#58 – The Chart Guy

BOOK RECOMMENDATIONS

Michael didn’t want to be drawn on a book recommendation as there are JP Morgan reading lists. Steve’s recommendation is to read Michael’s outstanding publication, Eye on the Market.

How Steve Knows the Guest

Michael signed up for Steve’s Substack early one Saturday morning and when he saw his name, Steve immediately emailed him and asked if he could help. They had a Zoom call and it transpired that Michael was working on the hyperscalers’ server depreciation. Steve gave Michael the data he needed and some input on his model, which was astonishingly detailed,  and Michael kindly agreed to come on the podcast which was recorded at the amazing new JP Morgan office in New York – Below are a few BTS photos:

Behind the Scenes

It’s a huge building:

The lobby has a grand USA flag on a full size flagpole – look how small the people are in the photo:

The AV team at JP Morgan has a super professional setup: 

And a nice bunch they are too – they looked after me really well. Thanks guys!

and of course some amazing views:

Chapters

00:00 Introducing Michael Cembalest: JP Morgan’s Market Strategist

03:00 Cembalest on Market Evolution and Eye on the Market

06:25 Why US Equities Deserve a Premium: Structural or Cyclical?

09:37 Hyperscaler CapEx and the Early Returns of AI Investment

15:57 Concerns Over Meta’s Aggressive Off-Balance Sheet Accounting

21:21 Predicting a US Bond Market Crisis and Dollar’s Reserve Status

23:26 Dollar’s Reserve Status

27:55 Protecting Portfolios and the Deterioration of Private Credit

34:31 AlphaSense Deep Research and Open AI’s Energy & Revenue Challenges

38:29 Assessing Open AI’s Valuations and the Wave of Tech IPOs

45:00 US Market Tech Concentration and Advice for Young Investors

49:48 Cembalest’s Favorite Chart: How Markets Anticipate the Future

Transcript

Stephen Clapham (00:01.614)

Hi, I’m Steve Clapham and welcome to the Behind the Balance Sheet podcast where we meet leading investors and commentators and educate ourselves about the world of investing and the world. Our mission is to remove some of the mystique around investing and improve our understanding of successful investors’ strategies and tactics. Behind the Balance Sheet is an investment training consultancy. We help professional investors up their game in financial analysis.

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Stephen Clapham (05:01.614)

So Michael, I always start by saying I’ve really been looking forward to this conversation, but this, I have really been looking forward to this conversation because we’re doing this in the JP Morgan headquarters are pretty spectacular in New York. And you’ve started at JP Morgan in October, 1987, straight after the crash. So must’ve been a scary time. What made you choose the stock market?

Michael Cembalest (05:25.966)

Well, I didn’t. First of all, I started in the beginning of October. So I had been working there for two weeks before the crash. I remember thinking, like, gee, I wonder if this job’s going to stick because the stock market just dropped 35 % two weeks after I joined. I was a French and Russian literature major.

in college, didn’t know anything about finance or economics. And I got a job working in essentially what was a back office accounting and data monitoring function when I joined JP Morgan. it took me probably two, three years to kind of work my way more towards a front office position that was markets related.

Stephen Clapham (06:11.534)

And when you started, it’s a long time ago, did you have a PC on your desk? No. Because younger audience will find that really…

Michael Cembalest (06:21.934)

I remember I was very excited when I got my first computer. It had two disk drives, no hard drive storage, and a little rack for putting the five and a quarter diskettes for the data. And then when you traveled, you had a compact 286 computer and the thing weighed like 50 pounds.

Stephen Clapham (06:41.87)

So we’ve come a long way and you spent decades studying markets writing the iron the market reports What is there anything that’s the same as it was when you started out?

Michael Cembalest (06:56.558)

Yeah, lot of things have changed, a lot of things are the same. mean, a lot of markets are expanded. The credit markets in particular have undergone a massive shift. When I joined JP Morgan, JP Morgan was a AAA bank lending its balance sheet to other AAA entities. And so the biggest transformation, the first one that happened was that business went away because the capital market started providing

capital to high quality companies at cheaper rates than the banks could lend through commercial paper and bonds. And that’s when the banks had to of reinvent themselves and become merchant banks and get into &A and trading and things like that. So that was a pretty big transition. Some of the themes that are the same though have to do with the psychology of markets and chasing returns and

you know, after a correction is probably the best time to look at something. you know, the after, mean, after the devaluation of the Mexican peso in 1994, everything that was Mexican was left for dead. And then that was the best performing emerging market over the last few years. mean, those, those cycles repeat themselves again and again and again.

Stephen Clapham (08:09.838)

And your reports are available free of charge. I mean, I think that’s a bit ridiculous. We’re better than 90 % of the sell side research that people pay for. But talk a little bit about what’s the process behind Eye on the Market? I mean, how do you decide what topics deserve a deep dive? And who do you write it for?

Michael Cembalest (08:28.704)

Okay, so the eye on the market, so I was chief investment, I’m the chief investment officer of the asset management business, but for a while I was the chief investment officer just for the private bank itself. And the purpose of the eye on the market was the private bank used to be kind of more of a small intimate business, you know, 20 years ago, and then it started to grow. And it’s inconsistent to have the people running the money also dealing with clients. So the notion was I would sit at my desk, focus mostly on investing client assets.

And instead of having to travel around and explain what we’re doing to clients, I would write the eye on the market as a way of explaining to our private clients what we were doing in portfolios. Now, we wouldn’t be disclosing individual positions and we would usually give it some seasoning time after we made an asset allocation shift before we’d start to write about it. But that’s where the eye on the market started in 2005 as a method of explaining to clients this is why we’re.

investing in the following countries, what do we think about growth versus value, what’s our duration position, currencies, commodities, infrastructure, hedge funds, things like that. And it started out very much as a bread and butter portfolio allocation thing. And then it started to drift into other topics, particularly after the financial crisis.

Stephen Clapham (09:43.224)

And you do really deep research. How do you manage to keep detached and keep that 50,000 foot view when you’re spending so much time down in the weeds? Is that difficult?

Michael Cembalest (09:55.318)

Well, the clients force it on you, right? Because you have to do some pretty intense research in order to decide, like for instance, let me give you an example. Last year, healthcare multiples were trading at the lowest they’ve been in 25 years relative to the market. And in order to take a stab at something like that, particularly given the collapse in managed care and some components of healthcare, you really had to know what was going on. So we do some deep research. And then the question is, how do we convey that?

to the diaspora of our clients in ways they can understand. And one of the things I’ve learned to do by force of our clients is to explain things in ways they can understand. I’m amazed. I remember, I don’t want to say the name of the firm, but I digest a lot of research. And I’m always amazed. Sometimes I’ll call somebody and say, look, I’ve been in this business for over 35 years, and you’ve got a guy there who writes something, and I don’t understand more than 30 % of it every single time.

So that’s a problem for you. That’s not a problem for me. That’s a problem for you. And so I give a lot of feedback to the people that I get research from because I expect them to be able to write in a vernacular, understandable style the same way that I do.

Stephen Clapham (11:07.422)

really brilliant stuff and you’re overweight US equities and you highlight that US companies are better quality and deserve a P premium which is fair enough but I mean it’s almost two-thirds of global market cap isn’t that a bit much yeah

Michael Cembalest (11:20.866)

Yes, it is. we started, so you have to remember that we started with the global overwrite to the US in 2009. We had just been coming out of a period of a massive surge of construction and other investment in southern Europe, Spain, Portugal, Italy.

there was a European outperformance boom, both economically and in the stock market that took place during that period before the European balance of payments crisis. And it struck us that without that impetus, that Europe was going to underperform. And we were also looking at some ongoing deflationary trends in Japan. So the actual position that we had for the better part of 15 year was overweight United States and a small amount of overweight to emerging markets and underweight Europe and Japan.

that thing paid consistent dividends year after year after year. Every single year, I would see some brave strategist say, okay, this is the year. This is the year that Europe finally comes back. They were just consistently wrong. We had our rationale, but my experience as an investor led me to say, you know what? This thing just keeps going. It started out with multiples close to each other and we got to the point by the end of 2020 2024,

that the rest of the world was trading at almost a 40 % PE multiple discount to the US. So at that point, you never know where the bottom is. Some people thought it was 15, 20, 25, 30, keeps going 35, 40. When it got to 40%, we said, okay, let’s watch it from here because we’ve never seen this kind of multiple discount before. And we started evening out the positions in the portfolio and heading into this year, our strategy was more balanced closer to.

MSCI benchmark weights for the lack of a better word, a way to explain it. So yes, the irony is that the America First president coming in was the end of America First outperformance.

Stephen Clapham (13:24.974)

I keep hearing about US exceptionalism. I want to ask you if you think it’s structural or cyclical and I mean us has got a lot going for it mean, you know when I come here really strikes me, know how powerful the country is and you’ve got energy independence technology leadership deep capital markets better demographics in Europe or in China and the culture is really business oriented right? So you’ve got fewer holidays. Everybody’s got success mentality but

my perception i don’t know if you agree with this but my section is a lot of wealth has been created by buoyant stock markets very generous bought bonus programs and i’m just wondering can all this continue at the same rate because the valuation start higher and other countries may start to catch up on some of you

Michael Cembalest (14:11.534)

Yes, and last year was a big catch up year. right last year in the equity markets last year was a big catch up year for emerging markets for Europe for Japan Other than India the US was the lowest then the US equity markets did fine last year But they were the lowest performing equity market of the major ones other than India So last year was a catch-up year to be sure and now just to put some rough numbers on it The US the the discount for the rest of the world to the US is about 30 % instead of 40 %

I don’t think that goes back to parity, right? I think a 20 % discount is as good as it gets. So there’s still some more room for outperformance versus the rest of the world. if you want to look, if you want a diagnosis of how the US differs from the rest of the world, I will point you to another European. Read the Draghi report. Everything in there is exactly what’s wrong with Europe or what he sees as wrong with Europe in terms of productivity, growth, efficiency, labor mobility, capital mobility.

energy security, he goes into the whole thing.

Stephen Clapham (15:13.23)

Yeah, and I know it has got a lot of weaknesses by just looking at the US Yeah, almost half of consumer spending which is a big driver of society is from the top 1 % and the top 1 % It’s all about the stock market. It looks very circular to me. So if you had a big correction in stock, yeah, they’re Massive unwinding isn’t a really big risk

Michael Cembalest (15:32.085)

Absolutely.

Michael Cembalest (15:37.218)

Yes, it is. It’s a big risk, but I think a short-term one. I mean, if you had some kind of correction, most of the corrections that are value-based corrections kind of repair themselves reasonably quickly. yeah, look, a lot is riding on the AI sector, because that’s where those large valuations are. The high valuations are in the tech space. We’ve already seen what can happen when things unravel. The software space has gotten clobbered this year, down 20 to 30%.

from high multiples and software is a good example of what could happen to the broader market if those profit fundamentals come under siege as well.

Stephen Clapham (16:14.932)

And just on AI, I we first met or started talking about when we’re about the hyperscaler CAPEX and we’re seeing huge commitments there. I mean, is this another tech bubble or is it something more durable?

Michael Cembalest (16:31.374)

It’s a mix, right?

You know, whenever I see Google explain what they’re doing, it makes perfect sense to me. Whenever I listen to Metta saying what they’re doing, it doesn’t, right? mean, Metta is spending 70 to 80 % of its revenues on capital spending, which is a number that’s unheard of in the entire history of corporate finance. The average S &P company spends 20 % of revenues on capital spending in R &D and maybe 20 % for the average technology company. So…

When you look at Google and Amazon and Microsoft at 30 to 35 % and Meta at like make up a number, this is the bed of the century, right? On AI technology and data centers and GPUs and processing and all that kind of stuff. Where really early, unfortunately right now, everyone that’s trying to understand whether or not this makes any sense is dealing with very preliminary information.

abstract accounting firm surveys of corporate AI adoption. You know, very rough measures of the share of companies willing to pay actual hard money for AI services. know, an estimate from Microsoft as to how much their agentic AI investments are paying off. It’s very tea-leavy right now. And there’s not a lot of hard data on it. The hard data we have is how much being spent.

We don’t have a lot of hard data on how much is being earned. I’m sorry, and we do know that the free cash flow margins of those big hyperscalers are starting to come down.

Stephen Clapham (18:10.04)

going down very rapidly.

Michael Cembalest (18:11.916)

Yes, through the third quarter of last year, they were stable, which meant that they were spending a lot of money out of corporate cash flow and at a reasonable pace that wasn’t degrading their overall free cash flow margins. Just the last two quarters have started to see those numbers roll over pretty fast.

Stephen Clapham (18:30.316)

And of course, we’re seeing all the off balance sheets. I just wanted to pick up. You said you’ve got good numbers on the outflows, bad numbers in the benefits. How do you try and measure that in an organization like this? It’s fun.

Michael Cembalest (18:45.74)

Well…

Michael Cembalest (18:49.194)

We have tons of information, right? And again, you know, there was this internet meme a few years ago, what color is this dress? I don’t know if you remember it, but was the gold dress, was it gold, was it blue? was whatever you wanted it to be. And it turns out it was a function of lighting and things like that. If you want to really amp yourself up on…

corporate adoption of AI and what they think of it, read a report from Wharton. If you are looking for something more depressing, read a report from MIT, right? I mean, again, we’re at a stage where it’s a bunch of surveys and very abstract analysis that people are using to explain where we are. And I try to digest all of the possible information I can get my hands on to make an assessment of where we are in this whole thing.

But even when I look at JP Morgan internally, the firm is making a massive bet. Some of those efforts are yielding pretty attractive productivity results and some aren’t. unfortunately, it’s just really early to assess how this is going to play out in the long run. people going to be? And what’s happening with software and Claude Cowork, I think, is a microcosm.

How much are people willing to transform the way their lives function to save money? That’s what is behind a lot of this stuff. I don’t think we know.

Stephen Clapham (20:22.614)

And how are you using it personally?

Michael Cembalest (20:25.902)

Me, sparingly. My investment process is like, yeah, I’ve been spending the last 48 hours preparing a special piece for tomorrow on the Iran war and the implications for energy prices, commodity investments. There’s very little AI-related assistance that I need. Me personally, I will use AI for things like a Google overview.

is perfectly fine for me. Where can I find, what’s the best Bloomberg ticker for global sulfur and helium prices? Most of the time I’ll get a pretty good solution from AI overview. By the way, I’ll type it in. Any other works or doesn’t work. So I have immediate feedback whether or not it’s told me the right thing. I’m not gonna ask it, like, what was the reason for the decline in…

the average size of nuclear plants, which is something that happened, there was a blip in the 1990s where the size of the plants went down for years before going up again. Like that, I have to do that work myself. I’m not gonna rely on it stitching together a bunch of different factoids that it finds.

Stephen Clapham (21:38.476)

and just going back to mess up how concerned you think we should be about the fact that it’s being quite aggressive in its accounting you know my background is is an account right and and when i see them putting assets off balance sheet and committing more capital the consequence of that so spending money to right give a false impression when i see them extending the depreciation life to the significant impact and and there any doubt how worried are you

Michael Cembalest (22:10.414)

Look, again, having joined the firm in 1987, there have been many, many cycles where companies have paid, deliberately paid, a higher cost of capital in order to obscure or transform the way things look to investors. When people first started doing it, it worked because the tools were so poor that some of those obligations were hidden from investors.

The amazing thing to me now is that Metta is willing to pay another 100 basis points to keep an obligation off balance sheet. And every single analyst in the world is loading that back into their metrics when they do their Metta analysis because they know that it’s the full faith and credit of Metta, irrespective of the fact that they diluted some accounting firm and a law firm into describing it as an off balance sheet obligation. I find that

kind of strange that people are willing to pay real cash money to change the perception of something when the information abundance now is clear to everybody that’s doing serious work, that that should be added into Meta’s overall debt load. So but yeah, they’re still doing it. And, and the reason I’m a little less worried is because when I talk to any meta analyst or any software analyst, any analyst anywhere and our own team,

That meta blue owl JV obligation is part of our meta metrics. It’s not hidden from anybody. Except for them, in their own minds.

Stephen Clapham (23:43.82)

Yeah, I mean, it seems slightly strange, just talk a little bit about bonds. mean, bonds offer real yields again for first time in a while. And US bonds have actually been pretty stable in spite of the deficit when the economy is going gangbusters and you’ve got a big deficit. How do you think about the long term outlook for treasuries?

Michael Cembalest (24:09.422)

You know, the rewards of being the world’s reserve currency are substantial. No, I don’t think any other country in the world would be able to sustain the kind of fiscal policy and debt burden that the United States has and see so little reaction in the bond markets. So a lot’s riding on this whole issue of the dollar being the world’s reserve currency.

One of the favorite positions of some analysts out there is that that is changing. We track six or seven different measures of the dollar standing as a world reserve currency in its share of foreign exchange trading, its share of global reserve assets, its share of global SWIFT payments, its share of the denomination of new debt and equity issuance of offshore entities. We don’t see it changing that much. So in the near term,

I don’t really see anything catastrophic happening with the dollar. know there’s a lot of people that feel that the sanctions and the tariffs and things like that are going to be changing. But on the ground, we don’t see it really shifting. If that reserve currency status ever did change, the US is in a world of trouble because they would have to start to monetize the debt that other entities didn’t want to This administration is doing as much as any.

to tear down the fundamental supports for that reserve currency system that supports the dollar. We’ve got another three years of them. We’ll have to see what happens. Certainly, the war in Iran is another blow against it because it’s going to cost somewhere between 50 and 200 billion, which is money that the US doesn’t really have.

My view is that there’s a crisis coming in the US, a bond market crisis in probably three to four years. It’s a pretty nasty one. First, I’m going to be retired by then. I am seriously, extremely pleased that I won’t have to work through it because it’s going to be a very unpleasant period. It looks like this. At some point, around 2030 or 2031,

Michael Cembalest (26:35.342)

100 % of government revenues in the United States, federal tax revenues, will be required to pay interest on the debt and entitlements. There won’t be a penny left for anything else. That is obviously a completely unsustainable situation. Heading into that, maybe by a year, year and a half, the rating agencies will probably tell the United States, if you don’t do anything about this, we’re going to downgrade you. And then you start seeing Abu Dhabi and the GIC and Tumasek and some of the large Shafi’i wealth funds

not necessarily selling dollars, but no longer buying new ones in the auctions. That then precipitates a bond market crisis, which I would define as an increase in the 10 year of let’s call it 150 to 200 basis points over a short period of time. Now you have a legitimate bond market crisis on your hands, equities are down 15 % and

then a lot depends upon what happens. I’m holding open the hope and the potential that that kind of a crisis will give US policymakers, kind of like the second TARP bill vote in 2009, that the politicians faced with that kind of crisis will have the cover of the crisis that they can use in order to justify some painful decisions about taxes and spending.

So that’s one avenue. If that happens, that’s great news for the bond markets and equity markets, because you take this tough medicine, you’re correcting some of the imbalances, and you move on. If instead they take the easy way out and just having the Fed monetize the debt, that’s a problematic outcome.

Stephen Clapham (28:13.186)

So in that circumstance, what do you do today to protect clients’ portfolios? Does that affect your view of the 60-40?

Michael Cembalest (28:22.398)

Well, one of the most important things to not do is prepare portfolios for things that are happening outside the time horizon of your investments. What I just told you was a risk seven years ago. And a lot of the Cassandras and the Rubini’s of the world would have recommended preparing for it then and would have been fired long before today. So part of the skill of money management and every hedge fund manager and every private equity firm

is like, what’s my timeline and when do I need to prepare for certain things? And when is it too soon to start shifting my portfolio around because I’m giving up too much return. Ultimately, lot of investments in markets are war chest strategies, which is you need to make as much money as you can because at some point, you know, you’re going to give some of it back and you may not be able to anticipate it. And, you know, and I’ll give you a little bit of an example, which is

The Indian rupee is a classic example. Indian interest rates have always been higher. And if you buy a rupee based asset, you’ll make money, make money, make money, and then boom, there’s a devaluation or depreciation of the rupee. You give some of it back and then it starts to go up again. And investors that generally accept this cycle instead of constantly trying to game it have actually turned out to do better over the long run because they’re not short cutting the gains they make.

before you have those corrections. Some corrections are easy to anticipate, some of them are really hard.

Stephen Clapham (29:55.63)

Yeah, I mean this one seems quite obvious. I wonder, do you have a view about private credit? I mean, should we be worried? There seem to be quite a lot of nasty indicators out there.

Michael Cembalest (30:07.244)

I think the underwriting over the last two years specifically has been pretty bad. Before then, the broadly syndicated loan underwriting was bad, but the private credit underwriting was better, which then led to a flood of assets going into private credit and then their underwriting collapsed. One of the things about credit markets though is the dumbest chart, I have these in my head.

I have these, there’s like 10 of the charts that I would categorize as the dumbest charts I’ve seen in finance. One of them, maybe number one, is a chart that people plot of high yield spreads and they draw a horizontal line at about 600 basis points and it says average, Except it’s never at 600 basis points. It’s always either much higher, much lower, because you’re either in an economic expansion or you’re in contraction. And so in an economic expansion,

Default rates are low, they’re 1 to 2%. The return on private credit and other extended credit is generally good. When a recession comes along, then the spreads go to 1,000, you take some write offs, whatever. It’s another example of a war chest strategy because high yield is just not liquid enough for an institution to amass a large position and trade it in and out of it. You have to accept that the recessionary pullbacks are part of what you’re going to experience.

And private credit is in the same boat. And yes, when private credit was generally offering 3 % over high yield, that was enough. Now the spreads are tighter and the value proposition is not nearly as good. And you’re starting to see some cracks. I had some private credit people tell me they thought that the software holdings they had were the bedrock and safest parts of their portfolio.

Stephen Clapham (32:00.012)

How long ago was that?

Michael Cembalest (32:01.23)

November, November, right around the time that Claude Co-Work and some of these other things were just being released and it was an external shock to the software space that a lot of people were caught completely blindsided, myself included.

Stephen Clapham (32:18.56)

And what are they saying now, those people?

Michael Cembalest (32:20.778)

No, well, you they’re hard to find. I think they’re all dealing with their portfolio issues, right? And yeah, so over the last two years, I mean, and I wrote this two years ago, I said, it feels like the ground is shifting on private credit. I think that people should slow down their allocations because the underwriting is deteriorating. And you can track it. As a credit guy, you would love these metrics, right? You can track

EBITDA ad backs, right? I don’t know if your audience knows what those are. And if I explain them, they’re going to think they’re insane, right? But here’s what they are. You start out as a lender saying, well, I’m only going to lend towards a number of coverage of earnings. But the borrower will say, yeah, but I’m going to make all these changes and I’m going to make earnings better. So when you do your covenants, let’s add 20 % to my earnings as if it’s, those synergies have already happened.

Those EBITDA adbacks didn’t used to exist in private credit, the lenders wouldn’t allow them. They only existed in the broadly syndicated loan market. Now the private credit lenders allow them. It used to be that if you had borrowed money from a private credit lender and you sold a subsidiary, you would have to take 100 % of the proceeds and pay down the loan. Then you could do whatever the hell you want. That’s changing too.

you only have to pay some of those proceeds, the rest of it, you can do what you want, right? And those are all indications of a relaxation in terms of conditions, which is a reflection of more negotiating power on the part of the private equity firms borrowing the money than the private credit firms lending the money. And as a loan investor, that’s not a good transition for you.

Stephen Clapham (34:05.174)

Will the balance of power change, you think?

Michael Cembalest (34:08.206)

Yes, it will. It usually takes a recession or a substantial contraction in the supply of liquidity and we’re not anywhere near that.

Stephen Clapham (34:17.71)

Well, we could be quite quickly, I suppose.

Michael Cembalest (34:19.79)

No, mean, yes, we’re starting to see some cracks in the system, but there are still so many people willing to lend at those concessionary terms. What has to happen as what we’re looking for to start deploying more money in this space is a real sign that the lenders have fled and that the private equity firms are willing to negotiate the terms and conditions which are a better value for lenders. We’re nowhere near there.

Stephen Clapham (34:48.962)

No, there’s just too much capital around. I’ve written actually about the ad backs because ad backs are I mean, astonishingly loosely structured. Are you a professional investor? How many 10 Ks an annual report do you look at in a year? Ever wished you could cut through the noise and process them faster and more effectively? We run a forensic accounting course for larger institutional clients in their offices. For smaller investment funds and individuals, we also do them

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helping you accelerate analysis, deepen understanding, and make sharper decisions. See it in action at offer-sense.com forward slash btbs. This is a tool serious investors won’t want to work without. In your end of the year piece, you talked about OpenAI being the weak link in the whole AI edifice. I wonder if we could just talk a little bit about that. mean, it seems to me that people have assumed that it’s the winner.

Stephen Clapham (37:14.838)

the leader and all the evidence suggests to me that this is a commodity. Is that unfair?

Michael Cembalest (37:22.368)

Well, mean, when I described OpenAI as the weak link, it’s because to me, there’s two key bridges they have to cross before justifying the valuations that they’ve been getting. Number one relates to energy and number two relates to the way they make money. Let me do the second one first. So right now, they don’t really have an advertising revenue model and

And they don’t really have a really robust corporate revenue model. It’s a lot of subscription-based stuff. And that just seems like that’s going to have to change. It seems like they’re going to have to develop more institutional ways of making money, including advertising. And second, they have made over a trillion dollars of commitments for certain build-out. And they’re going to require

something like 30 gigawatts, which is the equivalent of 30 nuclear power plants in order to make good on all of the commitments that they have. That gets into a whole hornet’s nest of how the United States and other countries are going to be able to add all of that generation capacity at meaningfully attractive levels over the next few years. To me, those are two huge question marks about how open AI gets from where they are now to where they need to get to in the future.

There’s just a lot of questions there for

Stephen Clapham (38:48.814)

And you talked about an internal memo that Sam Altman had written forecasting a need for 250 gigawatts of power by 2033. I mean, that sounds like mad to me.

Michael Cembalest (39:03.02)

I think sometimes some of the Silicon Valley crowd like to speak in hyperbole because they would say, OK, fine, it’s hyperbole, but at least I’m kind of bringing people towards these higher goals. And I don’t think that some of those numbers are meant to be taken seriously. When our chairman says this is how much we’re spending on technology and this is what we’re playing, this is where we think we can get in terms of market share and the European commercial banking business. Those are hard targets that have been developed by

project teams and vetted by the board and other people involved. But I think when Sam Waltman talks, it’s meant to be more allegorical. But even in an allegorical framework, that number was shocking, which is why I included.

Stephen Clapham (39:46.87)

yeah i was shocked by it and were you surprised that you managed to raise a hundred ten billion dollars from nvidia and masa yoshi song or

Michael Cembalest (39:58.526)

No, I mean, first of all, you have a lot of entities that have raised money and need to deploy it. they can’t, know, SoftBank can’t be making small investments. They have too much money. And so there’s a lot of there are a lot of investors out there looking for big tickets. So that’s number one. Number two, a lot of money gets raised at times based on the vibe and based on

perceptions of where things are heading. Last year was a phenomenal year for stocks linked to small modular nuclear reactors, even though not a single one of them is actually under construction. And there are absolutely zero accomplishment targets that you can say have been reached. I mean, it was 100 % a vibe-based rally based on the perception that, well, the world’s are going to need these things.

You know, we got a lot of smart people working on it. And I mean, it’s all kind of allegory and anecdote. So I think part of a lot of the companies raising money are raising money based on the perception that we’re in this massively transformative world. you know, part of that is fueled by the incredible speed with which OpenAI has reached the 10 to 20 billion dollar, you faster than any other company in history.

So, I mean, they actually have certain metrics that look kind of remarkable, but part of it is also the statements that are being made by Anthropic about what’s going to happen to the labor market. And by Jensen Wang saying recently that OpenClaw is the most important software release of all time. And I told our people internally, to me,

I mean, I think Nvidia is obviously one of the best companies of all time and Jensen belongs in the pantheon of great CEOs. That particular statement sounded to me like this chairman of Saudi Aramco saying that the Hummer is the most important vehicle that’s ever been sold to the public. Right. Because there are times when these guys say things that are oriented towards policy and and you know how the world is changing. And then there are other comments that are mercenarily linked to their own fortunes and shareholders. And so, you know,

Michael Cembalest (42:18.144)

I think people sometimes look at everything that Sam Altman and Jensen and Tim Cook say and assume that all of it is meant as part of kind of a debate about the future and sometimes it’s less than that.

Stephen Clapham (42:33.154)

and the hundred and billion dollars won’t last and very long right these spending a lot of money and so he’s not he’s going to need another round and if he at some point is going to come to public market right i mean i was quite surprised to manage to raise a hundred and billion dollars at that

Michael Cembalest (42:49.11)

Remember, a lot of people who a lot of people are working backwards and saying, okay, when and if this thing goes public, I’m going to want to have a market weight position. I’m not going to be able to get a full allocation in the IPO. So I might as well participate on this thing because this cap this pre IPO capital raise, because I’m building towards a market weight position. Right. So I think some people

view these rounds in that regard.

Stephen Clapham (43:22.254)

Well, that’s interesting because I was wondering if he came to the stock market this year to raise $200 billion, I wonder if he could do it.

Michael Cembalest (43:30.732)

I don’t know. But again, we’re talking at a time that there’s a lot of volatility in capital markets conditions because of changing monetary policy, the war, volatile commodity prices. I know of some entities that have put in orders for these and intend to keep doing it in the pre-IPO market because they’re trying to build to what they think will eventually be.

a standard market weight position in the company. As a public entity.

Stephen Clapham (44:05.568)

Is there too scared to be have a zero weight in a

Michael Cembalest (44:09.998)

Yeah, I mean, a lot of institutional money and certain endowment and foundation money would say, yeah, we want to start out with a market-weight position in any stock. Now, most companies don’t have to worry about that because by the time they go to IPO, it’s 26 basis points of the S &P 500. Here, it’s going to be more than that.

Now the IPO may not be oversubscribed, but what if it is, right? So that’s, think, a lot of the thought process.

Stephen Clapham (44:42.39)

And this is a big issue, isn’t it? Because we’ve got SpaceX probably coming. There’s a bunch of very large tech companies that have stayed private for periods that we’ve never seen before.

Michael Cembalest (44:56.458)

between them tapping the equity markets as IPOs or what about Google in the fourth quarter of last year, out of nowhere for the first time in years borrowing money to finance data centers. So between the equity market and debt capital market, there’s been a shock to the system here. Now there’s plenty of investor capital that’s willing to take it on now, but it is little bit of a shock to the system to see all of that.

potential supply coming.

Stephen Clapham (45:28.682)

and have you looked at all united at a study few weeks few months ago if all these big private companies came to market tech would be like she i mean it’s already very significant in u.s. market we even more significant and we kind of all have to be tech analysts

Michael Cembalest (45:48.11)

Yes, but you know, the United States is somewhat of a victim its own success because the United States has historically been the most liquid market, the most diversified market that people use as the benchmark for all equity investing. If you look at other countries, you see very high concentration, if you do the top 10 company market share, the US is not at the top. Other countries are similar or higher.

both on top 10 stock concentration of the overall market or sector concentrations. A lot of smaller countries are very concentrated in terms of their sector weights and public markets. It’s just that the US never used to be. The US used to be this beautifully diversified market, if you had anywhere in the world if you made money, you could put it in the S &P 500 with the knowledge that you were getting utilities and healthcare and staples and…

and consumer discretionary and energy and basic materials and tech and software. so yeah, now those numbers are starting to drift up in the same way that the financial sector numbers drifted up before the financial crisis. it’s becoming more skewed, but in that regard is kind of looking like a lot of other markets and less like what it used to be, which is unfortunate. And a reason why

we’re looking to diversify our exposures and not just be too concentrated in the US going forward from here. But it’s really important to recognize that the tech sector of today is a lot more profitable, at least for now, than the tech sector of 20 years ago when there were no profits associated.

Stephen Clapham (47:33.55)

I’m less cyclical of course. So I normally finish by asking you to recommend a book and I know this is a sensitive topic for you. I’m not going to ask you to recommend a book but if you were teaching a class for young investors what would be the three most important economic macro concepts that they should think about and they should understand?

Michael Cembalest (48:01.55)

There are a lot of them. The advice I would give is slightly different. And I’ve talked to lots of young people that come to JP Morgan or at schools or something. And the financial industry is extremely jargon intensive, right? I met you because I was reading articles and didn’t understand the jargon. And I found my way to you because I was trying to understand this issue.

of the depreciation approach for certain components of data center investments, having shifted from three to six years, and why did that happen, and what does it mean? so understanding industry jargon is really important for young people, because if they don’t understand it, they’ll be in a meeting, and there’ll be a discussion, and they won’t really understand what’s going on. And they’ll leave the meeting. And I have had analysts forever.

I can tell by looking at them whether they can understand what’s being said. And you can tell when someone’s just completely lost. And the only solution to that is hard work. And I tell people you should read the Financial Times every day, and you should read Barron’s. And every time you see a word or a phrase you don’t understand, it’s a pain.

You got to circle it. You got to highlight it. You got to print it. You got to save it. You put it in a folder. And then if you work at a certain kind of organization or if you have friends, have someone explain it to you. There’s no better investment than you can make than that. Because a 23-year-old would be perfectly fine reading your really well-researched stuff, but only if they had some kind of working knowledge of the widgets and the terminology involved with the analysis.

And so for the young people that want to get into this industry, you have to make that investment.

Stephen Clapham (49:56.078)

It’s a very good lesson for me, but I’m going to make sure I’ve got less charting because I write for the professional investor. And you’re kind of known as the chart man, and you told us what your least favorite chart was. What’s your most favorite chart?

Michael Cembalest (50:09.314)

My, so this summer there was a 20th anniversary Eye on the Market compilation that was put together. And so we had the chance to go back over the last 20 years and pick some of the favorite charts and.

My favorite chart is how markets anticipate the future. So let me give you an example.

Michael Cembalest (50:41.112)

During the savings and loan crisis in early 90s, at one point, the bank stocks are down 60 to 70%. Only 20 % of the ultimate bank failures have taken place, but that’s when the bank stocks bottom. And for clients that are like, well, wait a minute, Mike, you want us to start investing in banks again, every morning I wake up, there’s another headline about a failed bank. I have to say to them, well, yes.

But like the way the financial markets function as a discounting mechanism, by the time the bad news on bank failures stop, the bank stocks will be 150 % up. And I have probably 50 versions of that chart in every business cycle across equities and commodities and credit. it’s the hardest part of this business because you have a crisis of some kind. And then there’s this kind of

incessant flow of bad news because the press is trying to explain to you the reason for the thing that just happened. It’s already happened. It’s in the price. And if you say, I’m going to wait until the clouds clear, you can do it if you want, but I’m going to wait and see until I, you know, I’m not going to invest until I start to see the unemployment rates come down or some other lag indicator, you’re going to miss all of the upside. So

And the short takeaway is sometimes we can’t see the things that lead to the crisis. And I’ll give you an example of one. But once it happens, you then have to start looking forward and say, OK, what’s in the price? for instance, in March 2009, only like 10 % of all the mortgage defaults that were going to happen had happened. But that’s when you had the bottom in a lot of housing related investments.

in the summer of 2008.

Michael Cembalest (52:43.758)

Remember, things started to get rattly in the summer and the preferred stock of the GSE started to sell already at a pretty substantial discount.

Stephen Clapham (52:55.884)

our friend.

Michael Cembalest (52:57.154)

which is in the center of the global financial system. Our firm made a capital investment for our own account of $2 billion in Fannie and Freddie Preferreds. And so we didn’t even see it coming, because those went to zero. Three months later, three months after they were purchased, the GSEs went into conservatorship and the Preferreds went to zero. So if we missed it, how bad things were, that’s a signal that sometimes the rot

that’s taking place in something is not even apparent to people that are sitting in the middle of it. And so you’re not gonna be able to anticipate every correction. The next best thing you can do is have your wits about you after it happens to the extent that you have some liquidity to look for future opportunity. And that’s been the unending cycle of my long career.

Stephen Clapham (53:51.116)

Michael, thank you so much. I’ve so enjoyed the conversation. Thank you for taking it. Thank you.

Michael Cembalest (53:54.35)

Thank you, Stephen. Nice to see you.

Stephen Clapham (54:14.638)

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