Categories: Eye on the Markets

Ketu Desai


By Ketu Desai

We are getting closer to rate cuts. The inflation numbers finally started to show a disinflationary trend. Headline CPI was flat on the month. Core CPI ex-shelter, a measure that the Fed pays close attention to, was actually negative. The Fed’s preferred inflation measure (PCE) is running at 2.6%. The Fed is forecasting just one cut this year while the market is expecting two. Either way, the next move will be a cut in a gradual and shallow cycle.

The neutral rate is higher than it was after the Great Financial Crisis. Monetary policy is not the driver of the economy or the market. This is a cycle driven by fiscal spending and a CapEx cycle led by AI. Less than 20% of the $2.4 trillion from the Infrastructure Bill, Inflation Reduction Act, and CHIPS Act has been spent. We are also in a significant corporate CapEx cycle driven by AI, which is also just getting started. Large cap tech alone will increase CapEx 35% this year. This is an arms race. This spending is what is driving the market, especially market-cap weighted indices. The market is far more sensitive to any changes in this spending than it is to monetary policy. Following fiscal policy and AI will be far more profitable this cycle.

The defining feature of the rally has been its narrowness. The top seven tech stocks have outperformed the remaining 493 by over 70% since the start of 2023. The market-cap weighted S&P has more than doubled the performance of the equal-weighted S&P since the start of 2023. Over the past year, just 7% of the stocks in the S&P 500 are actually outperforming the index. Nvidia accounts for over a third of the entire YTD gain. The top ten stocks are 35% of the index, greater than the previous peak of 30% in 1963. The extreme outperformance is justified by earnings growth.

Over the past year, large cap tech grew sales 15% with margins up 6.1% leading to 60% earnings growth. Compared to the remaining 493, which grew sales only by 3% with margins contracting and earnings falling 2%. While the earnings gap will narrow, it will be hard to fade these names until the AI story changes. Not to mention, they have the best balance sheets, highest cash flow generation, the best margins, are not sensitive to rates, are the most levered to AI, and have the largest buybacks. They will benefit the most from the trillions that will come into the market as FOMO starts to hit those sitting in cash. With significant geopolitical and election uncertainty around the globe, money will flow for the best. Simply put, they are both on offense and defense right now. The pain trade might be even more concentration.

For the past fifteen years, software companies have been some of the biggest winners in the market. Investors were willing to pay high multiples for Software-as-a-Service (SaaS). Investors loved their high growth rates, high margins, and reliable subscription revenue. They were not subject to the boom-and-bust cycles of hardware companies. Companies such as Adobe, Salesforce, ServiceNow were some of the biggest winners in the market.

In recent weeks, investors for the first time in a while have started to question their investments in SaaS companies. We’ve been receiving warning shots all year that growth was slowing at SaaS companies. Salesforce missed both top and bottom lines as it saw its stock fall nearly 20% and glide to just 8-9% growth with lower margins. We have witnessed similar slowing across many names in enterprise software with near-term risks is that the sales cycle is longer and tech budgets getting tighter. CTOs are investigating how AI can be integrated into their business. The longer-term risk is that AI could make certain software commoditized. The IGV (software ETF) trades at a 50% premium to the S&P. With that kind of premium, slowing growth, high positioning, we may be in the early innings of the SaaS unwind.

Looking forward, the market will focus on the election, second quarter earnings, and a Fed meeting.

Ketu Desai is the Principal of i-squared Wealth Management Inc. (, an investment management firm based in New Jersey. [email protected]