Going beyond the “Nifty AI Five” and the Presidential showdown
New catchphrases keep popping up all the time to describe the small group of stocks that have led the market since last year. Magnificent Seven, Super Six, and Fab Five are just some examples. Not wanting to be left out of the action, we propose the “Nifty AI Five” (Microsoft, Nvidia, Meta, Google and Amazon). We realize it most likely won’t catch on, but it does have the merit of including today’s dominant investment theme of Artificial Intelligence while echoing another period of stock exuberance in the early 1970s (the “Nifty Fifty”) which – spoiler alert – did not end well. Recent rotation out of mega-cap Tech and into smaller, more prosaic sectors/stocks could have legs, in our opinion, with positive implications for more reasonably valued dividend paying stocks and, of course, the Great White North. We believe EPS growth and valuation differentials have a lot to do with the recent move. The Nifty AI Five are still expected to grow faster than the rest of the market in 2024 (following their impressive outperformance in 2023), but Canada could outgrow the U.S. next year based on consensus. This would be a massive relative improvement. In other words, their advantage is shrinking, and the market has noticed.
U.S. elections
The U.S. Presidential Election is also becoming top of mind for investors as it is now just a little more than three months away. It is important to note that where we are in the economic and interest rate cycle matters far more to investment returns than politics. However, tax code changes, tariffs and subsidies can all impact industries to varying degrees. While Trump remains the favourite in betting markets, recent momentum clearly favours presumptive Democrat nominee Kamala Harris. As we have been saying to clients, from our own point of view the one thing to remember is that Trump is a known quantity (and a very polarizing one at that,) so there is a natural ceiling to his support. On the other hand, Harris’ prosecutorial background and coherence on issues may lead her to impress some undecided voters over the coming months. In other words, “optionality” may be on her side, so a Trump coronation is far from a foregone conclusion. The makeup of Congress will also matter enormously since pushing through domestic legislation is notoriously difficult when the White House, House, or Senate are controlled by different parties. Even with a Republican or Democratic sweep, increasing political polarization doesn’t guarantee easy legislative wins.
From a macro perspective, neither party has been fiscally responsible over the last several years. Case in point, the U.S. is still projected to have a 5%+ deficit to GDP ratio in 2024, despite the economy expanding. Call us old fashioned, but times of economic expansion should be used to pay back debts, not add to them. Keeping some dry powder for stimulus when it – unavoidably – becomes necessary seems like the right approach to us, but this has not been in vogue with politicians for a long time.
Should he win, it is reasonable to expect Trump to continue ratcheting up trade tariffs which are inherently inflationary, particularly if other countries engage in tit-for-tat tactics (think of those as a tax on consumers). Tariffs also tend to reduce potential growth rates over time, which is not helpful for corporate profits, particularly those of multinationals. This is not just a Republican approach, however, since Biden has consistently ratcheted up pressure on China over the last few years. This risk complicates the U.S. Federal Reserve’s (“Fed”) task to normalize its monetary policy in the near future.
From a sector perspective, key Republican winners should include sectors/companies that benefit from increased tariffs (e.g., steel stocks, autos), deregulation (Financials, health insurers, big pharma), lower environmental scrutiny (energy, mining), more defense spending and continued lax gun regulations. Traditional Democrat-favoured sectors include renewable energy and infrastructure-related companies.
Canada – One of the global rate cut leaders
As expected, the Bank of Canada (“BoC”) cut interest rates again at the end of July which means Canada remains one of the leaders in easing monetary policy among developed countries (along with Switzerland). More importantly, we are leading the U.S. in cutting rates which has positive implications for the S&P/TSX given approximately 40% of the market is interest sensitive (Banks, Telecoms, Pipelines, Utilities, and REITs). In other words, while our market has lagged the S&P 500 due to our lack of Tech behemoths, we think Canadian stocks should continue to close the gap in the second half of the year, particularly with the recent broadening out of participation with smaller caps and value leading the charge.
As noted by BMO Chief Economist Doug Porter, caution is not the word we would associate with the Bank of Canada’s verbiage surrounding their second rate cut of the cycle. Joining only the Swiss National Bank in the two-cut camp, the BoC met expectations with its 25 basis point (“bps”) trim at the end of July, taking the overnight rate down to 4.5%. But, for the second decision in a row, the move was accompanied by surprisingly dovish language. Leaving little to the imagination about its intentions, the Bank fretted about downside risks, even warning that inflation could go too low for comfort. Governor Macklem openly talked about the need to get growth going again, and specifically cited the 6.4% unemployment rate. He also said again that the rate differential with the U.S.—now 87.5 bps below the mid-point of the Fed funds target—is not close to its limit. We’re calling for two more cuts this year, and then a gradual decline in 2025; the risk is clearly for more and faster as noted by the most recent market expectations. For the BoC, the market is gradually leaning toward a cut at each of its last three meetings this year.
Bonds thrived on the Bank’s mild message which helped turn index performance positive for the year. The two-year Government of Canada yield fell below 3.6% for the first time since the spring of 2023, in the aftermath of the SVB collapse1. Short-term yields are now down by more than 100 bps from a year ago when the Bank was last hiking rates and are now closer to 3.40%, implying a minimum of another 100 bps of cuts in the next 12-24 months. The ten-year yield also moved lower recently, trading below 3.20% and more than 100 bps off the highs of the last 12 months, but remains higher than where it traded back in the spring of 2023.
As for the Canadian dollar, BMO’s Economist notes that it was less than enthused by the BoC news. The widening gap with U.S. rates has cut the loonie to the low-72 cent zone (or above $1.38/US$), and it appears quite vulnerable to any bad news. The only thing keeping the currency from seriously swooning is the growing expectation of the Fed soon joining the rate cut parade. In contrast, the S&P/TSX was a quiet outperformer amid the volatility elsewhere in global equities. After woefully lagging in the first half of the year, the Index is on track for a fifth weekly rise in a row, benefitting from some serious rotation among sectors, back to safety and/or rate sensitives and away (for now) from the highest of the high-fliers. The BoC’s stark dovish turn this week certainly did not hurt.
Market concentration and subsequent returns
There has been a lot of discussion about the Nifty AI Five lagging the rest of the market of late. The AI theme could have legs in our view, and it certainly has benefitted several Tech/Communications companies to date, although we reiterate that the market is already discounting an enormous amount of sales and profit growth at this point.
Because we wanted to move away from mere anecdotes, we asked our research partners at NDR to help us quantify subsequent market cap and equally weighted returns following periods of abnormally high stock concentration. They produced a custom study for us, and a few conclusions stand out. The most important is that subsequent returns tend to be lower when starting from high concentration, and that high valuations make stocks especially vulnerable to bigger drawdowns. This makes intuitive sense since we know that the market is inherently mean reverting. The time frame for said mean reversion is the only unknown, but we believe we are witnessing it, based on the following:
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The current weight of the top 10 stocks, at almost 35% of the S&P 500, is much higher than during the Tech bubble and was only equaled by the “Nifty Fifty” in the 1970s (as a reminder these were “secular growth” household names such as GE, JNJ, PG, IBM, Xerox, MMM, etc.) in recent memory. The massive recession of 1973-75 (fueled by the OPEC oil crisis, Vietnam war debt and the fall of the Bretton Woods system) led to a real GDP contraction of 7% and a steep bear market. While the market fell 14% in 1973, and 26% in 1974, the Nifty Fifty’s high valuation (P/E of over 40x) contributed to them doing even worse with respective declines of 19% and 38% in the same period.
Following the Tech bubble bust, the S&P 500 went down 10%, 13%, and 23% in 2000, 2001, and 2002, respectively. The NASDAQ (where most of the egregiously overvalued Tech highfliers were listed), however, did far worse with losses of 39%, 21%, and 31.5% in the same period.
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Market-weighted returns were clearly less attractive following a higher than average (23%) concentration reading at 7% annualized vs. 13.5% when concentration was below average.
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Among sectors, relative to history, we see very high concentration in Consumer Discretionary (AMZN, COST, WMT, etc.) and Tech, and unusually low concentration in Industrials and Health Care, two sectors we favour.
Technical analysis
In our Investment Strategy comments we mostly focus on the price action of headline indices such as the S&P 500 and Nasdaq Composite since that’s where the lion’s share of client money is invested. However, the most noteworthy price action of the past month was in small- and mid-cap stocks which roared on the back of better-than-expected inflation data. The net result was radical improvement in all our key breadth indicators, something that had been a major concern of ours for weeks now. For example, all the advance-decline lines we follow have recently made all-time highs again. This includes the traditional NYSE A-D line as well as the common-stock-only A-D line and the S&P 500 A-D line.
The number of individual stocks making 52-week new highs on the NYSE is back to the healthy levels we saw in the first quarter, and the percentage of stocks in the S&P 500 trading above short- and long-term moving averages underwent the biggest three-day jump since the rally began last October.
The reason that’s so important is because the sort of narrow rally we’d been experiencing from April to early July is typically only seen ahead of real bear markets of 20% or greater. The improvement as of late essentially resets the clock for any significant downside risk.
So, we’re back into a healthy environment where most stocks are participating again which, at face value, is exactly what you want to see. After all, the healthiest bull markets are the ones where most stocks are participating. The downside is that the shift into small- and mid-cap stocks was only one half of a major shift in factor investing that’s seen the biggest outflows in the mega-cap growth stocks since 2021 or 2022, depending on how you measure it. The action in these indices poses an interesting question, which is: How much will the surge in small- and mid-cap stocks offset an impending pullback in the mega-cap growth stocks? So far, the answer has been “not much at all,” since the S&P 500 recently suffered its biggest three-day loss since last October, and with medium-term momentum gauges for both the Nasdaq and the S&P 500 just beginning to roll over from deep overbought extremes, the bias should remain to the downside into late August at least.
Where it gets tricky is that this is the part of the calendar year where seasonality becomes a headwind for equities all the way out to October, so we would not be surprised if the action in U.S. equity markets remains choppy and negative for the next 4 to 8 weeks. That’s also in line with presidential election year seasonality, where it’s normal to see corrections of 8-10% ahead of the U.S. election as investors scale back risk during that uncertain time.
If that plays out according to historical standards, then a test of 200-day moving averages is not out of the question. Peak to trough, that would work out to approximately a 10-11% decline. Whatever happens remains to be seen but either way any corrective action through these typically weak late Q3 months should be viewed as an excellent buying opportunity within this otherwise healthy cyclical bull market. The best way of looking at it is this: U.S. equity markets have just undergone the best 8 to 9-month rally since the lift-off from the pandemic bear market low in early 2020. Prior to that you, have to go all the way back to the lift-off from the credit crisis low in early 2009 to see a similar-sized rally, so we’ve just experienced something truly special. It’s normal to expect a pause from time to time, and the U.S. election and all the craziness surrounding it these days seems like a great excuse. As we have noted in prior Investment Strategy comments, all our “canaries in the coal mine” indicators remain bullish and supportive of more upside so we should see further new, all-time highs once we get past the election.
Here in Canada, the prospects for the S&P/TSX Composite look much better for two reasons. First, we’re not heavily weighted in growth stocks, and second, a sizeable portion of the Index – nearly 40% of the capitalization of the Index – are interest sensitives (Banks, Telecoms, Pipelines, Utilities, and REITs). Toward the end of July, we saw breakdowns around the world in both short and long rates, which is hammering growth stocks and turbo-charging interest sensitives. The net result was a breakout to a new all-time high in the S&P/TSX above resistance at 22,213, which opened a new trading target of 26,257. Granted, a medium-term “risk off” phase in U.S. equities will certainly bleed into our market but it appears as if the S&P/TSX is set to outperform its U.S. counterparts for the remainder of the year, and perhaps into 2025 as well.
Please speak with your BMO Nesbitt Burns Investment Advisor if you have any questions, or would like to discuss your portfolio.
1 The SVB Collapse refers to the collapse of Silicon Valley Bank in March of 2023, which is what kicked off the regional bank sell-off. At the time, SVB was the 16th largest American bank in the U.S. based on total assets.
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