We have just experienced one of the strangest quarters that I can remember. At the beginning of June, Goldman Sachs research indicated that all of the return for the S&P 500 year-to- date through May was attributed to just seven stocks; the other 493 stocks in the S&P 500 have an average return of zero, nada, zilch. How did that happen?

Let’s start with some history. We are going back all the way to 2022…which sounds silly in most conversations, but stock market participants are famous for their extraordinarily short memories. After a decade of technology stocks dominating all the returns in the stock market, the rest of the market finally got some revenge in 2022. Value investors outperformed their growth colleagues for the first time in a long time and the gap was large in the final quarter of 2022. The Russell 1000 Value Index was up 12.42 percent, while the Russell 1000 Growth Index was up only 2.2 percent.

The new year began with growth stocks making a comeback: In the firstquarter of 2023, the growth index was up
14.37 percent, with the value index up just 1.01 percent. At first this was just the normal back-and-forth of the markets. We often refer to a phenomenon known as reversion to the mean – meaning that stock investment results tend to move toward the long-term averages. If they get well above the average they tend to drop, and if they get too far below the averages, they tend to rise. That explains one good quarter for the growth stocks, but as we moved into the month of May, something else started to take over – something that is certainly artificial, but is it intelligent?

Time will tell as far as stock prices go, but there is no doubt that artificial intelligence (AI) has dominated the stock market in 2023. The poster child for this phenomenon has been Nvidia; the stock has risen 189 percent in 2023. Before we get too excited, remember one thing pundits never bring up: Nvidia stock went from $326.76 in November 2021 to $121.39 in September 2022. The stock is up approximately 30 percent from its high in late 2021, which is a solid two-year return, but not as exciting as the “up 200 percent” we hear about.

The rebound in Nvidia stock has to do with generative AI such as ChatGPT. These are computer algorithms that can create new content. It is a breakthrough in computer technology, and the long- term potential is tremendous. Experts in the field have suggested that AI will be bigger than the internet, and there is already fear of AI coming for all of our jobs. The machines will take over just like they did in “2001: A Space Odyssey,” or “The Terminator,” or “The Matrix,” or “I, Robot” … you understand, it has been a thing for a while now.

Nvidia is the leader in designing chips used in Graphic Processing Units (GPU), which are key to the computer power necessary for AI. Microsoft has also benefited as they are a leader in the cloud and have announced a partnership with OpenAI, the maker of ChatGPT. Additionally, some well-known tech companies have the potential to benefit: Meta (Facebook’s parent company), Alphabet (Google’s parent company), Amazon, Apple, and Tesla are all believed to be beneficiaries of AI’s potential. Combined with Nvidia, they have been dubbed the “Magnificent Seven.”

It is these seven stocks that have dominated the returns this year. They completely skew the valuation of the market and the market’s return, and it is these that pundits are really talking about when they ask if the market can continue to rally. Let’s address them specifically.

I am no technology expert, but I do know a little about how the market reacts to technological breakthroughs. The market response is a phenomenon called the Gartner Hype Cycle: It begins with a technological trigger – the breakthrough itself kicks things off. We then move to the peak of inflated expectations, and early publicity leads to grossly exaggerated claims of potential. Then, we enter the trough of disillusionment – technology has never adapted as quickly as the zealots believe it will, and when the fantastic predictions fail to immediately materialize, then bubbles burst and stocks plummet.

That leads to the slope of enlightenment: Technology has never adapted as quickly as zealots believe, but it has adapted faster than naysayers would suggest. People start to see realistic applications. These realistic applications eventually lead to the plateau of productivity, in which the new technology is being used to make our lives easier – not as first imagined, but in real ways nonetheless.

AI is currently in the peak of inflated expectations. Nvidia’s stock is selling at a price-to-earnings (P/E) ratio of 215, so a speculator in Nvidia’s stock is paying $215 for every $1 in earnings. That is not sustainable, but does that mean the market will come crashing down?

No, it does not. There are 493 stocks in the S&P 500 alone that have been neglected thus far in 2023. The excitement over AI is understandable, but it is only part of the market story thus far in 2023. The other part remains the insistence by many pundits that the recession they said would be here by now is just delayed, as opposed to them just being wrong. The theory goes that the never-arriving recession is right around the corner and therefore stocks will get beat up, so let’s get ahead of it and beat them up now…except for the Magnificent Seven, because with the power of AI these companies will be able to grow regardless of what is happening in the economy. That is true and was certainly the case in the aftermath of the Great Recession. Then it was the FANG stocks (Facebook, Amazon, Netflix, and Google) that held up the market. However, the idea that we are heading into a recession today has thus far been wrong. At some point, reasonable people must admit their mistake.

Let’s play devil’s advocate just for a second: Let us pretend that the people who have been saying we are heading into a recession for the last year and a half are actually correct, so the recession arrives and the AI companies are the only ones growing. So far so good, but what about the stocks that usually hold up in recessions? Defensive stocks like utilities? Duke Energy’s stock is down 13 percent year to date. This makes no sense for two reasons: First, utilities should hold up well in a recession, and secondly and perhaps more importantly, what do GPUs (graphic processing units), cloud computing, and electric cars all have in common, besides AI? They all use enormous amounts of electricity. What does Duke Energy sell? Oh yeah, electricity. In what world can Tesla and Nvidia thrive but utilities suffer? That world does not exist.

Maybe utilities shouldn’t have been beaten up like they have been this year, but when that recession we keep hearing about finally comes, stock valuations must come down. Fair enough, but the index valuations are now completely skewed by the Magnificent Seven. One of the ways Iron Capital looks at valuations is to compare the valuations of different asset classes, and then comparing them. The valuation spread, or difference, between domestic stocks and international stocks is currently at a two standard deviation level. In plain English – the difference between international stocks and domestic stocks is larger than it normally is by an unusual amount … so unusual that this happens less than 5 percent of the time. Nvidia may be selling at 215 times, but the French energy company Total Energies is selling at only 6 times. This is unbelievably inexpensive.

So, what does all this mean? It means the headline story of the first six months of 2023 is misleading. When pundits say the market is up, they are really only talking about seven stocks in the S&P 500. When they say it is expensive, they are really only talking about seven stocks. When they say it can’t continue, they are right – if they mean those seven stocks. The other 493, on the other hand, are poised to catch up.

We are optimistic about the rest of 2023, but it can’t look like the first half. First, the doomsayers need to admit they are wrong: We are not heading into a recession because interest rates are returning to normal levels. Second, AI may indeed be bigger than the internet one day, but that day is a lot farther away than the zealots believe…it is also closer than the naysayers might think, but it isn’t here yet.

Before this little detour into insanity, we saw the markets rotating to value, small and international. That remains the long-term trend, and one six-month tease doesn’t change it. That rotation has legs, and the power of both momentum and valuation. We just need patience. Prudent investing pays off in the long run, but it does require patience.

Warm regards,

Chuck Osborne, CFA
Managing Director

July 2023