Stocks Were Sinking on AI Fears. Then Powell Came to the Rescue.

Stocks shot higher Friday after Fed Chair Jerome Powell hinted at an interest-rate cut in September. (Michael Nagle/Bloomberg)

The stock market snatched victory from the jaws of defeat this past week, thanks to a surprisingly dovish Jerome Powell.

Nvidia’s earnings report could be what it needs to head even higher.

Fear was in control during the first few days of this past week. Artificial-intelligence fever had turned into AI flu, causing Nvidia stock to drop for three consecutive days and the rest of the Mag Seven to stumble. Then, Federal Reserve Chair Jerome Powell’s speech at Jackson Hole suggested he was leaning toward a September interest-rate cut, sending stocks roaring back.

Created with Highcharts 9.0.1Market SnapshotSource: FactSet

Created with Highcharts 9.0.1Dow Jones Industrial​AverageS&P 500 IndexNASDAQ Composite IndexRoundhill Magnificent​Seven ETFAug. 18Aug. 22-5-4-3-2-10123%

Despite starting on Friday with losses—and, in the case of the Nasdaq Composite, very large losses—the S&P 500 index finished the week up 0.3%, while the Dow Jones Industrial Average rose 1.5% to a record high, and the small-cap Russell 2000, long a laggard, gained 3.3%. Only the Nasdaq finished the week lower, but only by 0.6%.

The response to Powell’s pivot seems appropriate. Heading into the speech, the market was betting on few rate cuts—perhaps none—before year end, as Powell wrestled with a weakening job market, on the one hand, and a potential uptick in inflation, on the other. Powell, though, began his speech noting that the risk of rising prices had “diminished,” while the unemployment rate had risen by nearly a full percentage point from a year ago.

Investors focused on his labor-market views. Ironside Macroeconomics founder Barry Knapp, for one, is more worried about the job market—payrolls grew at a paltry 35,000 a month for the past three months—than inflation, and was relieved to hear that Powell was, too. “More dovish than expected, appropriately so,” he says. “There’s a chance they could end up [cutting by half a point] in September.”

Others are focused on the persistent problem of price inflation. Consumer prices, excluding volatile food and energy, rose 3% year over year in July, faster than economists expected and above the Fed’s 2% target. Wholesale prices, a leading indicator for consumer prices, rose 0.9% month over month in July, the biggest increase in about three years. If inflation remains at 3% and consumer spending slips, causing the U.S. economy to grow at a rate of just 1% to 2%, it could result in “stagflation”—and a market correction, says Barry Bannister, chief equity strategist at Stifel.

That isn’t 1970s-style stagflation —when inflation averaged some 7% annually, with growth about 4%—but it’s still bad for stocks. The S&P traded for about 15 times trailing earnings entering the ’70s and exited the decade at nine times. Today, the S&P 500 trades for 25 times trailing earnings. That valuation is why Bannister fears a drop of 10% to 20% from recent highs.

For now, investors are more aligned with Knapp than Bannister. And with rates most likely declining, they can turn back to Nvidia and the health of the AI trade. Nvidia is expected to report a profit of roughly $1 a share on $46 billion in sales when it reports second-quarter earnings on Aug. 27. Based on prior responses to the numbers, the company needs to beat the Street earnings estimate by roughly 10% for the stock to rise.

There’s also the matter of guidance. Nvidia has consistently guided next-quarter revenue above the Street, and it needs to do so again for the stock to pop. A third-quarter sales guide of about $54 billion and earnings of $1.10 or better should be good enough.

If Nvidia delivers, as Powell did on Friday, those sputtering animal spirits should roar back to life.

Write to Al Root at allen.root@dowjones.com