Head of Equity Strategy
Summary: Concentration and valuation risks are coming back into US equities as May 2023 is ending today. The rally this year has been predominately driven by technology stocks and especially recently AI-related stocks. The narrowness of the rally and the fact that US equity valuations are back to levels not seen since July 2022 are elevating risks for investors and lowering future expected returns.
The total return in S&P 500 this year is 10.3% as of yesterday’s close, but the rally has been extremely unbalanced as we have written extensively about in this year’s equity notes. Just look at the best performing stocks this year. Starting with Apple as the biggest stock in S&P 500 with a market value of $2.79trn at the bottom of the performance table and moving upwards see total returns year-to-date of 37% or higher indicating the wild performance of not only technology companies but especially the largest stocks in the index such as Nvidia, Meta, Tesla, Amazon, Alphabet, Microsoft, and Apple. Concentration risk and narrow rallies in equities are often not good signs as they reflect a narrow theme played by the market and thus things can quickly turn around if the theme is sold off again. One potential catalyst could be a weaker than estimated US economy over the summer months.
The rally in US technology stocks this year, and in particular AI-related stocks, due to the market pricing in Fed rate cuts as the Fed will be forced to respond to lower economic growth, has pushed US equity market valuations to the highest level since July 2022. As we wrote in yesterday’s equity note, the global semiconductor industry has reached the highest equity valuations since early 2010 as growth expectations for semiconductors due to trends such as AI, electric vehicles and data center have fever levels. It almost feels like an echo from past bubbles.
Our combined equity valuation index on US equities reached 0.82 standard deviations above the historical average since 1992 up from 0.21 in September 2022. In other words, the US equity market never repriced below its long-term average underscoring the strong sentiment in US equities. If we look at what the current equity valuation means for future returns, based on past patterns, then we can see that the expected 10-year annualised real rate return is between -3% to +3% suggesting significant downside risks relative to the long-term average of +5% real rate return. Lofty equity valuations often goes hand in hand with overextended equity valuations in growth pockets of the market leading to subsequent outperformance of value stocks, which AQR co-founder Cliff Asness also recently predicted at the Morningstar Investment Conference.
AI: The good, the bad, and the bubble
While a deep recession may not be iminent thanks to central bank policy, interest rates will have to stay high for longer, and this will be accompanied by volatility risk from the unwinding of bubbles, especially within AI.
Steen Jakobsen,
Chief Investment Officer
The emergence of advanced AI systems is by far the most surprising event this year, turning everything upside down, while risks and benefits are debated. AI will also become an arms race between the US and China.
Peter Garnry,
Head of Equity Strategy
As China navigates global fragmentation, its cycle of technology application, productivity enhancement, and growth is threatened by US breakthroughs in generative AI, limited computing power, and geopolitical tensions.
Redmond Wong,
Market Strategist
Japan’s expertise in semiconductors and robotic integration could be the foundation of AI dominance. Combining two of this year's themes, Japanese equities and artificial intelligence, brings a wave of opportunities.
Charu Chanana,
Market Strategist
The AI fever has turned the technology into a darling, pushing crypto further into no-man’s-land. There are striking similarities between AI and crypto, and if these are to come full circle, AI won't be spared for bubbles.
Mads Eberhardt,
Cryptocurrency Analyst
Stocks related to artificial intelligence (AI) have appeared on investors' radars. Expectations are high, but it may be necessary to consider how to get exposure to AI in a diversified way.
Hans Oudshoorn,
Trainer Academy
The USD is on its back foot as markets celebrate an eventual Fed rate peak and steady long US yields. The stakes are even higher for the Japanese yen if longer major sovereign yield curves have to price in economic acceleration.
John J. Hardy,
Head of FX Strategy
While commodities, broadly speaking, have faced some tough months, a partial reversal during June could signal that the asset class is getting back on its feet with energy holding up and precious metals with upside potential.
Ole S. Hansen,
Head of Commodity Strategy
As inflation remains high central banks face hard decisions about whether they should keep hiking interest rates or stop. Meanwhile, the rise of AI creates bubble-like conditions that only make the decision harder.
Althea Spinozzi,
Senior Fixed Income Strategist
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