2Q24 KAR Market Review Podcast: Conflicting Data Adds More Noise Than Signal

KAR Chief Market Strategist Julie Biel, CFA, discusses what it’s going to take for the equity market to broaden, why cyclicals have outperformed defensive stocks, the AI investment opportunity, and other forces driving the market.

Transcript

BEN FALCONE: Hello, this is Ben Falcone, managing director with Kayne Anderson Rudnick, and with me today, I have Julie Biel, chief market strategist, portfolio manager, and senior research analyst at Kayne Anderson Rudnick. Welcome, Julie. Julie, market returns were much narrower in the second quarter, with the S&P 500® and Russell 1000® Growth up notably, while small and mid-caps underperformed. Can you provide our listeners with your perspective on markets as we are at the halfway point of the year? 

JULIE BIEL: So, trends from the first quarter persisted into the second quarter of the year, and while the market started the year expecting six rate cuts from the Fed, expectations have fallen more in line with the Fed's dot plot, and we are now closer to probably two expected rate cuts, maybe one.

With less relief from interest rates, investors continue to seek out ways to get safety, but they're doing it by following the secular growth leaders in technology. And, indeed, the market actually got even narrower this quarter, with the top 10 S&P constituents accounting for nearly 38% of the benchmark. On an earnings basis, this group accounts for 31% of all net income.

If we drill down to the Magnificent Seven more specifically, this group has definitely seen multiple expansion. The Mag Seven now accounts for 32% of the S&P composite by weight but only 23% of earnings. So, while we understand investor positioning to go where the growth is, we do believe that valuations could be a bit full here.

With all the euphoria around artificial intelligence-exposed companies, we're also seeing some fear for the strength of the economy. This quarter saw a strong rally in utilities, in large part around the demand expectations for the growth in AI. It is actually estimated, for example, that an AI query uses about 10 times more electricity than just a regular Google search. 

But the next best sector of the quarter was [consumer] staples, and this is despite staples producing somewhat muted results this quarter and issuing tepid guidance. What we think is happening here is investors may be creating a barbell of risk with strong momentum investments in tech balanced with more defensive postures in staples. 

If we compare across market capitalization, large cap continued to deliver growth while mid and small cap declined by similar amounts. We saw similar dynamics at play in small cap where investors favored consumer staples, and discretionary saw the worst performance. Within mid-cap, communication services and utilities were the strongest performers.

BEN FALCONE:  Julie, the Fed signaled a more cautious approach to easing throughout the rest of 2024 and thus would seem like no major moves will be made until 2025. What will it take for the market to broaden out and have greater participation? Is this possible with the Fed remaining on the sidelines, or do we need rate reductions amidst the soft landing? 

JULIE BIEL: So, at the beginning of June, after persistently hawkish Fed member speeches, we did see some dovish commentary from Fed Chair Jerome Powell. Now this opens the door to a potential rate cut in September with two rate cuts possible for the year. We do not think that 50 basis points of rate relief is going to be sufficient to materially change the fortunes of consumers or companies who have been struggling under the weight of higher interest rates. But the pivot could have a more powerful impact on investor psychology than maybe you would expect to see fundamentally in companies this year.

We would not expect a more material broadening of the market until we see a more material broadening of earnings expectations. We're seeing some early evidence of a recovery in industrials and healthcare, but generally speaking, we see more divergence between and amongst companies in each sector. The stocks of each sector really trade together based on sentiment and then when earnings happens, all of these companies reset to reflect the individual fundamental results.

Now, this is not atypical, where your companies would trade as a group until actual earnings come out and people can kind of discern who are the strongest performers. That said, the magnitude of the resets that we're seeing at earnings, and stock reactions overall, both up and down, are quite wide, which to me indicates that there is a lot more investor psychology, a lot more narrative at play rather than individual, fundamental bottom-up analysis that's happening. 

BEN FALCONE: Julie, cyclicals have shown a continued outperformance versus defensive stocks. Why? And can this continue?

JULIE BIEL: While we saw strength in cyclicals in the first quarter, likely propelled by enthusiasm for rate cuts, that advantage really started to fade in the second quarter. Financials, energy, industrials, and materials were all the worst performers in the second quarter in the S&P 500. We think there are some themes that are supporting cyclicals, such as infrastructure spending during an election cycle, which you would expect, but we also believe that any economic weakness is going to impact many of these more cyclical businesses first and would really focus on individual fundamentals to inform investing in these sectors. 

We would never encourage investors to be shunning wholesale sectors of the economy. However, we really think it's important to be thinking about the quality of each of the individual companies and let the fundamentals dictate rather than having a very strong narrative overlay in terms of positioning.

BEN FALCONE: Julie, of course, AI has been a continued topic in the markets. Have you seen any changes in the trajectory of its impact and monetization opportunities across markets, or do you think we're still in the developmental phase? Also, as the usage trickles down, do you think the efficiencies created will flow through to investor returns? 

JULIE BIEL: AI continues to be the dominant theme of the investment landscape today. We have seen evidence that companies are touting the potential of AI without actually articulating what kind of financial impact we can expect. You may have heard of this term called “AI washing,” similar to greenwashing. We think it's still too early to be able to forecast how AI will permeate the economic landscape. It's kind of similar to the internet, where when that really started to come to the fore, we weren't really sure what the highest and best use cases for the internet were. It takes time for these technologies to permeate.

Most of the technological changes that we see follow what's called an IPA model, that is, infrastructure, platform, and applications. Right now, we are in the infrastructure phase of AI, where hardware is dominating growth to build out the capabilities in order to leverage that AI. We would note that in previous infrastructure buildouts, growth has sometimes been uneven, and investment was not always successful in generating good returns. 

And what's unique in this cycle is the incumbents are now driving the disruption in infrastructure. That's a little bit unique. Platforms are starting to emerge in the form of underlying AI languages, but the killer AI app has not yet appeared. The analog of this would be the advent of ERP software. That was when people could really leverage all of the technological change that had happened to that point.

Now it could take meaningful time for AI applications beyond chat technology that we know about today to emerge, but investor tolerance for CapEx [capital expenditure] spend appears to be pretty solid. Your Googles and Amazons of the world, they’re not seeing a lot of investor pushback for the kind of CapEx spend that they're doing in order to build out this infrastructure layer.

For now, we believe the earliest beneficiaries of generative AI will be software companies leveraging the technology for code development. The risks for early challenges with AI hallucinations or errors appears to be less of an issue in this use case. So, for example, we've heard about reporters that would try to use generative AI to summarize something in an industry happening, and the problem is they can't rely on that data just yet because sometimes that software will hallucinate for them.

With code generation, these engineers are using the software to help it write the kind of most basic boilerplate code that they need when they’re building out new functionality. That is something where there's fewer issues with hallucinations, and it ends up making these developers sometimes 20, 30, 40% more efficient if they can have that very boilerplate code written for them.

So, while we think both small and large software companies are going to be using the technology to improve their efficiencies and accelerate their software development, it's really hard to see other use cases that have a meaningful economic impact.

BEN FALCONE: Julie, is there anything that you can definitively point to that gives you conviction in the investment landscape as we look out to 2025 and beyond?

JULIE BIEL: So, the last 12 months have been marked by consistently conflicting data. As investors, we have access to much more information on the economy or individual companies or consumers than ever before. And I think what strikes all of us at Kayne is that all of this data has probably created more noise than signal. And I think this is why investors are piling into relatively few ideas that have really clear earnings visibility and that valuation has kind of taken a backseat when it comes to those companies. Investors are searching for that kind of clarity that makes it much easier for them to feel confident about the future.

The fact is right now, we're in a very uncertain environment. We continue to posit that it is impossible to accurately forecast the economic outlook, and we would really caution anyone against spending a lot of time doing that. We think instead it's better to focus on owning the best quality businesses possible, particularly as we exit a 13-year period of unparalleled monetary ease as rates descend to more normal long run levels in the 3 to 4%, we would note that this is materially different than the zero to half a percent we have enjoyed for more than a decade. Without that powerful tailwind of ultra-low rates, we would expect quality to have a more meaningful connection to investment returns than has been the case in recent times. 

BEN FALCONE: Julie, thanks for taking the time again to provide your insight to our KayneCast listeners.