For the past several quarters we have advised caution that risks of inflation, high interest rates, geo-political concerns, and a looming recession justify staying invested in a “conservative-moderate” diversified way. So far this has proven to be an effective strategy, as certain sectors have performed very well (mega-tech & consumer discretionary equities, short-term fixed income), while others have lagged (core industrial & financial equities, commodities). Of note, the funds and managed accounts that we utilize for our clients hold many of both these stronger stocks and these more modestly-performing asset classes. On balance, portfolios have experienced sound returns for the year.
So, What Now?
We continue to suggest investing with patience and diversification. Below we will present two cases for your consideration as to why we feel this way, one more broadly optimistic, the other offering a specific warning regarding the persistent rise in a handful of Artificial Intelligence (AI) friendly mega-tech stocks.
Optimism – Debt limit seems averted, inflation is easing, consumers are solid, and cash reserves remain steady. Recession maybe, hard-landing unlikely.
Investors headed into Memorial Day weekend worried about the debt ceiling crisis and breathed a sigh of relief as news of a tentative deal emerged during Saturday barbeques. While Congress still needs to deliver the votes, it’s looking increasingly likely that media eye-catcher will be averted. That response begs the question, though: haven’t stocks already rallied too much this year? The S&P 500’s 10.3% total return year-to-date (YTD) seems to fly in the face of talk of recession amidst continued high inflation and interest rates. The Federal Reserve may be ready to pause its rate increases, or may yet raise another quarter point in June (only the data and time will tell) as job market strength makes reducing wage and price pressures elusive. The market’s climb may seem at odds with our current, potentially tenuous economic environment. However, read on and you will see that this YTD "market gain" has in fact been in just a handful or two of mega-tech stocks.
The consumer economy remains remarkably robust, even as credit patterns normalize following the extraordinary stimulus measures during the COVID-19 pandemic. It is evident that borrowing costs have increased, while the willingness and capacity to borrow have declined. This will exert pressure on the U.S. economy in the latter half of the year which should subdue inflationary concerns. The U.S. banking and financial system remain robust, with well-capitalized banks, ample private capital reserves available for asset acquisitions, healthy corporate balance sheets, and investors holding substantial cash reserves. Yes, a recession may very well be on the horizon, but that horizon keeps moving further into the future as the U.S. economy shows greater resilience than anyone expected. A closer look at the market reveals that those risks have not been ignored. Rather, they likely explain the lack of appreciation in stocks beyond the handful of mega-techs that have surged and lifted the averages since the start of the year.
AI - What's Up and What's Not?
Of the S&P 500’s 10.3% total return, 9.99% was accounted for by just a handful of mega-cap tech stocks, leaving a mere 0.3% return for the entire rest of the market. Irrational exuberance or rational? Most of those price-soaring companies are central to the development and application of emerging AI capabilities. The public’s awareness of AI was triggered by the release of ChatGPT in November 2022. Since then investors have embraced stocks with even a tangential role to play in enabling or applying AI because, as one tech analyst wrote in a recent commentary, "AI is absolutely being adopted by companies and causing disruption...Artificial Intelligence is an agent of change. That is irrefutable." Companies across the economy are tapping into AI’s potential and that demand is causing a surge in investment in the hardware (servers and their chips) and software (cloud services providers, among others) on which it relies.
A Cautionary Consideration – In continuing to load up on these stocks, it appears that investors are taking a long-term view, even if the path forward may be bumpy. Some of these popular stocks which are aligning with the promises of AI have become “expensive” as conventionally defined. Owning a share of a company gives the investor a claim to the entire future path of earnings. We will not see an instantaneous jump in profits from AI in most cases. We are seeing instead an overwhelming step-change in the valuation of expected future sales and earnings growth of companies enabling this “irrefutable” change.
Historical evidence suggests that this remarkably narrow leadership is not without historic precedent. This focus on AI, albeit with huge long-term potential and short-term risk, is presently in-vogue just as many periods of tech disruption have displayed in the past. The chart below compares prior tech valuation over-extended peaks and suggests to us that something truly timely will be required to keep tech stocks climbing to even higher valuations to perpetuate this euphoric moment in time. No doubt AI holds tremendous promise, however, recent stratospheric price increases require us to consider being a bit cautious right now in these high-flying companies.
Seesaw - a seat at each end.
We actually believe the current menu of investment opportunities is very large. We are reluctant to overcommit to the sectors and speculative assets that have become so popular, but they all reside on one side of the seesaw and that seat is up high in the air right now. Counter-intuitively, the implied economic forecast of investing in that side of the seesaw seems immensely bearish. The implication is the global economy will be so weak that only a handful of companies will be able to grow. We strongly doubt a global depression. The other seat on the seesaw (the one now closer to the ground) contains all the other investment opportunities in the US and around the world. This is the side of the seesaw that provides diversification in our portfolios.
So, What Now? Balance on the Seesaw.
Given that our crystal ball remains hazy, our educated takeaway from this remains as it has for some time now…best approach is to remain balanced in anticipation of the return of volatility. Our plan is to keep an eye on the data to see how the economic "landing" starts to take shape. Of course, our thoughts may or may not be suited to your specific investment needs. We suggest if you have concentrated holdings in the mega-techs, well done, but you may want to pare some profits off the top. For the majority of our clients who have an objective of moderate growth with balanced risk, with equities, stick with some growth but overweight a bit the relatively undervalued equity classes of value and overseas. With fixed-income, stay tactical in allocations as markets are very dynamic right now in both duration and credit volatility. And holding a modest amount of cash-like funds is fine as well. Finally, with alternatives, the adaptability of managed futures and the steady income stream of low-leverage real estate funds may make sense during this period of uncertainty.
James and I hope you found this update to be of value. We welcome your feedback or questions.
The views stated in this commentary are not necessarily the opinion of First Allied Securities Inc. and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing. A diversified portfolio does not assure a profit or protect against loss in a declining market.
For informational purposes only. These strategies may not be suitable for you. This material does not take into account your particular investment objectives, financial situation or needs and is not intended as recommendations appropriate for you. Please consult with your financial professional for the purpose of assessing whether the ideas or strategies are suitable to you based on your own personal financial objectives, needs and risk tolerance. All investments involve varying degrees of risk, including loss of principal, and there can be no assurance that any specific investment will either be suitable or profitable.
Alternative Investments often engage in leverage and other investment practices that are extremely speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the loss of the entire amount that is invested. There may be conflicts of interest relating to the Alternative Investment and its service providers. Similarly, interests in an Alternative Investment are highly illiquid and generally are not transferable without the consent of the sponsor, and applicable securities and tax laws will limit transfers.