The Fast and the Furious

The fervour with which the market has jumped onto AI as the next big trend that will change the way we work, is almost unprecedented and, as such, those companies that are directly or indirectly enacting this have seen significant appreciation in their market valuations.

The 77% return from the NYSE FANG+ index (Apple*, Microsoft*, Nvidia*, Amazon, Tesla, Meta, Snowflake, Netflix, Alphabet and Advanced Micro Devices) year-to-date exemplifies this issue, especially when compared to the 5% return from the equal weighted S&P 500 index. Most of the mega-cap ‘safe havens’ that many investors revert to in times of uncertainty are, post the recent reclassification of companies’ sectors are found in either Technology or Communication Services, which rose by 42% and 35.6% respectively in the first half of the year.

One of the technicalities of the Nasdaq Index is that it has rebalancing rules that come into force if one company accounts for 24% of the whole index or is companies with a weighting of 4.5% or more make up at least 48% of the index. As of today, the Top 5 and Alphabet account for 51.2% of the Nasdaq so the trigger has been pulled.

A re-weighting would cut the relevant stocks back to 40% on a pro-rata basis. The new weightings are due to be announced on Thursday this week and come into force at the open on the 24th which will force the many Nasdaq index ETFs to follow suit and rebalance their holdings, which could amount to $29bn of sell orders in the big six companies, which may in turn effect the weightings in the S&P trackers and other ETFs with large weightings in the mega caps.

It is also noticeable that the number of C-suite members who, after the recent rally have been reducing their exposure has increased significantly in recent weeks and now stands at the highest level for two years.

This outperformance has been underway during a time of rising bond yields. The US 2-Year note currently yield 4.9%, up from 3.1% at the same point last year, and the 10-Year yields 4.1% versus 3.0% on the same basis. For long-dated assets, the 20- and 30-year notes are more often seen as an indicator of direction of travel, as we saw for the first three quarters of last year, when the ‘cross-cycle quality compounding’ stocks de-rated rapidly as bond yields rose and central banks rapidly increased interest rates normalised from near-zero rates.

Whether the Central Banks have raised rates to rapidly without giving markets time to absorb the change and thus led their respective regions into recession remains a distinct possibility, although the economic data remains mixed and companies for the most part have remained quietly optimistic on the current trading environment and their outlook for the second half of the year.

Our concern, however, is the outperformance of the mega-cap technology & communication services companies, and the Nasdaq in particular, which as referred to earlier, is dominated by them. Thus far they have not followed the direction of long-duration bond yields and the correlation seen last year has disappeared. With 20-year bonds now yielding 4.3% and the 30-year at 4.1% we heed the words Sir John Templeton who famously said that four most dangerous words in the English language are “this time it’s different”.

We believe that AI is going to change the way companies operate, as seen in a survey by Accenture*, which found that 97% of executives said that AI will be transformative to their companies, however, many companies will now face a decision whether to adapt or die. There are now many factors in place suggesting that we may see a correction in this outperformance and thus it will become increasingly important to identify those companies that are genuine sustainable compounders with products or services that are suited for the next era of the digital age, and have a wide enough defensive moat to fend off competition, and those who have been swept up with the wave despite having no tangible differentiated offering. When a correction comes investors tend to shoot first and ask questions later, which often provides opportunities for the long-term investor to pick up new holdings, or add to existing ones, in true quality compounders at attractive valuations.

When this correction will come, only the market can decide, but we remain vigilant and ready to take opportunities should they arise.

*Held within the VT Tyndall Global Select Fund.