are unable to find jobs and are literally giving up. The Fed is getting a new boss today. He is probably a hawk, but it doesn’t matter because the last few inflation numbers are so ugly, even doves would have to hold their noses–er, beaks–to vote for rate cuts. The Fed is not only not going to come to the rescue with a salve, but may in fact inflict more pain by raising rates in the future–the bitter pill. The leading numbers to the leading numbers–are also pointing to more inflation. Are there scenarios where inflation abates quickly in the wake of a peace deal? Yes, but those are the edge cases–meaning they are less likely than continued inflation.
So, back to my friend. He found me recently and wanted to follow up on that investment he told me about. I told him the same thing I always tell everyone, about the same thing I have been telling you every day: there is no free lunch on Wall Street. He chuckled, as if perhaps I had finally revealed the punch line to some long-running joke. I was not joking. But here is the thing–and this is where it gets interesting–who wants a free lunch anyway? A free lunch means no risk. No risk means no return. In other words, that free lunch is probably not very tasty. And no return means you might as well be sitting in cash watching inflation eat your purchasing power one bite at a time. The goal, my friends, is not to avoid risk. The goal is to understand it, price it, and then decide if the meal is worth ordering.
Which brings me to what is happening in the markets right now, and it is a doozy.
The S&P 500 closed above 7,500 for the first time in its history on Wednesday. The Nasdaq hit a fresh all-time high at 26,635. The Dow punched back through 50,000 for the first time since February, when the Iran conflict erupted and lit the world on fire. Seven straight winning weeks for the S&P 500 and Nasdaq–the longest streak for the former since a nine-week run ending in late December 2023. Markets are in the middle of a full-on celebration, and the confetti is flying. AI is the engine, earnings are the fuel, and optimism is the accelerant. Cisco jumped over 13% after raising its revenue and earnings outlook. Nvidia is up 15% for the month alone after the US cleared ten Chinese firms to receive H200 chips. After last night’s close, Applied Materials beat on the top and bottom line. The AI infrastructure trade is not just alive, it is eating everything in sight.
Buy? Well, if you have been paying attention to me, you know that we need to talk about what is sitting underneath all this champagne.
Risk number one is the man who just walked into the most powerful financial job in the world. Kevin Warsh was confirmed as the 17th chair of the Federal Reserve by a 54-to-45 Senate vote, which was the most divisive confirmation in Fed history. He took the baton from Jerome Powell officially today, May 15th, and his first FOMC meeting is scheduled for June 16th and 17th. Here is what the market is pricing: a 97% chance of no rate cut at that meeting. And it gets more interesting than that–rate HIKE odds have climbed to roughly 39% after April's CPI came in at 3.8%, the highest reading in three years, and April's PPI hit 6% year over year, the highest since December 2022. The FOMC itself was the most divided it has been since 1992 at its last meeting, with four voting members dissenting. Warsh is walking into a room where some of his own colleagues are whispering about raising rates, not cutting them. Whatever you think Warsh is going to do, understand that the market has priced in a fairly benign outcome. A hawkish surprise at the June meeting–and the updated dot plot that comes with it–could reprice equities very, very quickly. My friend would say the chances of that are "insignificant." I would say the chances of that are precisely the thing you need to be thinking about.
Risk number two is the Strait of Hormuz, and I have been beating this drum for months now because it will not stop being true. Brent crude is sitting above $106 per barrel this morning. WTI is above $102. The IEA has reported that crude and fuel flows through the Strait fell by nearly six million barrels per day in the first quarter of this year and has warned the global oil market will remain materially undersupplied through October–even if the conflict is resolved next month. Even if. Saudi Arabia, meanwhile, informed OPEC that its production dropped to its lowest level since 1990. The ceasefire is, in Trump's own words, on "massive life support." Iran is exercising selective control over tanker traffic, letting some ships through on bilateral arrangements while maintaining the leverage of the blockade. This is not a resolved situation. This is a slow bleed that keeps feeding inflation numbers that keep tying the Fed's hands. The market is looking past it because the AI trade is shiny and the earnings have been good. But oil at these levels is a tax on every consumer, every company, and every margin in the S&P 500.
Risk number three walked out of Beijing this week carrying a very nice headline and a contract to purchase 200 Boeing jets. The Trump-Xi summit produced warm language, promises of soybeans, energy purchases, and what both sides called a "constructive relationship of strategic stability." And look, I am not dismissing it entirely. Any reduction in geopolitical friction between the world's two largest economies is a net positive. The average US tariff on Chinese goods still sits at around 47%. China's average tariff on US goods is still around 32%. Two-way goods trade has dropped from $690 billion in 2022 to around $415 billion last year. China has a well-documented history of making purchase commitments that expire, reverse, or simply do not materialize. The market wanted a grand bargain. It got a framework and a photo op. The question is whether the rally priced in the photo op or the grand bargain, because those two things have very different valuations.
Now, before you think I am a bear, let me be clear–I am not. The underlying earnings story is real. An 84% earnings beat rate this season, with year-over-year earnings growth of nearly 25% (S&P 500 through last night), is not something you dismiss. The AI capex cycle is enormous and is broadening beyond the Mag-7. And the technical picture, with the index above both its 50-day and 200-day moving averages, is constructive. The next major test is NVIDIA’s earnings on May 20th, and the whisper numbers are high. If NVIDIA delivers, and it has made a habit of doing exactly that, this streak has more room to run.
The point is not that the party is over. The point is that at 7,500 on the S&P 500, you may not be getting paid extra for the risks that are sitting right in front of you. Warsh's first FOMC meeting, $106 oil feeding through to prices that consumers are already screaming about, and a China deal that is one diplomatic misfire away from unraveling–these are not edge cases. These are the main scenarios. The informed investor does not ignore them because the tape is green. The informed investor asks: what do I need to be paid to own this market at these levels, given these specific risks? And then they answer it honestly.
That is the difference between my friend and the rest of us. He sees a great return and calls the risk "insignificant." We see a great return and start asking uncomfortable questions. The uncomfortable questions are what keep you in the game for the long haul.
There is no free lunch on Wall Street.
YESTERDAY’S MARKETS
Yesterday, the S&P 500 rose 0.74% to close above 7,500 for the first time in history, while the Nasdaq gained 0.88% to a new all-time high, and the Dow advanced 0.75% to reclaim 50,000. Technology stocks led the session, with Cisco jumping 13% after raising its revenue and earnings outlook and NVIDIA gaining 4.4% after the US cleared ten Chinese firms to purchase H200 chips. The gains were supported by optimism surrounding the first day of the Trump-Xi summit in Beijing and solid April retail sales data, which showed a 0.5% month-over-month increase.
NEXT UP
Industrial Production (April) is expected to have increased by 0.3% after slipping by -0.5% in March.
Next week, we are going to get more important earnings in addition to housing numbers, regional Fed report, FOMC meeting minutes, Flash PMIs, and University of Michigan Sentiment. All of this under the watchful eye of a new Fed Chair! You better check in next week…you know that there is no free lunch, but you will surely want to know what you are getting for your money. 😉