Artificial Intelligence Exuberance Drives S&P 500 Higher

By TRG Advisors on June 1, 2023

Looking Under the Hood

From a bird’s eye view, the stock market has performed in an outsized fashion so far this year. Looking at the market cap weighted S&P 500 (SPX), performance year-to-date is the fourth highest in the last ten years, trailing only 2013, 2019 and 2021. However, when taking a closer look, consolidated strength and widespread weakness tells a much different story.

As of May 30, 2023, the S&P 500 year-to-date total return is +10%. However, almost the entire increase is attributable to seven stocks: Apple (AAPL), Microsoft (MSFT), Nvidia (NVDA), Amazon (AMZN), Meta (META), Alphabet (GOOGL/GOOG) and Tesla (TSLA). These have accounted for roughly 100% of that move, while the remaining 501 names in the index account for the residual flat return. In other words, if we exclude these seven stocks, the index returns are close to zero dollars. Moreover, in the market cap weighted Invesco QQQ ETF (QQQ), which tracks the Nasdaq 100 Index, these same seven names account for 54% of the ETF’s holdings. We interpret this as a lack of breadth in the market.

Technology and Communication Services Outperformance

As an investor, if you have not been involved in some of these names you have likely underperformed the index. The thread tying these names together is Artificial Intelligence (AI). Each of these companies have invested billions of dollars each year into the groundbreaking technology that is set to disrupt the global economy as we all know it, and most investors have hopped on the AI train leading to the outsized performance in the Technology Select SPDR ETF (XLK), +33% YTD, and Communication Services Select SPDR (XLC), +30% YTD.

The AI Hype Is Real

Demand for artificial intelligence is undoubtedly real, visible in the second quarter revenue projections given by leading edge AI chip designer Nvidia (NVDA) that blew out consensus estimates ($11billion vs. est. $7.18 billion). Historically, Nvidia has generated most of their revenue from their Gaming segment, where they have been a market leader for more than a decade. However, given the rapid innovation in its H100 Deep Learning chip, priced at $40,000 per unit, and strong customer demand, Nvidia projects its data center segment to represent more than 60% of revenue and grow 93% year-over-year in the coming quarter. This well-surpasses competitors who are expecting negative year-over-year growth rates in their data center segments. The unexpected revenue projection was driven by a “steep increase in demand related to generative AI and large language models.” Representative of the technology’s pervasiveness, the subject “artificial intelligence” and closely related synonyms were mentioned 105 times during the call, a 59% increase against their call just one year earlier. Since the earnings release on May 24, 2023, the stock has moved 31% higher and as the adage says, a rising tide lifts all boats, almost all artificial intelligence related stocks have followed suit.

Both Meta (META) and Microsoft (MSFT) are capitalizing on the AI trend as well. Meta mentioned how 40% of content in your Instagram feeds are now recommended by AI. Given the turbulence in the advertising space from the Apple’s App Tracking Transparency Policy, along with a struggling digital advertising market, Meta is leaning heavily into AI to improve Feed and Reels content recommendations, which in turn improve ROI for advertisements. Microsoft (MSFT) is a clear beneficiary from the AI trend, given their reported $20B investment in OpenAI that brings advanced large language models like ChatGPT-4 to life. Companies are integrating AI into customers’ daily workflows to reduce monotonous tasks, such as data entry and note taking, thus increasing productivity and efficiency.

Where To Go From Here?

The stock market so far this year has been driven by AI exuberance, which is resulting in sharp increases in both AI-related stock prices and valuations and underperformance in sectors other than technology and communication services. However, we are in the camp that most stocks will exhibit mean reversion behavior, including those stocks who have been on the losing end year-to-date.

Economic indicators, such as strong new home sales in the face of 8% 30-year mortgage rates, positive industrial production rates, April consumer spending doubling expectations (+0.8% vs. est. +0.4%), and initial jobless claims remaining stubbornly low tell a story of a strong economy.

These indicators are driving our belief that sectors that have underperformed so far this year are geared for stronger performance throughout the remainder of the year. As always, we continue to have a value biased approach and look to add high quality names on sale.