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The path to bull market glory doesn’t go through Walmart, Berkshire Hathaway, and Eli Lilly.
There has been near-panic buying in traditionally defensive, high-quality stocks in recent weeks, an almost equal and opposite offset to the selling pressure in semiconductors and AI development spending. The three stocks above – the only members of the $1 trillion market cap club that aren’t big tech – have collectively added $550 billion in market value over the past month, almost making up for what Alphabet lost.
The Nasdaq-100 and the S&P 500 Low Volatility ETF (SPLV) are hurtling toward each other in a picture of satisfying symmetry that nonetheless reflects an almost comical level of tactical rotation executed by an investing community accustomed to playing one factor against another.
While this back-and-forth has so far protected the S&P 500 as a whole from an appreciable setback for months, it has left it stuck around levels dating back to May – before we had two seasons of earnings releases showing 30% annual earnings growth.
A week ago, I suggested that the AI theme was poised to stage a rally or risk abandoning its leadership status and destabilizing the market as a whole. So far, this trade has failed to respond to moderate oversold conditions or a series of cosmetically strong hyperscaler quarterly results, further loosening its grip on the benefit of the doubt.
In stressed markets subject to soul-searching about the long-term bull thesis, prices often must travel further to find convinced buyers, while market action must disappoint bearish buyers to extinguish complacency. It’s hard to know if we’re there, but we’re probably closer now.
The Nasdaq-100 closed Monday right at its 200-day moving average, down nearly 11% from its record high. After an unnerving and failed rebound attempt Monday morning, the Philadelphia semiconductor index finished down another 3.8% and stabilized below the late July low set as hedge fund Situational Awareness completed its liquidation.
“Markets failed to understand that seasonal downside pressure typically subsides by mid-October and instead ended the month with some of the sharpest selling pressure seen in late summer and early fall,” notes JPMorgan technical strategist Jason Hunter. He advises his clients to remain defensive “until we see clear evidence of a bottoming process on the charts or until there are clear signs of capitulation.”
This is a proven model, even though many sharp market downturns have ended without what could be described as total capitulation.
Market action is drawing praise for how non-tech stocks have held up better, with many groups benefiting from the “quality” rotation while abandoned consumer cyclical stocks are getting some respite from falling oil prices and the 10-year Treasury yield falling below 5%.
This gives active managers plenty of work to contend with a highly concentrated and technology-dependent S&P 500. But I will continue to argue that the bull market built on the AI story will almost surely need the AI story to get back on track and continue moving forward. A prolonged period in which the equal-weighted S&P 500 outperforms the market-cap-weighted version is otherwise known – generally – as a bear market.
The weighting of AI-related stocks in the S&P 500 is off the highs but remains near 45%, according to Morgan Stanley.
As the chart shows, AI wobbled relative to the rest of the market during this uptrend before reasserting itself. But there’s a trickier element to today’s gut check: In earlier phases of construction, the key limiting bottleneck gave investors something to buy to exploit.
The initial scarcity of GPUs meant that Nvidia had to own it first and foremost from 2023 to 2024. When cloud capacity, power, and cooling proved to be the scarcest resources, hyperscaler stocks performed and AI-adjacent industries were significantly reevaluated. Then the memory kicked in as the choke point and Micron and Sandisk went stratospheric.
Now, as Nvidia’s Jensen Huang said, capital is the constraint and that not only leaves no assets to buy, but it largely increases the cost of capital as mega-caps go negative in terms of free cash flow.
Overlapping feedback loops and blurred correlations between markets and the real economy have further undermined investor conviction. Treasury yields no longer move with oil, but largely with AI investment sentiment, both of which have been in decline lately. AI stock setbacks also dampen inflation dynamics and the wealth effect of stocks, meaning fewer rate hikes from the Federal Reserve are expected now compared to a month ago.
This all probably sounds like an elaborate trap, and it has become a trap for previously crowded trades. Could this reflect the end of the market’s chapter of AI exuberance, which, as I keep pointing out, peaked around SpaceX’s IPO in June? Can’t say for sure, but if it did, I’m not sure things would be much different at this point.
But I don’t want to rule out the possibility that a lot of the known challenges are largely reflected in the prices.
I argued in August that we should assume that the valuation peak for this cycle has been reached. We have now fallen back to a forward P/E of 18.5 on the S&P 500 from 23 a year ago and the Nasdaq-100, at 20x, has the lowest premium to the S&P 500 valuation in nine years. I agree with the idea that the market is telling us that companies are “over-profiting” now, but at least the valuation risk is less today than in recent months.
Sentiment towards AI stocks is at an all-time low. Fund positioning in technology has fallen below the neutral point. This year, significant trading lows occurred near the end of the month on March 30 and July 29, and the relative value of the Nasdaq-100 strength is exactly as oversold as it was at these turning points.
So stay tuned for possible relief rebounds that could evolve into something more substantial if the midterm elections play out in a way that allows traders to relax a little in the home stretch of the year.
Market Temperature Gauge
John Kolovos of Macro Risk Advisors on the latest reading: “Similar to valuation, sentiment is not a timing tool, but it is becoming increasingly difficult to find bulls, as a near-perfect storm of tight financial conditions collides with tech profits that have gone from bad to worse in the blink of an eye.”
Around the street
-Another good big-picture conversation about the practical business and investment implications of the next phase of AI proliferation on Patrick O’Shaughnessy’s Invest Like the Best podcast, this one with investor Cliff Sosin. Of particular interest is his comparison of the economics of AI infrastructure with those of internet connectivity providers and his argument that most of the increase in productivity will be devoted to “consumer surplus” rather than corporate profits.
-For my birthday on Monday, my colleague and friend Sara Eisen wondered how I was going to write myself a birthday message. I immediately regretted suggesting he ask ChatGPT, which generated this believable and somewhat embarrassing result:
“Another year, although the long-term trend remains constructive. A slight deterioration of the underlying internal parameters, perhaps, but nothing to suggest a decisive break.
“The candles on the cake are approaching historically high levels, although valuation concerns have persisted for years without derailing progress. At this point, the key question is not whether I have aged – that is largely priced in – but whether wisdom gains can continue to offset the inevitable compression of energy multiples.
“For now, I maintain a cautiously optimistic outlook, with upside, downside support from family and friends, and no immediate need for Fed intervention. Happy birthday to me. The secular bull market remains intact.”
Market closed
The rush into stocks perceived as defensive has been a crucial driver of Apple shares’ massive outperformance relative to the Nasdaq-100 since the furor around AI investments erupted a few months ago. Apple, before releasing its earnings report on Monday, had outperformed the Nasdaq-100 by nearly 20 percentage points over the previous six months.
Its singular refusal to join the aggressive spending spree to build AI capabilities preserved its free cash flow and made it the perfect counterweight to investment trading, while inflating Apple’s valuation to a 15-year high.
But its free cash flow yield advantage has now narrowed, thanks to its rising share price and the collapse of its peers’ stocks.
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Gn bussni
