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i-squared Wealth Management Inc. Market Update
In recent weeks there have been some major developments in AI that have significant implications for index investors. As background, the S&P 500 is a highly concentrated index, where the top ten companies make up just under 40% of the index. All but one of the top ten are tech and AI related companies with major hyperscalers such as Alphabet, Microsoft, Meta, and Amazon carrying large weights. The investment proposition in hyperscalers is changing. Their AI cap-ex spend is expected to reach north of $3 trillion through 2029. They are going from cash flow machines to negative free-cash flow, high return on equity to lower, shifting from asset-light to asset-heavy, issuing equity, and reducing buybacks. Google announced an $85bn equity issuance. There are reports that Meta might also issue equity. Amazon and Microsoft are likely not too far behind. They are issuing equity at a time when they are a source of funds for AI-winners and major new IPOs such as SpaceX, OpenAI, and Anthropic. They are in a lose/lose situation, if they don’t spend, they will fall behind on AI and that could be existential. If they do continue to spend, they will have to issue equity, lever up, change their business model and have negative free cash flow.
Government regulation and intervention risk has also increased for hyperscalers. The Government issued an export control directive to suspend Anthropic’s Fable and Mythos 5 by any foreign national. As these models get more powerful, Government scrutiny will only increase. Further, it could shift power from a handful of labs toward model orchestration and open-source ecosystems. Ultimately, it feels like the models will be commoditized and pricing will go significantly lower, which likely means a low return on investment. Deutsche Bank says, “for the bulk of everyday tasks (perhaps 90% of them) [China’s DeepSeek’s V4-Pro] does much the same job at roughly 1.5% of the cost of Fable 5.” OpenAI is reportedly taking the first steps to lower pricing to gain share. There are better opportunities for capital than in companies that are negative free cashflow, issuing equity, have potential for government intervention, and potentially facing a price war. This is reflecting in their stock prices, as they are down on the year and underperforming the broader market by double-digits.
With the headwinds hyperscalers face, equal-weight strategies and small caps are set up to take leadership. With nominal growth running in the mid-single digits, many more companies can provide high growth. The market will look to the companies that are the cheapest for that high growth. This means it will be the revenge of the value stocks, small caps, old-economy stocks, cyclicals, banks and financials, industrials, certain healthcare and biotech companies. Basically, most things that have done very little for 15-years, while the market was held up by a few stocks. Goldman estimates 36% earnings growth for small caps this year and 38% next. Not only will many of these companies benefit from higher top-line growth from higher nominal GDP, they will likely see margin expansion over-time from AI & technological advances. Every 1% labor cost savings translates to about a 2% boost in EPS for the S&P, but over a 6% boost for small caps. They will also see margin expansion from lower rates. Lower rates will favor many of these businesses, as they are often more levered. The combination of moving past peak oil prices and hawkishness, will allow rates to stabilize and move lower. The 5YR breakeven inflation rate is down to 2.24%, the lowest of the year, allowing the Fed to tone down its hawkish bias.
Many of these areas of the market have low positioning and a smaller market cap, so it won’t take much reallocation for big returns. The market cap of the top ten stocks is approximately $28 trillion, while the market cap of the entire Russell 2000 is $3.5 trillion. Just a 10% allocation away from the top ten S&P names would mean a nearly doubling for the Russell. We are just at the beginning of a reallocation. Positioning is only in the 8th percentile. The Russell has more than doubled the S&P’s performance this year. It is just breaking out of a five-year base with long-term momentum and trend indicators pointing higher. The spread between large and small is at historically wide levels. When we have had similar levels of valuation for small caps relative to large, small caps went on to outperform for the next 12-years by 6.5% per year.
Looking forward the market will focus on second quarter earnings, AI, and the latest from Washington and the Fed.