The AI Fueled Rally Continues
As June ends, the US stock markets will post another solid monthly advance. The Dow, the S&P 500 and the Nasdaq have posted positive monthly gains in five out of six months this year. This positive performance is attributed to declining inflation and solid economic data that in turn has buoyed both corporate earnings and investor sentiment.
Year-to-date performance, however, has been quite disparate. The Nasdaq (+18%) and the S&P 500 (+15%) have vastly outperformed the Dow (+4%). The biggest driver of this difference is exposure to the semiconductor chip sector that has been subject to the recent Artificial Intelligence (“AI”) craze. These few companies with NVIDIA leading the way account for 55% and 42% of the Nasdaq and the S&P 500’s year-to-date performance, respectively. Said differently, if you removed these companies’ performance, the Nasdaq and S&P 500 are up 8.5% and 8.1%, respectively. These are still solid returns, but it shows just how important AI has been to headline index returns.
The fixed income market also rallied in June bringing the US Aggregate Bond Index’ year-to-date total return to 0%. Bonds have been a material drag on investor portfolios for the better part of the last four years. As interest rates rose to combat inflation, bond prices fell. The bond market entered this year expecting nearly seven Fed Funds rate cuts but stingier inflation and a stronger economy than expected has reset expectations to just one or two cuts. This adjustment created volatility in the bond market this year, but recent tamer inflation and labor market readings have bolstered bonds. We noted last month that we expect interest rates to remain higher for longer. This should be supportive of positive mid-single digit bond returns. If the economy were to weaken, bonds are now well positioned to reward investors even more.
The Diversification Challenge
Last year it was the Magnificent Seven driving up the stock market. This year it is Nvidia and a handful of AI peers responsible for much of the market’s returns. When will the rest of the market get its turn? A broadening of the market would be welcome as there is substantial, unrealized value in non-technology sectors. In fact, for investors to achieve a diversified portfolio demands exposure to non-technology sectors, like energy, financials, and healthcare. Modern portfolio theory rests on using diversification to construct a portfolio to achieve the optimal balance between risk and reward. Therefore, diversifying holdings across sectors is important. Yet, markets with a concentrated return attribution force an uncomfortable trade-off between taking too much position concentration risk to achieve superior returns or suffer underperformance. Of course, you could do this but at what potential risk?
Further increasing concentration risk are the large allocations now given to just a handful of stocks in the S&P 500 index itself. The table below shows the top five holdings in the S&P 500 index.
The top five holdings in the S&P 500 index today account for 26.7% of the entire index. The top ten holdings account for 35.7% of the index, which is double the concentration ten years ago. In fact, the S&P 500 is currently the most concentrated since the 1970s[1]. This means that large movements in any of these large components can have an outsized impact on the entire market index. In other words, the market index itself lacks proper diversification in this regard.
Moreover, because the S&P 500 index uses market capitalization to weigh its members, the extraordinary outperformance of Microsoft, NVIDIA, and Apple relative to the rest of the index has led to high weightings (6-7+%). These individual weightings subject the index to potentially even higher volatility. To protect one’s portfolio from being whipped around by large positions, experienced portfolio managers cap individual position sizes. We cap individual stock positions at 5%, for instance. This means, however, that we are definitionally underweight these stocks in the name of safety. While this positioning creates a little bit of a performance headwind in the short run, we think of it as paying an insurance premium on a policy that one day we may be very glad we had.
Market Outlook
So long as the economy remains sturdy and inflation continues to decline, the conditions are supportive of a continuing bull market. As we just pointed out, however, we need to separate out AI stocks. AI stocks are being propelled by a secular tidal wave of demand that is largely detached from the economy and interest rates. AI’s transformative potential is still in the very early innings and a mandatory investment for nearly all types of businesses. AI stock prices have surged but a lot of it can be justified by a surge in profits. There will come a time when earnings growth decelerates, valuations decline and these stocks fall, but it is anyone's guess when this will occur. NVIDIA is set to release its new Blackwell chip and other AI-related businesses are just scratching the surface developing AI applications, so this is a theme that requires exposure. Nevertheless, we can expect volatility. We can also expect that the best performing AI stocks may change as well. Currently, the chipmakers are the big winners, but we expect that others may join in, including cloud infrastructure providers (ORCL), cybersecurity (CYBR) and those benefiting from AI’s productivity benefits, such as drug developers (XBI).
The rest of the market is more dependent on macroeconomic variables. Inflation continues to head downward. There are risks to that view, but our bigger focus is the labor market and, especially, consumer spending. Consumer spending has remained remarkably high despite higher interest rates and elevated price levels. But there are cracks beginning to show. Credit card balances are surging, retailers are seeing evidence that consumers are “trading down” and customer traffic at restaurants is showing some weakness. Lower income consumers are most affected not surprisingly. The high end is chugging along, and higher stock prices support their continued spending. We are not ringing the alarm bell on the economy, but we are watching every macro data point closely.
Bonds are a different story. The bond market may be at the beginning of its own bull market. With inflation generally in check, interest rates have stabilized and bond volatility has declined significantly. These are necessary conditions for bonds to play their traditional role once again in portfolios, which is to hedge stock exposure. Historically, when stocks go down, bonds go up. This has not been the case for years.
So, today, high quality, investment grade bond yields have reset to multi-decade highs and offer investors excellent mid-to-high single digit returns all else equal. This is our base case scenario. However, there is a bull case over the next 12-24 months that we find particularly interesting. In the case that the economy falters two things will happen. First, investors will seek shelter in high quality bonds. Second, the Fed will be forced to cut rates more aggressively and this will force investors currently hiding out in money market funds and short-term T-Bills to redeploy that cash further out the curve. In this scenario, long-term interest rates may decline potentially creating windfall bond profits. These profits could help offset any stock-related losses. We have developed a portfolio reflecting this strategy and are beginning to implement aspects of it throughout all of our strategies.
Conclusion
One of the hallmarks of our investment process is preparedness. As tactical investors, we do not have a crystal ball foretelling the future, but we can prepare for potential scenarios and react quickly and appropriately. There are times in market cycles when you can “set it and forget it”. This does not feel like those times. Rather, the market is marked by several potential inflection points that carry different outcomes. Interest rates may start heading lower. The consumer may weaken. AI could revolutionize industries. Bond convexity may come into favor. Where there are inflection points, there is opportunity, but it may require change. Change is what we are good at.
Disclosures
LIM is a Registered Investment Advisor based in Dallas, Texas and registered with the Securities and Exchange Commission. Registration does not imply a certain level of skills or training. LIM is a company with purpose, dedicated to creative and unique thinking. We focus on portfolio valuation and research, along with superior client experience. We seek to identify investment opportunities by looking at economic factors, security valuation and human behavior. We start with the fundamentals of portfolio management and valuation. Then we build on these fundamentals with unique thinking and creative intelligence gathering to form a viable investment thesis. We believe this approach leads to dynamic global portfolios with increased return and managed risk. LIM utilizes Charles Schwab & Co. Inc. (“Schwab”), a FINRA-registered broker-dealer, member SIPC, as its custodian of assets. LIM is independently owned and operated and not affiliated with Schwab.
Additional disclosures:
This document may contain forward-looking statements based on LIM’s expectations and projections about the methods by which it expects to invest. Those statements are sometimes indicated by words such as “expects,” “believes,” “will” and similar expressions. In addition, any statements that refer to expectations, projections or characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Such statements are not guaranties of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual returns could differ materially and adversely from those expressed or implied in any forward-looking statements as a result of various factors.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results.
Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
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Definitions
The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock’s weight in the Index proportionate to its market value.
The Nasdaq Composite Index is a market cap-weighted index, representing the value of all stocks listed on the Nasdaq Stock Market. The composition of the Nasdaq Composite is a mix of long-established companies that have been on the exchange since inception, to IPO newcomers, companies that grew from OTC exchanges or switched from other exchanges.
The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry. It has been a widely followed indicator of the stock market since October 1, 1928.
The Bloomberg US Aggregate Index is a broad-based flagship benchmark that measures the investment grade, US dollar-dominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate pass throughs), asset-backed securities and commercial mortgage-backed securities.
The S&P 500 Equal Weighted Index is the equal-weight version of the S&P 500. The index includes the same constituents as the capitalization weighted S&P 500 index, but each company is allocated the same fixed weight at each quarterly rebalance.
The Russell 2000 Index is comprised of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 Index total market capitalization.