People are holding their breath right now, waiting for the “next thing” to happen. Most are focused on the debt ceiling or the new (and ever-present) hype around artificial intelligence.
The current consensus is positive. Though not all is rosy.
On one hand, the growth technology trade is working, backed in large part by AI and semiconductor stocks. Conversely, all else has traded violently sideways. We’ve also seen leading economic indicators deteriorate recently.
It creates an odd scenario. People are giddy about tech stocks, but other things could be crumbling at the same time. Also, stock performance in general has basically been an inverse of last year:
Change is constant.
To examine this disconnect, let’s look at some near-term history. The tale of the tape behind post-2009 tech stock performance was monetary policy and liquidity. With interest rates near zero, capital flooded into growth as there was nowhere else to go:
COVID-19 added fuel to the fire. Pandemic support pumped extraordinary amounts of money into the system:
We heard ridiculous stuff like how even though a tech stock is trading at 72 times its enterprise-value-to-revenue multiple, the growth rate is higher than its revenue multiple, so it can “grow into its valuation.” Lots of people were drinking the sauce.
Liquidity tightening had something to say about that though.
Stocks and bonds were hit hard in 2022 as the Federal Reserve tightened at a historical clip to help combat inflation. As easing worked in one direction, tightening worked in the opposite direction:
This is what makes 2023 so interesting. Tech growth and AI are turning their respective noses to the Fed. We see two main catalysts have driven the upward momentum.
First quarter earnings were better than feared. Have you ever heard the phrase, “under promise and over deliver?” Well, that's what growth tech did.
We started discussing growth tech in the third and fourth quarters of last year. The “big money” investor interest and mass downward adjustments of growth forecasts caught our eyes. Prices fell and apparently “big money” thought the doom was priced in.
But what does that mean? Shouldn’t it mean fundamentals are eroding and stocks will decline? Not exactly. As the most recent earnings reports showed, clearing a much lower bar of estimates can be valuable.
Technology firms have improved greatly from “moving fast and breaking things” to “growing slower and fixing things.” For instance, many companies laid off workers and maintained their earnings. In some cases, firms improved despite lower or slower growth.
In a higher-rate environment, less duration is ideal. In other words, cash pulled forward is preferable. Mega-cap growth tech is maintaining duration risk especially well, as this group has a significant amount of operating leverage. It’s a stark distinction from regional banks’ managing of duration risk.
Let’s drill down on the “stock of the year” so far, chipmaker NVIDIA (NVDA)#^. It’s riding high on AI hype. NVIDIA was experiencing massive year-over-year growth at the end of 2022 and the start of this year. But it was expected to contract in the coming quarters.
Demand pulled forward due to the pandemic did well for the stock. But revenue growth was sharply decelerating:
However, a bit of guidance about future AI business sent the stock soaring. As of this writing, it’s up around 175% so far this year:
That makes sense, right?
AI Inflection Point
The hype around AI might be justified. Entire industries and business models have the potential to be upended. To be clear, the default names to play in the space so far are Microsoft (MSFT), NVIDIA (NVDA), Google (GOOG, GOOGL), Amazon (AMZN), and Meta (META)#^.
AI isn’t the “new thing.” The reason it’s being touted now is because it could be the “new permanent thing” to bring productivity enhancements that significantly outweigh what the internet has done so far. When “big money” fund managers start paying attention, so should you, because stock prices start to move.
This potential revolution has directly impacted the performance of the market. Without the AI-related boom, the S&P 500* would be meaningfully down:
In fact, the S&P 500 has outperformed its equal-weighted counterpart by the widest margin since at least 1990:
How can we use this information going forward?
Looking at the past 30 years, the cap-weighted S&P 500 has outperformed the equal-weighted version half the time. But only three of those years resulted in losses 12 months later.
Also, BMO Investment Strategy Group came out with an interesting research paper. It showed how the S&P 500 has returned an average 6.7% in the subsequent six months after outperformance of the market’s largest five stocks:
In 12 periods of similarly narrow breadth, BMO found the index has only gone on to produce a negative return once.
Looking broadly, there are plenty of slowing economic indicators. And as discussed, the market is being bolstered by the AI boom. Even still, according to FactSet, the trailing 12-month price-to-earnings (P/E) ratio for the S&P 500 is 21.3 times earnings, which is less than the five-year average of 22.5 times earnings:
But just because we've had consolidation around AI doesn't mean that the performance going forward is going to be bad. Some people think it will be. But as we know, markets act unexpectedly.
In the war between growth and value stocks, there’s been a reversal. Value won 2022, but growth is re-establishing itself this year and taking the reigns as it has for much of the recent past. It’s created narrow leadership where investors have crowded around certain sectors while other industries have struggled.
But this creates opportunities for the broader market after any economic downturn!
#Cornerstone Financial Services, LLC owns MSFT, NVDA, GOOGL, AMZN, and META directly in managed client accounts.
^Daniel Milan personally owns MSFT, NVDA, and AMZN.
*The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.
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