Rational Exuberance

By Dr. JoAnne Feeney, Portfolio Manager

Investors headed into Memorial Day weekend worried about the debt ceiling crisis and breathed a sigh of relief as news of a tentative deal emerged during Saturday barbeques. While Congress still needs to deliver the votes, it’s looking increasingly likely that catastrophe will be averted. Stocks are rallying in response in pre-market trading. That response begs the question, though: haven’t stocks already rallied too much this year? The S&P 500’s 10.3% total return year-to-date (YTD) seems to fly in the face of talk of recession amidst continued high inflation and interest rates. The Federal Reserve may be ready to pause its rate increases, or may yet raise another quarter point in June (only the data and time will tell) as job market strength makes reducing wage and price pressures elusive. The market’s climb may seem at odds with our current, potentially tenuous economic environment. But is it? This time, investor exuberance has some solid foundations.

While the unemployment rate is at historical lows and consumer spending solid, job openings have moderated and consumer indebtedness has increased while inflation has eroded household budgets. Manufacturer orders have dropped from their mid-2022 peak (and justifiably so) and manufacturer surveys point to slower growth ahead. Yes, a recession may very well be on the horizon, but that horizon keeps moving further into the future as the U.S. economy shows greater resilience than anyone expected. A closer look at the market reveals that those risks have not been ignored. Rather, they likely explain the lack of appreciation in stocks beyond the handful that have surged and lifted the averages since the start of the year.

The seven largest technology and consumer companies (led by Apple, Microsoft, Amazon, and Alphabet)[1] accounted for almost all the rise in the S&P 500 thus far in 2023. Of the S&P 500’s 10.3% total return, 9.99% was accounted for by just eight stocks (Alphabet has two, GOOG and GOOGL), leaving a mere 0.3% return for the entire rest of the market. A hint at this concentration in performance is found by contrasting the percentage changes in the S&P 500 (in white), which is a market-capitalization-weighted index, with that of the equal-weighted S&P 500 (in blue):

The equal-weighted index shows that the average stock has risen only 0.4% YTD, even as the S&P 500 has risen over 10%. The lack of breadth in the market’s rise reflects those economic (and political) risks.

Those eight largest technology and consumer stocks, by contrast, rose on average by 67%, compared to that measly 0.3% for the rest of the market.  Irrational exuberance or rational? Most of those companies are central to the development and application of emerging Artificial Intelligence (AI) capabilities. The public’s awareness of AI was triggered by the release of ChatGPT in November, 2022, and since then investors have embraced stocks with even a tangential role to play in enabling or applying AI because, as my colleague, Randall Coleman wrote in a recent commentary, “AI is absolutely being adopted by companies and causing disruption…Artificial Intelligence is an agent of change. That is irrefutable.” Companies across the economy are tapping into AI’s potential and that demand is causing a surge in investment in the hardware (servers and their chips) and software (cloud services providers, among others) on which it relies.

Some of these stocks have become “expensive” as conventionally defined. The most commonly used valuation metric, the price-to-earnings ratio, looks at a stock’s price relative to a single year’s earnings. Owning a share of a company, however, gives the investor a claim to the entire future path of earnings. We will not see an instantaneous jump in profits from AI in most cases. We are seeing instead a step-change in the expected future sales and earnings growth of companies enabling this “irrefutable” change. Investors have found companies that can provide years of growth at a time when growth more broadly is slowing down.

It appears that investors are taking a long-term view, even if the path forward may be bumpy. We are frequently asked whether the market has become “too expensive” and if it’s a good time to own equities. The recent rise in the S&P 500 amplified those inquiries. Yet, the market, outside of the “Super Seven,” has barely budged. It reflects the broader concerns of recession, but in so doing, it has left opportunities for the investor who recognizes that our current risks—inflation, rates, and recession—would stir up, at most, only temporary headwinds for the economy and stocks. Over the long haul, equities have done a terrific job of helping households build wealth, and these times are no different. In the meantime, the Super Seven are leading the way.

[1] The seven are Apple, Microsoft, Amazon, Alphabet (GOOG, GOOGL), Nvidia, Tesla, and Meta.

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