The US market has risen 10% this calendar year and is up 18% from its October 2022 lows, despite widespread investor bearishness around US market prospects.
The US does remain more than 10% below late 2021 highs, allowing the bears to continue to label the rebound as just a bear market rally.
An increasingly narrow advance
Alongside the grind higher in the US index, there has been increasing commentary around the increasingly narrow “breadth” of the US market rally. This year in particular, virtually all the gains in the S&P 500 are attributable to the mega cap tech stocks (the “Big Seven”).
What has Driven the Dramatic Tech Revival?
In contrast to the views of many tech bears, who were anticipating the big 2022 selloff to usher in a structural bear market, interest has rapidly returned to US tech after the heavy selloff.
Falling long-term interest rates helped the long-duration tech sector lift off the bottom in the back end of 2022. This year, first quarter big cap tech results have generally beaten expectations, helping lift the tech sector further.
Excitement over the artificial intelligence (AI) technology revolution has become the key driver more recently. Key milestones this year were the release of the ChatGPT AI application, and more recently the blow out Nvidia result, where AI driven chip demand saw 1-year forward earnings estimates rise over 80%.
Nvidia rallied 26% on the day of the recent result and is now up a staggering 160% year-to-date. While Nvidia is the poster child for investor bullishness around AI, all of the Big Seven have recorded strong gains this year.
So, are we now back in a tech bull market, or is the tech sector becoming dangerously overheated? More broadly, with leadership so narrow and the economic outlook clouded, is the US market vulnerable to a big reality check?
Not Looking like a Typical Young Bull
The very narrow advance of recent months is not typical of a new bull market advance, although many aspects of the current cycle are far from normal.
On the one hand, the narrowness of the tech rally is “rational” to the extent the market is backing the dominant, cashflow rich, industry leaders, rather than the speculative profitless tech plays that were very much a part of the 2021 rally. AI is a disruptive technology from many perspectives but the US tech mega caps are at the forefront of this disruption. The mega-caps are well advanced and very well-funded with respect to research and development (R&D) programs. Moreover, they are already showing tangible earnings benefits, as starkly evidenced by the powerhouse Nvidia result.
There will undoubtedly be a number of new winners from the AI revolution, however, as was the case in the initial internet boom of 1999/2000, it might take some time to work out exactly who the emerging winners will be. The market has taken the view that many of the mega-cap incumbents will be winners, alongside a yet uncertain cohort of smaller innovators. This seems a rational expectation to us.
Though AI is exciting and most likely a truly transformative technological innovation, it might be a case of too much too soon in the case of the Nvidia price surge, even if the huge earnings upgrades flowing from its last result suggest the company has an exceptionally strong growth outlook (43% per annum over the next 5 years is the new consensus expectation). Valuations for the other big cap tech names still look largely plausible, in our view. However, given the pace of the recent advance, they too might be due for a breather in the near term.
What seems clear is that US tech is unlikely to fade quietly into a structural bear market, as many tech bears had been hoping.
While we see a mixture of genuine substance and potential near-term exuberance in the recent tech rally, we do see the lack of participation from the rest of the market as somewhat cautionary for overall index prospects.
Macro Clarity Is Proving Elusive
This lack of performance outside of mega-cap tech likely reflects concern around the interest rate and economic outlook. This lack of certainty around the macro narrative compares with high levels of market conviction in the emerging micro-narrative around big tech and the AI revolution.
Investors will need more clarity around the outlook for the US Fed and the US economy in deciding which way to definitively position themselves. At this stage, the consensus appears to be leaning toward the notion that the US market will succumb to a weakening earnings cycle brought on by a US recession (the most anticipated recession in history).
This is a plausible scenario. However, as we have discussed previously, we feel an equally plausible alternative scenario is that easing inflation pressures, alongside slower but not disastrous growth, sees the rally broaden later in the year. So, the situation is delicately poised in our view.
We remain relatively neutrally positioned but continue to like the longer-term prospects for big cap US tech. The US market does not look particularly overbought in an aggregate sense, and overall positioning remains cautious (which is bullish), although the narrowness of the rally suggests some near-term caution until the macro backdrop becomes clearer.
Our Investment Base Case
Macro outcomes in respect of inflation and growth will likely govern whether the US rally broadens or fails over the balance of the year. Our base case is that the US market can still push higher by year-end, notwithstanding the prospect of slower growth. Ultimately, we believe inflation pressures will turn out better than feared, while the economy will not get into major trouble. This scenario does not appear to be a bad backdrop for stocks despite current investor sentiment.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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