June 1st, 2023

We noted in our Q1 newsletter that the broad-based rally we were seeing in the most economically sensitive stocks had caused us to get more bullish on the stock market at the beginning of the year. That has proven to be the right call thus far, with the S&P 500 up almost 11% year to date as I write this. However, over the last couple of months, we have seen a rotation in stock market leadership from the economically sensitive stocks to very large tech stocks.

Perhaps the biggest reason we have seen this rotation is the emergence of new artificial intelligence technologies over the past few months. Notably, OpenAI released the ChatGPT3 AI chatbot in November 2022 and the updated ChatGPT4 in March 2023. In January, Microsoft announced an additional $10 billion investment in OpenAI and in February they announced the addition of an OpenAI powered chatbot to their Bing search engine. There have also been several high-profile releases of “generative AI” products that can do tasks like creating pictures and artwork from text-based prompts.

All this buzz around AI has resulted in investor demand for “AI stocks.” For better or worse though, there are very few pure-play AI companies that are publicly traded. More of these companies will surely go public over the next few years, but the supply of AI stocks is very limited at the moment. This has led to some wild moves in the prices of the AI stocks that are publicly traded.

Below is a chart of some of the stocks that get lumped into the AI basket:

As you can see, these stocks have handily outpaced the S&P 500 year-to-date. You can also see the volatility associated with these stocks (C3.ai is the poster child for AI volatility).

Microsoft, Google, Amazon, and Nvidia are all extremely large companies. In fact, they are the 2^nd, 3^rd, 4^th, and 5^th largest companies in the world, respectively. This means that when they are performing well, they have the power to keep stock indices moving higher even when most of the other stocks in the world aren’t doing as well. That is exactly what we witnessed over the last 3 months.

The following chart compares the performance of the technology sector of the S&P 500 to the S&P 500 itself, and the “Equal Weight” S&P 500. The S&P 500 is weighted according to market capitalization (the total value of each company based on the current market prices) whereas the equal weight ETF weights each of the 500 companies equally. This really highlights the effect that the very large tech companies have had on the market so far this year.

The next chart highlights the divergence in year-to-date performance between the S&P 500, US Mid-Cap stocks, US Small-Cap stocks, and Emerging Markets stocks:

The last chart shows the S&P 500 and each of the stock sectors in the S&P 500.

As you can see, seven of the eleven stock sectors have posted a negative total return year-to-date, with an eighth (industrials) barely eking out a gain. The three positive sectors are:

• Technology: No surprise
• Communication Services: Which has nearly 52% of its holdings in just Facebook and Google, which most people consider to be tech companies.
• Consumer Discretionary: Which has over 41% of its holdings in just Amazon and Tesla, which again, most consider to be tech companies.

We certainly understand why the market is viewing these new AI technologies so positively- the tasks this software can perform are truly remarkable and the potential market for selling this technology is massive. However, we have seen stock bubbles around new technologies before- think the Dot Com bubble, 3D printing, autonomous vehicles, electric vehicles, and the list goes on. Many of the companies associated with these new technologies don’t end up performing as well as expected after the hype wears off.

On the stock market as a whole, the very narrow leadership we have seen over the past few months is far less healthy than broad-based strength where hundreds of stocks are moving higher together. We have started to see some broadening out this week and we hope that trend continues.