Ketu Desai
By Ketu Desai
February was the month that AI disrupted the stock market. New tools from Anthropic and others created doubt for investors about the terminal value of many businesses. The epicenter of this is software companies who see multiple compression as most is derived from terminal value, which is now uncertain.
The selling spread to private equity and credit is due to high exposure to software companies. Trucking companies, real estate, legal services, travel, credit cards, financial data and service providers all got hit this month. The market sentiment has shifted from AI boosting business through productivity and margin expansion to it disrupting business; an overhang that will loom over many sectors such as software, private equity and credit, and certain travel websites.
For others, it’s difficult to be negative when the administration is trying to run the economy hot as the stimulative impacts of the “OBBB” will hit in the coming months. As the new Fed cuts rates aggressively, start buying bonds, and Fannie and Freddie buying MBS, there will potentially be lower tariffs with an earnings growth of 15% and margins hitting an all-time high at 14.8%.
Insiders agree they have meaningfully stepped up their purchases. Historically, when we see this type of insider buying, forward returns are strong.
Market structure has become increasingly important for portfolio construction. Much of the volatility was exacerbated by market structure. For many years, wealth management firms, target-dated funds, risk-parity funds, pensions and endowments, institutional investors, and CTAs dominated the marketplace. They often ran diversified portfolios which targeted volatility and typically run an equity portfolio with fixed income as both a diversifier and volatility compressor.
In recent years, these investors no longer dominate the marketplace with multi-manager platforms (pod-shops), quant funds, options traders, and retail now taking over. Many of these investors think of portfolios in buckets, factors, and themes. Pod-shops and quant funds often run high gross exposure (high leverage) with low net exposure. They will either run long themes / sectors or short ones. When taking down gross, fixed income will not hedge the portfolio because the moves will be incredibly violent.
Many big and popular names, previously thought of as “safe” were down over 20% in February. We saw dispersion at levels we last saw during the Great Financial Crisis at a 99th percentile event. With how fast the markets move these days and how disruptive AI has become, hedging your portfolio requires a new strategy. Understanding which pod-shops and quants are long and short is extremely critical. Having positions that are not crowded and dynamic hedging will allow you to survive de-leveraging events.
This is a market that favors equal-weight & active as opposed to large-cap, passive, and market-cap weighted. The combination of AI disrupting industries and the market structure will create massive winners and losers. For instance, the performance gap just two months into the year between software and energy is 50%. Even within tech, the gap between the winners and losers is in the 100th percentile, levels last seen in 2000.
Stocks are showing high dispersion and low implied correlation. The problem for index, buy and hold investors is that the sectors working in this environment are some of the smallest. Energy is just 3% and materials are less than 2%. The S&P 500 is more than 50% tech and tech-adjacent companies (GOOG, META, NFLX, TSLA, AMZN, etc…). This part of the market has moved away from generating high cash flow, having significant buybacks, and being capital-light instead.
The hyper-scalers will spend $646 bn this year, about 2% of the GDP; more than the military spending of Germany, France, UK, Japan, Italy and Canada combined. This creates massive uncertainty, when many of them have high multiples. Despite strong earnings growth, they are trading heavy because the market is re-evaluating the terminal value, which causes multiple compression. With these re-evaluations comes a rotation into other areas that have more certainty, such as energy, materials, healthcare, industrials, certain staples and utilities, and even certain semiconductors.
This process is likely to go on for a while due to the amount of positioning tech has built over the past 15 years. We could be in a situation similar to 1965, when the top ten stocks were nearly 40% of the index. These ten had underwhelming performance for a while after, while the rest of the market took leadership. Index investors will have large portions of their portfolio underperform, to the benefit of active and nimble investors.
Looking ahead, the market will focus on the latest from Washington, more AI news, and economic data.
Ketu Desai is the Principal of i-squared Wealth Management Inc. (www.isquaredwealth.com), an investment management firm based in New Jersey. ketu@isquaredwealth.com
