Microsoft: AI Has Driven This To New Highs, But Storm Clouds Are Brewing (NASDAQ:MSFT)

by Levi; produced with Avi Gilburt

Artificial intelligence has existed for decades, but over the past six months it has been having a big moment.

That is how Lyn Alden opened a recent post. We do well to listen to the wisdom that she brings to the table in any discussion regarding stock valuations and future prospects for specific companies, as well as macro trends.

Recently Lyn shared a piece regarding the “AI Craze”. What follows is an excerpt from that post and helps us understand the current landscape. Then, we will discuss the technical picture and point out specific price levels to help identify what is most likely next for Microsoft (NASDAQ:MSFT) stock.

Lyn’s Discussion On The “AI Craze”

People imagine technology to be an exponential growth trend, but really it’s more of a stepwise trend. We stagnate for periods of time, find a breakthrough, experience an exponential growth period, hit a ceiling, and then stagnate for a while again. That’s the cycle we tend to go through.

For example, humans spent thousands of years wanting to fly with practically no progress. Then in the late 1700s we invented the hot air balloon and then the airship, and played with those for a century and a half with middling success. But ultimately, it was the combination of discovering petroleum, making engines, and processing aluminum, that made true flight possible.

Once we put those pieces together, we went from the Wright Brothers’ first powered flight to the Apollo 11 moon landing within the span of one human lifetime (1903-1966; just 66 years). It was an absolutely explosive period for aerospace innovation. But then we stagnated. In 1969 we had the first flight of the Concorde supersonic commercial airplane, and today we don’t even have that anymore for various technical and economic reasons that we couldn’t overcome. Our maximum flight speeds and ease of space travel have generally flatlined, outside of some niche military use-cases.

AI seems to be going in a similar “stagnant and then exponential” trajectory. For decades it was “neat” and gave us marginal gains in various areas. But finally with enough processing power and computer science breakthroughs, it has reached the point of being broadly applicable.

Generally speaking, AI can automate all sorts of tedious things, and will likely get better at it over the next several years. The creation of art, videos, music, code, and engineering designs can be made easier with text-based generative content. And it’s recursive; AI can review code and make programming easier, which accelerates software development, including AI software.

So, I think the impact from AI will be real and long-lasting.

However, that doesn’t mean we can pay any price for AI-related stocks. Just like how the development of the internet in the 1990s was real and long-lasting, it didn’t mean that dot-com stocks could be bought at any price. Many of them, including internet backbone companies like Cisco (CSCO) became wildly overvalued and had to spend a long time growing into their valuation even as the internet continued to take off in terms of adoption.

Microsoft (MSFT) is one of the biggest, most profitable, widest-moated, and most ubiquitous companies in the world. It’s one of only two corporations with a perfect AAA credit rating, which ironically according to S&P Global Ratings implies they are slightly less likely to default on their creditors than the U.S. federal government is over any given period.

In 2023, it has also become rather expensive again. The stock trades at 30x forward earnings despite already being a $2.5 trillion company.

The price/sales ratio is currently back over 12x, compared to the 10-year average of less than 7.5x.

This is despite the fact that the cost of capital is way higher today than any other time during that 10-year period. In other words, the opportunity cost for owning any particular equity is higher now; investors can get over 5% nominal gains on money markets and T-bills now, rather than the near-zero yield they would have gotten during most of this period.

An earnings yield is a company’s earnings per share divided by its share price (the inverse of a price/earnings ratio). If we take Microsoft’s earnings yield and subtract the 3-month Treasury yield from it and chart that spread over time, then Microsoft’s rate-adjusted earnings yield is currently at a rather low level.

Going forward, I don’t necessarily expect tech stocks to crash and go straight down like they did in 2022. They might just chop along in a range for a long time as earnings catch up. There are multiple different variables that can affect this.

Overall, I’d just be cautious when it comes to mapping out the forward expected returns of tech stocks like Microsoft from these levels, despite the fact that many of them are solid companies. I wouldn’t chase many of them at these prices.

Wave Setups Point To High-Probability Patterns

We have a regular feature that we simply refer to as “Wave Setups”. These are charts that Zac Mannes and Garrett Patten will post along with specific targets and also invalidation points for each setup. By way of review, here are the last two bullish setups for MSFT from December 22 of last year and January 26 of this year.

You can see from both charts that the setups did indeed play out as illustrated and led to nice gains for any that held a long position swing trade for the target shown on the charts.

However, once MSFT began to reach these targets, we considered the highest probability portions of the move as complete. We are now turning quite cautious the stock and can see storm clouds brewing for the near term.

The Technical Picture Going Forward

As you can see from both of our lead analysts, the current structure of price suggests that MSFT may be nearing an important high on the chart. While we are not outright bearish yet, note the recent comments from Zac:

While there is zero start to any clear move off a high yet nor any break of support…

If one wanted to start to explore something as a possible highly spec ‘place-holder’ position.

The C=A in the low 200s from this region up here and an extension toward 180s would be more ideal for the larger Cycle IV.

Risk: in this current setup, should the $375 level once again be exceeded to the upside, it would suggest that $390 is next.

What Truly Moves Markets?

We follow the fundamentals with Lyn Alden. Fundamentals are important. However, they typically will frame a thesis for a 3 to 5 year time period. As well, we have observed that fundamentals rarely lead the stock price on a chart.

So, if it isn’t fundamentals that lead, what is the driving force of important turning points in the markets? Sentiment. Simply put, fear and greed that battle against one another until the force of one overpowers the other.

Sellers will exhaust themselves at bottoms and buyers famously flame out at tops. All have observed fundamentals that get strenuously stretched to what appear to be absurd valuations to both extremes. Markets seem to be what we deem ‘irrational’ at these points. This is because markets are not logical, thinking entities. They are fluid, dynamic and non-linear in nature. Markets are sentiment in action before our very eyes.

Note this brief excerpt from an article that Avi Gilburt wrote regarding what truly moves markets. The piece was entitled, ‘This Analysis Will Change The Way You Invest Forever’. In part-2 (you can read it here) of the six-part series, Avi shared this point regarding Ralph Nelson Elliott’s market research and findings:

In 1941, Elliott stated, regarding the financial markets, that “[t]hese [Fibonacci] ratios and series have been controlling and limited the extent and duration of price trends, irrespective of wars, politics, production indices, the supply of money, general purchasing power, and other generally accepted methods of determining stock values.” As you can see, the more research conducted into this subject, the more support we find to Elliott’s theories set out almost 100 years ago.

There are many ways to analyze and track stocks and the market they form. Some are more consistent than others. For us, this method has proved the most reliable and keeps us on the right side of the trade much more often than not. Nothing is perfect in this world, but for those looking to open their eyes to a new universe of trading and investing, why not consider studying this further? It may just be one of the most illuminating projects you undertake.

(Housekeeping Matters)

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