Mid-week market update: I know that I expected market volatility, but I didn’t expect the immediate source of volatility to be anxiety over DeepSeek. I should have known better when my physiotherapist, who didn’t know I worked in finance, started to talk about NVIDIA this week.
You can tell a lot about the character of a market by how it responds to sudden price gaps. The DeepSeek sell-off left a gap in NVDIA’s stock price. Now that the dust is starting to settle out over the news, the strength of the AI and semiconductor investment themes will depend on whether the gap gets filled.
The DeepSeek freakout
In case you missed it, here is a brief summary of the DeepSeek freakout. A Chinese VC financed AI startup announced that it had achieved a breakthrough in large language model (LLM) processing. By taking a number of “good enough” shortcuts, it was able to achieve similar LLM results with 1/30th of the processing power used by the hyperscalers building the current generation of LLMs. DeepSeek was able to achieve this breakthrough using open source code. Even if you were to shun the company’s product owing to its Chinese connections, it wouldn’t take much for a parallel startup to build out a similar product and achieve similar low-cost results.
The bear case brings up memories of the crash in the stock of Cisco Systems during the dot-com crash. There was a scramble to build fibre optic capacity during the heady days of the parabolic growth of the internet in the late 1990’s. One vendor, Cisco, made routers that formed the backbone of the internet. Cisco had a near monopoly on their product and their margins were astronomical. The reckoning resolved in excess capacity, and customers rushed to dump their Cisco routers on the market, which cratered the company’s sales.
Fast forward to today. Another company holds a near monopoly on advanced chips for AI processing and it’s enjoying astronomical margins in a market that’s experiencing parabolic growth. Since DeepSeek’s breakthrough was achieved with lower quality and slower NVIDIA chips with lower margins that are at risk of commoditization, will NVIDIA suffer the Cisco experience?
The bulls believe that there will always be increasing demand for faster and faster processors, and the DeepSeek innovation will expand demand for computing. The open question is what happens to demand and margins.
As earnings season proceeds, investors will be closely scrutinizing the capex plans of the AI hyperscalers, starting with Microsoft and Meta after the close of market today.
From a broader perspective, the DeepSeek freakout left the Semiconductor Index testing key levels of absolute and relative support. In addition, Trump’s recent threat to impose tariffs on semiconductors coming from Taiwan didn’t help the group either.
Constructive patterns
From a broader perspective, the S&P 500 filled the gap left by the DeepSeek selloff, but a price gap below remains unfilled, which is a constructive pattern. However, the market is near overbought, as measured by the percentage of S&P 500 stocks above their 20 dma (bottom panel).
While I have voiced some concerns about market breadth, breadth indicators are neutral in the short run.
The Fed non-event
Then we have the Fed decision, which turned out to be a non-event. The Fed left rates unchanged, which was widely expected. The FOMC statement was initially interpreted as slightly more hawkish. The inflation reference on “made progress toward the…2% objective” was dropped, but Powell discounted the effects of the change during the press conference as cleaning up the language in the FOMC statement.
The 10-year yield rose in response to the statement release by retraced most of the gains after Powell’s clarification.
I interpret these results as a data dependent Fed, and the market may experience some volatility as changes in the data affect expectations. The market continue to discount the next rate cut as occurring in June.
In conclusion, the financial markets will continue to experience choppiness in response to new developments, which are unpredictable. However, the structure of the technical picture continues to appear constructive in the short run, notwithstanding further surprises from Big Tech and Trump policy announcements.