AI and the FOMO (Fear of Missing Out) Market
“Anyone who believes exponential growth can go on forever in a finite world is either a madman or an economist.”
~ Kenneth Boulding, American Economist.
Most people tend to be rational and value conscious. Case in point, Costco, a favourite retailer of ours, has built an empire by providing great quality products at excellent prices – consumers clearly like that business model. In the case of investments however – and particularly stock investments – there are times when investors forget those instincts and decide to buy shares simply because they keep going up. Right now is one of those times in our opinion, and we believe Artificial Intelligence (“AI”) “arms dealers” are forming a classic investment bubble as shown by their extremely high price-to-sales valuation multiples (by arms dealers, we mean semiconductor companies such as ARM Holdings, Nvidia, and Broadcom who provide the chips to train large language models). Now a spoiler alert: investment bubbles never end well. This is true whether one looks at tulips in the 17th century, railroads in the 19th century, or early internet plays at the start of the 21st century. That being said, asset prices can continue inflating for far longer than many expect and that is particularly true of emerging themes that capture traders’ collective imaginations. In the final analysis though, while AI stocks may go higher still, the long-term risk/reward is looking decidedly less compelling at current valuation levels. Using real estate as an example, overpaying for a house lowers expected long-term gains; the same is true for shares of companies.
The Wall Street Journal recently cited a study which notes that more than US$50 billion has been invested in Nvidia’s chips since ChatGPT was launched in November 2022 (the unofficial start of the AI boom). However, Generative AI startups have only brought in US$3 billion in sales so far. While this number should rise, the discrepancy appears unsustainable, not to mention that the world may not actually need a dozen different large language models. There are, of course, other commercial and defense uses for Artificial Intelligence, but so far, the vast majority of profits have accrued to the aforementioned arms dealers. At some point, the business case must improve for software companies, or else they may become disinclined to continue growing their data center/AI spending at current rates.
This brings us back to a great quote from Sun Microsystems founder Scott McNealy in a 2002 interview as the tech bubble was melting down:
“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”
~ Scott McNealy, Business Week, 2002
The retort to this statement is that high growth and barriers to entry which protect high profit margins can make valuation multiples look more reasonable down the road. Fair enough, but in the case of chip design darling ARM Holdings, for example, the stock trades at 42x expected 2024 sales. Even if it meets very bullish growth consensus forecasts, it will still trade at 22x expected 2028 sales. The history of finance clearly shows us that no country, industry, or company can escape the “law of large numbers” where growth rates invariably come down.
We dove into stocks trading on the S&P/TSX Composite Index and S&P 500 Index that trade at a price-to-sales ratio above 10x (based on the next fiscal year’s sales estimates), and a few conclusions stand out:
-
This elite valuation club is concentrated in Technology stocks or other companies with strong tech attributes.
-
Generally, these stocks have had great returns over the last year. This is a bottom-up look at where investor money has been flowing in the market.
-
The vast majority of these stocks have negligible dividend yields.
This last point is especially interesting since historically, dividends have accounted for the majority of equity returns. Depending on the study one looks at, approximately 60% of North American total stock returns over the last century have come from dividends (and even more when dividend reinvestment is factored). The upshot is that it is the current low-yielding situation which is anomalous. We expect the historical trend to reassert itself eventually and for dividend-paying stocks, and especially dividend growers, to regain their luster with investors. The recent extra tax on share buybacks in the U.S. and a more normalized (i.e., higher) interest rate environment could eventually help change corporate behaviour and investor preference in that regard.
Dividends play an important role in our portfolios
Dividends are distributed to shareholders by companies as a sign of financial stability. Many dividend-paying stocks are those that have reached a point in their growth where their free cash flow can sufficiently cover strategic commitments – it makes more sense to distribute excess earnings as opposed to reinvesting in the company. Although not every dividend-paying stock is mature and stable1, companies that pay stable, growing dividends provide a significant advantage to portfolios. Comparing the S&P/TSX Composite’s return with and without dividends, from January 1985 to June 2024, we found that re-investing dividends led to triple the return relative to price performance.
Relative to growth stocks, these high-yielding dividend stocks haven’t seen as much love recently – with stocks yielding over 2% underperforming those stocks paying less than 2% (or 0) – so we believe that there are good value plays in the space. Companies such as Verizon (6.5% yield), Canadian Natural Resources (4.3% yield), and Medtronic (3.5% yield) have all paid stable, growing dividends over the past 20 years and operate in industries with relatively high barriers to entry.
Going back to 1973, higher-yielding stocks have done much better with lower volatility and downside on average. The recent outperformance of non-dividend paying stocks is the anomaly.
Technical analysis
In the June report, we discussed our “canaries in the coal mine” – the indicators that warn of real bear markets – including credit spreads, credit default swaps, market-based measures of economic activity and the performance of “risk on” vs. “risk off” sectors. They’re all healthy and mostly all at/near all-time highs which suggests the threat of a real bear market happening in the second half of the year is virtually nil. As such, the upside targets of 23,224 for the S&P/TSX and 5,575 for the S&P 500 remain in effect and we expect the indexes to achieve those targets, or get pretty close to them, at some point in the weeks ahead.
Where it gets interesting is that there has been some deterioration underneath the surface in breadth indicators as of late, which would suggest markets are teeing up for a medium-term pullback in the third quarter, in line with traditional and presidential election year seasonality. For example: while the S&P 500 and Nasdaq Composite made new all-time highs recently, they were not confirmed by any of the advance-decline lines we follow (traditional NSYE A-D line, common-stock-only A-D line and the S&P 500 A-D line).
In fact, NYSE breadth was actually negative more often than not for the final two weeks of June (i.e., more decliners than advancers most days) despite the persistent new highs in the S&P 500. At the same time, the percentage of S&P 500 stocks trading above their 50-day moving averages is at a lowly 44%.
A pullback to, or slightly underneath, a 50-day moving average is a fairly standard short-term pullback, which means the majority of the stocks in the S&P 500 are already in corrective mode to some degree. Finally, the number of individual stocks on the NYSE making 52-week new highs has also shrunk dramatically.
Back in February and March, it was common to see 350-400 issues making 52-week highs. For most of the second half of June it was less than 50. Essentially what’s been happening is that a few of the mega-cap tech names (AAPL, MSFT, and NVDA in particular) have been propping up the markets (driven by the persistent weakness in long-term interest rates) while mostly everything else has been flat lining or correcting.
At the same time, most of the indicators in our short- and medium-term timing models are stretched into deep overbought extremes. Momentum gauges, in particular, but also sentiment gauges where our Composite Sentiment Indicator is now back up into overly bullish extremes.
In a lot of ways, this is exactly what we saw happen ahead of last summer’s 10% decline in the S&P 500 from July to October. We’ve noted in prior reports that during presidential election years medium-term pullbacks tend to get underway in August, last about five to six weeks with a decline of around 8% and usually bottom before the election.
So don’t be surprised if equity markets go squishy late in the summer. It’s generally a temporary thing and given the state of our “canaries in the coal mine” the expectation should be for further new highs once we get past the election.
Are the highest Canada-U.S. interest rate differentials in recent history still justified?
The Bank of Canada (“BoC”) finally initiated its easing cycle in June, with a 0.25% cut in its overnight rate to 4.75%. The move, which had been widely anticipated, came ahead of the U.S. Federal Reserve (“Fed”), which is not expected to move on rates before September, if not waiting until after the November 5th U.S. election. The move was positive for interest rates, especially at the shorter end of the yield curve where the term sector tends to be more sensitive to monetary policy decisions and helped Q2 performance recover after a more challenging start of the year. The expected move by the BoC helped maintain the Loonie close to its weakest against the U.S. dollar, but it also pushed down further the Canadian yield curve relative to the U.S.
Objectively, different growth/inflation paths led to different monetary policy targets, with the BoC ending its rate tightening at 5% last year, short of the Fed’s 5.25 to 5.50% range. That difference alone helps justify the lower yield curve and, when combined with the current softer economic environment, it explains the outperformance of the Canadian bond market so far this year. However, it does not justify, in our opinion, the widest Canada-U.S. yield differentials seen in recent history.
First, early Q2 readings on Canada’s economic growth are more encouraging, while the U.S. has definitively slowed. In addition, our BMO economists expect Canadian growth to slowly pick up and gradually close the gap with the U.S., with the expectations of stronger results on this side of the border in 2025 – BMO expects 2025 GDP growth in Canada and the U.S. to expand at 2.0% and 1.8%, respectively. Second, after consecutive months of softer inflation readings, Canadian CPI in May surprisingly jumped higher, with its core measure settling just shy of 3% and close to the U.S. core measure of 3.4%. Interestingly, while lower than the U.S. level, it is higher than the Fed’s preferred measure of the core Personal Consumption Expenditure (“PCE”)2 price index which dropped to 2.6%. On top of this, monetary policy expectations on both side of the border are fairly similar with BMO’s economists calling for the BoC and the Fed to deliver 125 basis points of cuts before year-end 2025, leaving a policy rate differential of 50-75 basis points (“bps”), smaller than the widest historical differences (over 200 bps).
Granted that productivity gains in Canada remain more muted, our economy is more interest-rate sensitive, and that market rates may be more attuned to the better long-term U.S. economic prospects; nonetheless, these have been the conditions for years. We admit that long-term U.S. rates may also be pressured higher lately by increased odds of Trump winning back the White House in November. We debate; however, if this would be sufficient for the yield differentials to be maintained or even widened at this time. We believe instead that the current outlook leaves limited room for wider differentials and would argue for the cheapening of the Canadian yield curve vs. the U.S. (smaller yield differences). This means that in the near term, and barring any central bank surprises, there is little room for Canadian rates to move lower unless it is driven by a similar move in the U.S. rates market. In fact, we tend to believe that the risk is for reduced differentials leading to the Canadian market likely underperforming its U.S. counterpart.
For investors, underperformance does not necessarily mean negative returns, instead, it means potentially less attractive returns than what could be achieved south of the border. It also means that after years of being accustomed to capital gains, they may be more limited in the near term as we settle in a more normalized environment where the bulk of a bond portfolio’s returns will be generated by coupon income. Despite the volatility risk from labour and inflation surprises – as we experienced in June – we continue to recommend taking advantage of market rate pullbacks to extend term and move toward neutral duration.
Please speak with your BMO Nesbitt Burns Investment Advisor if you have any questions, or would like to discuss your portfolio.
1 Remember, dividends are not obligations, and companies have the right to cut or completely stop paying dividends. A prime example is the Great Financial Crisis when nearly all banks cut or completely eliminated dividend payments.
2 Core PCE and CPI are both measures of inflation, but they differ in their methodology and the items they include. CPI measures prices at the end user level, while PCE sources its data from the latest GDP report, meaning it has a more comprehensive dataset with better accountability for consumer substitution of goods. PCE also better reflects changes in household consumption and expenditures. Core CPI tends to show higher inflation than core PCE. The PCE’s weighting and source material make it the Federal Reserve’s preferred inflation measure (Source: Brittanica Money).
General Disclosure
If you are already a client of BMO Nesbitt Burns Inc., please contact your Investment Advisor for more information. The information and opinions in this report were prepared by BMO Nesbitt Burns Inc. Portfolio Advisory Team (“BMO Nesbitt Burns”). This publication is protected by copyright laws. Views or opinions expressed herein may differ from the views and opinions expressed by BMO Capital Markets’ Research Department. No part of this publication or its contents may be copied, downloaded, stored in a retrieval system, further transmitted, or otherwise reproduced, stored, disseminated, transferred or used, in any form or by any means by any third parties, except with the prior written permission of BMO Nesbitt Burns. Any further disclosure or use, distribution, dissemination or copying of this publication, message or any attachment is strictly prohibited. If you have received this report in error, please notify the sender immediately and delete or destroy this report without reading, copying or forwarding. The opinions, estimates and projections contained in this report are those of BMO Nesbitt Burns as of the date of this report and are subject to change without notice. BMO Nesbitt Burns endeavours to ensure that the contents have been compiled or derived from sources that we believe are reliable and contain information and opinions that are accurate and complete. However, BMO Nesbitt Burns makes no representation or warranty, express or implied, in respect thereof, takes no responsibility for any errors and omissions contained herein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this report or its contents. Information may be available to BMO Nesbitt Burns or its affiliates that is not reflected in this report. This report is not to be construed as an offer to sell or solicitation of an offer to buy or sell any security. BMO Nesbitt Burns or its affiliates will buy from or sell to customers the securities of issuers mentioned in this report on a principal basis. BMO Nesbitt Burns, its affiliates, officers, directors or employees may have a long or short position in the securities discussed herein, related securities or in options, futures or other derivative instruments based thereon. BMO Nesbitt Burns or its affiliates may act as financial advisor and/or underwriter for the issuers mentioned herein and may receive remuneration for same. Bank of Montreal or its affiliates (“BMO”) has lending arrangements with, or provides other remunerated services to, many issuers covered by BMO Nesbitt Burns’ Portfolio Advisory Team. A significant lending relationship may exist between BMO and certain of the issuers mentioned herein. BMO Nesbitt Burns Inc. is a wholly owned subsidiary of Bank of Montreal. Dissemination of Reports: BMO Nesbitt Burns Portfolio Advisory Team’s reports are made widely available at the same time to all BMO Nesbitt Burns investment advisors. Additional Matters TO U.S. RESIDENTS: Any U.S. person wishing to effect transactions in any security discussed herein should do so through BMO Capital Markets Corp. (“BMO CM”) and/or BMO Nesbitt Burns Securities Ltd. (“BMO NBSL”) TO U.K. RESIDENTS: The contents hereof are intended solely for the use of, and may only be issued or passed onto, persons described in part VI of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001. BMO Wealth Management is the brand name for a business group consisting of Bank of Montreal and certain of its affiliates, including BMO Nesbitt Burns Inc., in providing wealth management products and services.
BMO Private Wealth is a brand name for a business group consisting of Bank of Montreal and certain of its affiliates, including BMO Nesbitt Burns Inc., in providing private wealth management products and services. BMO Nesbitt Burns Inc. is a wholly-owned subsidiary of Bank of Montreal. BMO Nesbitt Burns Inc. is a Member – Canadian Investor Protection Fund and is a Member of the Canadian Investment Regulatory Organization. Please contact your BMO Nesbitt Burns Investment Advisor if you have any questions.
“BMO (M-bar roundel symbol)” is a registered trademark of Bank of Montreal, used under licence.
