January Wrap Up - Expectations, share prices and DeepSeek

It has been a vigorous start to the year. A new president sworn in the United States, a flurry of executive orders and cracks in the narrative of US Artificial Intelligence (AI) leadership. Despite considerable volatility and some negative headlines, global shares started the year on a positive footing, although closer to home the NZ share market slipped for the month. 

The math that determines the "fair" share price of a company is simple. Fair value is a function of two things. What cash flows the market expects that company to generate in the future, and what is the right interest to discount those cash flows back to the present day; the logic here being that a dollar received in ten years' time is worth less than a dollar received today. 

While this math is simple, how it manifests day to day in the share market is anything but simple. The reason for that is that we don't know, with any certainty, what the future cash flows of a company will be and there is also debate around the right interest rate to discount those values back to the present day. 

This uncertainty becomes a tug of war. On the one side are the bulls, investors that see nothing but good news for the future cash flows a company might generate. On the other side are the bears, the more cautious investors are conscious of the risks to those cash flows. 

Normally there is a healthy balance between bulls and bears and market prices are broadly fair.  But from time to time one group gains an ascendancy and expectations of future cash that a company will deliver become divorced from a more circumspect evaluation of a firm's prospects. 

We have talked in previous commentaries about the strong performance of US technology stocks and the rise of magnificent 7 US tech behemoths. The poster child of the magnificent seven is NVIDIA, the manufacturer of GPUs, the computer chips powering the AI revolution. 

The bulls have very much owned the NVIDIA narrative. The market story was simple. We need an awful lot of NVIDIA chips to fuel the growth in AI and NVIDIA has a near monopoly position in providing these chips, not just today but increasingly the market was expecting this to persist for some time to come. 

When the tug of war between bulls and bears becomes lopsided two things tend to happen. If the bulls are winning, share prices tend to rise and rise dramatically. We can tick that box for NVIDIA. This is a company that has gone from relative obscurity to being one of the largest firms in the world, posting an annual average return of over 100% during the two years to 31 December 2024. The other thing that happens is that those expectations become harder and harder to top. Much of the possible good news is captured and risk of negative surprises rises. 

Enter DeepSeek. DeepSeek is a Chinese AI startup building open-source large language models (LLM). DeepSeek shocked the market, building its LLM for a considerably lower cost, using both fewer and older NVIDIA chips than major US competitors. It was an impressive piece of engineering. 

It was the use of older and fewer chips that was the concern for the market. NVIDIA investors had seen no end in sight for growing demand for its chips, meaning ever growing future cash flows. If DeepSeek's approach becomes pervasive it could mean fewer chips and maybe that future cash flow won't be as high as previously thought. 

Changing expectations matter. NVIDIA fell 17% on the day the market become focussed on the DeepSeek risk, wiping around US $590b off its market value. That is a massive one-day change in value, more than the total value of the entire New Zealand share market, six times over. 

Anything but. Lower costs to produce models and lower costs to run them is ultimately a good thing for the long run future of AI. It should help improve the opportunities for companies using the technology and accelerate its adoption. Cheaper, better models is a win. But it's not a win for every company involved in the space. Being selective is important. 

The DeepSeek-NVIDIA story in January is an important reminder of a few things we should always bear in mind as investors. 

1. If all the good news is already in prices, risk goes up - the converse is also true. If everyone is negative and news is all bad that often spells opportunity. Understanding the temperature of the market for a given stock or the market overall is an important part of managing risk. 
2. Technology investing is not without risk - the goal of all technology companies is to replace existing technologies. Today's NVIDIA could be tomorrow's Kodak as new technologies roll out and disruption is an ever-present risk. Thinking you are smart enough as an investor to anticipate this and not get caught out is very brave to say the least. 
3. The winners from AI won't be obvious and some may not have been invented yet - while the initial beneficiaries of the AI revolution have largely been infrastructure companies and chip manufacturers, over time it will likely be those companies that use AI in innovative and creative ways. Or, as DeepSeek has done, find ways to optimise AI use. DeepSeek was only founded as a company in 2023 and a mere two years later, had a profound impact on the AI landscape. We should expect ongoing rapid change and the potential for surprises.

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