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The Runaway Trade

By Kimberly Woody

Summer complacency reigns. The momentum trade is in, and no amount of geopolitical unrest, political squabbling, or signs of consumer weakness seem capable of taking the wind out of the sails. Two politically weighty felony convictions did little more than trigger a yawn. A Russian nuclear powered submarine Kazan rolled past the coast of Florida along with a support flotilla with little more than a few casual political volleys criticizing Biden’s “weak stance.” On the other hand, Apple debuts a moderately robust integration of Chat GPT available only on later model iPhones, Oracle references AI on its earnings call 14 times, Adobe posts a modest beat and raise but discusses AI monetization, and the stocks soar. You are either Artificial Intelligence (AI) or not and market breadth confirms this with index concentration reaching an all-time record in May. The top 10 stocks as a percentage of the S&P 500’s market cap now register 37.4% and the Magnificent Seven stocks are responsible for more than 60% of the S&P 500 index’s return.

The interesting thing about momentum is that it is self-sustaining. Indexes become more concentrated, investors are gripped by FOMO and valuation standards are reevaluated.  “Momentum” becomes most problematic when it is no longer perceived as such. Strategists argue for a new paradigm. After all, how can one really discount future AI opportunities? There is massive opportunity but one only has to look back 25 years as a case study on how poorly investors capitalize on speculative opportunity.

With a stable economy, showcased in part by a solid first quarter earnings season, continued solid employment, and inflation that continues to drift lower albeit at a pace slower than anticipated, it’s difficult to make the case for Powell et al. to vote for a cut to short term interest rates. The Fed’s dot plot (a summary of FOMC member expectations), however, suggests one cut in 2024 is forecast. One might argue this is in response to the ECB’s cut last week (while counterintuitively raising its inflation forecast), is designed to project political neutrality ahead of the election, or is only to appease an audience that typically does not respond well to surprises. Just six months into the year, economists have gone from anticipating 7 to 8 cuts in 2024 to one, maybe two.

Don’t fight the tape. AI affords massive productivity and profitability advances for many industries. AI could have the potential to be the world’s way out of its’ debt conundrum, but that’s a topic for another day. The dominance of the Magnificent Seven cannot be diminished or, even worse, dismissed. Failure to have exposure to those names has resulted in underperformance relative to key indexes since the market correction in 2022. We lament the index providers complicity in further fueling these concentrations by adding to the Magnificent Seven weights at rebalance rather than dispersing positions. That said, lemmings eventually end up heading over the cliff. This environment warrants trying to anticipate where the puck eventually rests along with prudent trims to outsized positions. We continue to advocate for diversification and posit that it is most important when investors least want to broaden their asset class exposure.

Source: FactSet, Federal Reserve Board, Ned Davis Research

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