“Balancing AI”

If you haven’t been hearing about Artificial Intelligence (“AI”) lately you might be living under a rock. AI has been one of the largest themes driving the stock market this year – arguably, one of the only themes driving the market.

While the S&P 500 is up about 15% for the first half of the year, not all the stocks in the index are participating in the rally. In fact, it is a small list of the largest companies that are carrying the load. The top 10 largest stocks in the S&P 500 contributed 77% of the positive performance for the first half of the year.

What do those 10 largest stocks have in common? Well, all but two of those companies are large technology (or communications) stocks with some sort of AI play, whether as a direct component of the business or as a supplier to the infrastructure needed for the growth of the AI space (semiconductor manufacturers, for example).

The truth is this trend of concentrated performance has generally been playing out longer than the AI-craze (as we discussed before about the “Magnificent 7”) but having AI as part of the business story right now is giving certain stocks an extra boost. We aren’t saying this is the same situation, but during the tech-boom of the late 1990s, adding “dotcom” to the business name or strategy had a similar effect (until the crash).

We don’t doubt there will be substantial long-term benefits from AI, but as investors we need to be cognizant of the high expectations that are being “priced” into certain stocks – if everyone already believes something will work, stock prices will go up in anticipation of that strong performance. There is little room for error if the company fails to deliver on those high expectations. As much as we believe in those top-performing companies long-term, putting most of your “chips” on a small list of companies is not prudent.

The bottom line here is that we are going through a period of somewhat irregular stock market performance with a wide divergence between those leaders…and, well, pretty much all the rest. Normal bull markets see broader participation, meaning more stocks are performing well rather than just the small few.

Unfortunately, these imbalances can continue for multiple years as the market becomes even more unhinged – perhaps due to a bit of FOMO for those hot stocks, but also a lack of confidence in everything else. Eventually, either those popular stocks fall from grace, or the rest of the “ugly duckling” stocks finally get noticed and play catch-up. Our feeling is that it will be the latter as earnings growth starts to improve following a weak 12 months for those non-mega-cap tech stocks.

We see plenty of opportunities for buying attractively priced growth businesses in the small- and mid-cap segments of the stock market. It’s important to be selective as there are plenty of lower-quality, unprofitable businesses in that space as well. And don’t get us wrong, many of those Top 10 S&P 500 stocks are still attractive for long-term investments (we do own some of these stocks), but we would be uncomfortable with having as much concentration in those names as you get from owning the index, for example.

No matter what environment we enter in the next 12 months, we would expect good quality businesses with earnings growth to continue to execute just fine. Continue to hold a diversified portfolio and don’t try to chase the winners. While it may not make you popular at the next cocktail party, sometimes being a little boring is beautiful, especially when playing the long game.