U.S. Equities Ride Tech Wave Amid Valuation Concerns

Text transcript

Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves.

Peter Hardy, client portfolio manager, global value equities, American Century Investments.

U.S. equities continue to have a strong year with tech and AI stocks leading the way. What’s the long-term outlook here?

The risk-on rally that benefited big tech names really began with NVIDIA’s announcement in late May related to AI, and has extended through August here in the third quarter. Growth stocks beating value stocks, large tech names driving returns, the NASDAQ’s up 30% while the Russell 1000 values only up 2%.

So in many ways, the market is ignoring a lot of risk that led to declines in 2022 and saying that the potential issues associated with rising interest rates from an earnings perspective are null and being attracted to potential future earnings growth in AI.

As we previously discussed, AI is a major phenomenon and likely to be an impactful force to economic growth, both from a productivity positive standpoint and negative potentially from a human capital standpoint. So from a fundamental business perspective, it’s important to understand. But from an underlying monetization standpoint, the market has already ascribed a significant amount of economic value to AI without the actual returns benefits being certain and being long ways down the road.

For example, Microsoft just announced a big plan spending increase in AI and stated they have no visibility for AI revenue for the foreseeable future. Stocks up 24% since their AI announcements, had 1.8 billion market cap at the beginning of the year and has a 1.8 trillion market cap at the beginning of the year and a roughly $2.5 trillion market cap now. Microsoft is a great company. We have owned it, but sold based on valuation in the second quarter.

Additionally, Apple’s earnings announcement here in August led the stock to sell off. Based on their guidance, they’re expected to have four quarters of revenue declines. But even with the sell-off, Apple has gone from $2 trillion in market cap to $2.8 trillion through today.

We like Apple as a company, but don’t own it because it’s expensive. So we’re getting a little Austin Power-ish here, but both companies have seen their market cap increase by over $700 billion with uncertain monetization. I say that to say the outlook for tech and AI is good in the long-term, but short-term valuations are stretched, to say the least.

Are we still worried about the market’s breadth? Yes. The narrowness of the market with the largest names in the benchmark driving returns is something we discussed last quarter. So the big tech names are responsible for the bulk of the market returns this year. We create our risk-aware returns by buying high-quality companies that are valued appropriately relative to their return on capital potential. Normalized returns on capital is what we primarily look at.

As I alluded to with Microsoft and Apple. They’re both high-quality companies, but not necessarily cheap. They’re in growth benchmarks so it didn’t hurt us relative to our value benchmark, but our biggest negative attributor in 2023 relative to the benchmark is not owning a name like Meta. Meta was in the value benchmarks for a variety of reasons. We don’t consider it quality so unknowable there and there’s a high range of outcomes from a stock and business return perspective. The stock was up 140% through the end of the second quarter and then taken out of the benchmark and added to the growth benchmark. That name in particular constitutes the bulk of our underperformance relative to benchmarks this year. So while people think about these things as a growth dynamic, they are impacting value investors.

Another underlying dynamic that hasn’t been picked up upon as much as the big names driving broad market returns is additional pockets of risk acceptance that are showing up. And I use the cruise lines as an example here in the value space. Carnival, Royal Caribbean and Norwegian are all up over a hundred percent in 2023. That’s in the face of potential slowing economic growth and highly levered ballot sheets, which makes them uninvestible from our quality perspective. Basically, their leverage could result in the company struggling even in a good environment due to higher financing costs.

So I would say the market breadth is an issue, but the underlying dynamic of speculation without regard to financial returns or risk is the market dynamic that investors should be aware of, whether it’s big tech or other industries.

One of the most interesting things that has occurred during the quarter is that the outlook for interest rates has somewhat improved, but yields have gone up. So recent economic data has showed some strength, but inflation has fallen substantially throughout the year. Not to the 2% level that the Fed wants, but from roughly 8% to 3% here in August of 2023.

Alongside of that, during the quarter, we have had a pretty substantial increase in yields. The 10-year U.S. Treasury, for instance, has gone from 3.7% to 4.3% through today in August. We had a Fitch downgrade of government debt, large Treasury issuances that have driven that increase in yield.

The reason this is interesting is that increases in yields typically lead to equity volatility, but the market has largely gone up in the face of this increase in yield. So the stock market and the bond market are saying different things. Longer duration growth stocks have outperformed shorter duration value stocks in the face of this.

We’re risk-aware, not because we make a call on these type of things, but we just buy financially productive companies that pay dividends, yields are cheap. However, rising rates and rising yields, their lag impacts to economic growth and corporate profitability are risks that we assign to the market at this point, even though the outlook for interest rate increases is somewhat benign from here.

We’ve previously discussed our positions in consumer staples and healthcare, two areas where we are identifying opportunities based on a pathway to earnings and valuation improvement. That hasn’t changed and, in many ways, they’ve become more attractive throughout the year as they’ve underperformed in this risk-on rally. So our weights that we have previously discussed in those two sectors are still significant.

We’ve been finding other pockets of value during the year. For instance, in insurance, what you saw during Covid was lower degrees of losses for people who just weren’t out, say, driving as much, so fewer car crashes. Post-Covid, you’ve seen losses come back. Alongside of that, you’ve had some big catastrophic events with fires and hurricanes, et cetera, and this has impacted the earnings on insurance names. While some insurers that are not high quality may have a capital hit, these issues are really temporary earnings issues for our higher quality insurance companies. Additionally, because of the losses, pricing in the industry has improved. So pricing typically leads stock prices in the sector, and so we’re finding attractive opportunities in names like Allstate, accordingly.

In the vein of short-duration value stocks underperforming long-duration growth stocks, utilities, a very stable area of the market, have had pretty substantial negative returns, some selling off as much as 20% during the year. So these stable companies with high-end sustainable yields have gotten attractive. Nothing really company-specific, just really the risk-on nature of the market leading to us increasing weights there.