Ketu Desai
By Ketu Desai
August marked another step in the normalization process. CPI for the first time during this inflation fight came in with a 2-hander. Growth is settling into a steady state range between 2% and 2.5%. The yield curve is on the verge of normalizing positive. September will likely mark another major step in the normalization process. The Fed will start to normalize interest rates. The debate right now is whether they cut 25bps or 50bps. Either way, the process to get to a neutral interest rate is about to begin.
The pace at which we reach neutral will be determined by the labor market. Growth and employment data will now take precedent over inflation data. The Fed will join 17 other major central banks in cutting rates this year. This is a global easing cycle. As the market prices in cuts, the dollar has begun to weaken. The dollar in recent weeks has broken significant technical levels, as a weaker dollar tends to loosen financial conditions. The takeaway is that these conditions with the Fed put will allow investors to take more risk.
With loose financial conditions, markets are also likely to normalize. The defining feature of the market rally since the start of 2023 has been its narrowness. The market cap-weight S&P has more than doubled the performance of an equal-weight one. In the second quarter alone, the outperformance was nearly seven percentage points, one of the largest on record. The outperformance is solely driven by large cap technology.
When we have had a similar outperformance, the market-cap weight S&P has underperformed equal- weight by 21.7% and 42.4% on average, over the next three and five years, respectively. The top ten stocks are 36% of the index, greater than the previous peak of 30% in 1963. We appear to be at an inflection point where mean reversion could occur. Historically, when the Fed changes policy, market leadership changes. The market-cap weight S&P 500 trades at a 34% valuation premium to equal-weight. The entire valuation premium is driven by the large cap tech names, which have a 50% valuation premium.
Many of these tech names face headwinds as they are on their way to spend hundreds of billions on AI related CapEx, with a return that is highly uncertain. The sentiment around this spend has changed quite significantly in recent weeks. The market for the better part of a year gave these companies the benefit of the doubt, now it is questioning whether the return will be worth the spend. The CEOs view falling behind in AI as an existential risk for their business. They have made it clear that they are more likely to over-spend than under-spend, so if this spending continues and investors don’t know the return, it will keep a lid on valuation.
Nearly all large cap tech is under some sort of regulatory or legal pressure. In August, Alphabet lost its antitrust case, which threatens its business model, as well as the billions it pays Apple. Regulatory and capital allocation concerns are likely to remain a headwind. Headwinds such as these make it harder to have high levels of growth, especially on their denominator. Decelerating growth with a valuation premium and full positioning is a recipe for investors to reduce exposure. While some positioning has come off with the unwind of the Yen carry trade, positioning in large cap tech remains high.
It seems unlikely that trades that have been built up for a decade or more have unwound that quickly. From a technical perspective, many of the large cap tech face heavy resistance not too far above where they trade now. With high positioning, high valuation, decelerating growth, regulatory and capital allocation concerns, it may be difficult to break through this resistance.
As these tech companies spend hundreds of billions on developing AI models, consumers of AI can benefit from its early stages. Walmart’s latest earnings highlighted the potential for AI. Their CEO recently stated, “We’ve used multiple LLMs to accurately create or improve over 850,000,000 pieces of data in the catalog. Without the use of generative AI, this work would have required nearly 100X the current headcount to complete in the same amount of time”.
Similarly, Klarna’s CEO said, “In H1 24, we saw firsthand the benefits of adopting practical AI. Our AI assistant now performs the work of 700 employees, reducing average resolution time from 11 minutes to just 2, while maintaining the same customer satisfaction scores as human agents.”
It is becoming increasingly clear that AI is a “weight-loss drug” for corporations. We are likely in the early stages of the market rewarding the consumers of the technology (SPX 493) rather than the producers of it (large cap tech). Goldman estimates that AI could lift productivity by 1.5% per year, driving margins up 4%. Earnings growth reflected positively for the S&P 493 in the second quarter. They are expected to grow to double-digits in 2025. While large cap tech faces margin pressure, S&P 493 is likely to expand. Margin improvement from lower financing costs, AI, cheaper commodity and input costs will drive upside to earnings. After a long period of doing nothing, the conditions are coming together for S&P 493. The combination of a weaker dollar, looser financial conditions, rate cuts, Fed output, and earnings growth will likely lead to a more normal broad-based rally.
Looking forward, the market will focus on the election, the economic data, and the September Fed meeting.
Ketu Desai is the Principal of i-squared Wealth Management Inc. (www.isquaredwealth.com), an investment management firm based in New Jersey. [email protected]
