AI still dominates, but is the market ready to broaden?

BRIAN HESS: Hello, this is Brian Hess.

JACK JANASIEWICZ: I'm Jack Janasiewicz.

BRIAN HESS: And this is Tactical Take. Hey, Jack.

JACK JANASIEWICZ: Back at it.

BRIAN HESS: Back at it again. All right, so at the beginning of October, we made our first model trade in four months, and I thought we could break that down a bit today, at least to start. So there were a lot of moving parts to this trade. And let's start with the part where we closed out of some positions.

So we had positions on in ETF AIRR, which is an American Industrial Renaissance ETF, and PICK, P-I-C-K, which was a global metals and mining ETF. We cut those two positions at the beginning of October. Why did we get out of them?

JACK JANASIEWICZ: Yeah, we were trying to get exposure into various derivatives of the AI trade. And I think looking at the performance that we've had with those areas of the market, we weren't getting the direct exposure and the direct bang for the buck that we expected for that.

And so rather than trying to play derivatives of that trade, whether it be the reshoring, onshoring, the commodities – related to some of the supply shortages that we're seeing in the marketplace – we thought it was probably best just to take direct exposure. So one of these instances where the second derivative may not have really proven to be what we thought it should have been versus just take the direct exposure instead.

BRIAN HESS: And the correlations started to weaken a bit after we put the trade on as well. So they became less efficient of a way to position for the AI theme the longer we had them in the book. Okay, so we cut those two. And the next thing we did – zooming out a bit – is we added to our overall stock market overweight. So we were overweight stocks versus bonds by 1%. We now are 2%. Why did we add risk?

JACK JANASIEWICZ: As we think about where we are in the calendar year, usually the market starts to pick itself back up after some chop as we head into the end of September and into early October, with the backdrop of elections, the midterm elections coming up. And so from a seasonal perspective, the season will start to flip a little bit more positive.

And then we start to look at the economic backdrop. And the economic backdrop's still pretty supportive, maybe the one headwind had been on the rates front. And the market seems to have fully digested the potential for at least two to three more hikes from the Fed. So from that perspective, that's already discounted. So you start to think about the things that are supportive versus the headwinds.

It feels like a lot of the headwinds are being discounted at this point. With the seasonals flipping, some of the positioning cleaning up, it seems like we're set to move higher into the end of the year as we get past the midterm election backdrop here.

BRIAN HESS: OK, so it was about seasonality turning more favorable, coupled with rates having hit a level where it seems like maybe bonds are finding some support. And if rates come down, that could also breathe some new life within the stock market. Makes sense.

Now, if we think about regional exposure within our equity positions, we have a big overweight to US stocks. Now it's about 4%. And we're underweight international. Mostly underweight Europe, but we have a little bit of an underweight in EM as well. Why the big overweight to the US in favor of the rest of the world?

JACK JANASIEWICZ: Yeah, I think if you look at the growth differential backdrop, it's certainly skews much more in favor of the United States. And a lot of that's a function of the AI trade. You've got that sort of massive CapEx build that's really, I think, a supercharger, if you will, for the broader economy. You see it impacting the wealth effect. So it's making its way through consumption. You're seeing it work its way through the earnings backdrop. The list goes on and on there. So it's a hugely supportive backdrop for, I think, the US economy and markets in general.

You start to look overseas, less impactful. And on top of that, you're seeing central banks actually tightening rates there. So that growth impulse that we're seeing, much stronger in the US, much weaker overseas, on top of the idea that they are seeing rate hikes. So I think that presents a little bit bigger headwind, I guess, going forward for regions outside of the US and the developed world side.

BRIAN HESS: Yeah, the US seems to be the epicenter for the AI trade. There are some countries where the AI trade is really dominant in their stock markets, like South Korea, for example, or Taiwan, but these tend to be smaller markets. And so of the big regions, the US is the place to be for that AI exposure.

Now on the fixed income side, we added duration for the first time in a long while. And we did that by purchasing 2% in a long-term Treasury ETF. We've been spending a lot of time on this podcast, for several months now, highlighting how rates were getting more and more attractive, treasuries were becoming interesting. And so what made us finally pull the trigger and put our money where our mouths are?

JACK JANASIEWICZ: Yeah, it just seems like we're fully starting to discount that backdrop, whether it be for the inflationary side or just what we expect from the Fed. And I thought what was interesting – and we're recording this podcast on the 20th – if you look at the market reaction to both the more recent CPI and PPI prints, you know, they came in on the warmer side. And yet the bond market actually didn't really do much.

So I think from that perspective, a lot of that bad news, if you want to call it that, is, I think, currently discounted in current rates. And we run a fair value model that looks at a bunch of different fundamental macro inputs. And that fundamental model is something close to maybe a 5%, a little over a 5%, yield on treasuries on the 10-year part of the curve. And we're certainly looking like we're overshooting that backdrop.

So all said and done, it looks like the market may be finally sort of getting to a point where it's fully equilibrium, if you will, given all the backdrops that we've just talked about. And to us, maybe that cash market looks like it's on the cheaper side relative to where it's trading currently.

BRIAN HESS: Okay, so it's about balance of risks, the market maybe having overshot fair value to an extent, but then thinking about – if we think about how that fair value model could evolve going forward, when I take into account the various inputs in it, which are some fundamental, but some market based, it seems like the odds of those fundamental drivers moving lower and pointing to lower yields are a lot higher probability than the fair value model moving significantly higher. It would take a lot for your fair value model to move to 5.5%, for example, whereas the idea that it could move back to 4.5%, not difficult to accept.

And so if we're already overshooting the fair value model by a number of basis points, with scope for that fair value model to drop and with scope for us to, at some point, undershoot that fair value model, it creates the potential for a pretty big trade.

Whereas we think the risks of rates going against us in a huge way, and hopefully this won't be a famous last words situation, but we think that the odds of a significant bear market from here – further bear market in bonds, pretty low. Plus, we're being paid to wait. We're making a five handle on that yield while we wait for the return.

JACK JANASIEWICZ: It's that balance of risks, right? Risk-reward trade-off.

BRIAN HESS: Exactly, which is what we're supposed to be doing as risk managers and risk takers. Okay, so that's fixed income.

Now lastly, we did a couple of equity sector trades that deserve special attention this time. Now one aspect of our models that's weighed on relative performance this year, and which we've talked about in various episodes, has been our holdings in active, large cap US equity managers who are underweight the AI trade. And so as the AI trade has dominated returns this year, they've lagged their benchmarks. And that's weighed on overall model performance.

So with stock market correlations having fallen so much, and we've covered that as well, we've shown charts, and the day-to-day performance in the market often characterized by AItrade up, everything else down, or vice versa, the volatility of our relative performance in the models has gone a lot higher than what it had been, and a lot higher, frankly, than what we think clients are probably comfortable with.

And so we felt like it was a good time for us to try to intervene a bit to manage that volatility. And so we've created an ETF overlay that will account for our active equity managers' relative sector positions, okay. And so in order to facilitate this during that early October trade, we purchased a position in XLK, the technology ETF, and S-O-X-Q, SOXQ, which is a semiconductor ETF. I guess for you, my question, Jack, is can you just give your perspective on this changed environment and why it led us to take a more hands-on approach to managing these sector underweights?

JACK JANASIEWICZ: Yeah, and I think a lot of this comes back to tracking error, right? And when we start to talk about the volatility that you were just going through, that funnels its way into the tracking error. And when you have high conviction active managers, that tracking error can certainly wax and wane.

And when we see, sort of, the dispersion in returns, as well as the singular themes driving the marketplace to some extreme performance here, that accentuates this backdrop. And I got some stats here I think are worth going through that highlight this backdrop.

BRIAN HESS: Sure.

JACK JANASIEWICZ: When we look at the year-to-date performance for the S&P 500, it's up 13-- a little over 13% as of this recording. But the median constituent is up about 5.6%. So the median number versus the average, still below that.

But what's interesting, 20 names are up over 100% year to date, and when you go through those 20 names, that's basically 6% of the index, 13 of them are tech, 3 are healthcare, 3 are energy. So you can kind of see, OK, the energy play is pretty straightforward given commodity prices and oil prices. And when industrial's up triple digits as well, that's really an AI-related play.

JACK JANASIEWICZ: But it all comes down to the hardware, and semis, and software trade. And that's the AI trade. So you can certainly see having that exposure can certainly have a massive impact on your returns. But missing that has certainly a downside risk as well.

You also look at the broader market, 39% of all constituents are beating the index, but 39% of them are actually down year to date as well. So again, just looking at that really bifurcated market with the dispersion in returns, that creates an interesting backdrop.

And so not only do you have to get the winners right, but you also have to avoid the losers because you had that big gap in those sort of wings of the histogram distribution for returns. And, you know, these themes are also a big portion of that, right?

Energy is less than 4% of the overall index, which is – probably a good chance you may have simply ignored energy because it's too small of a weight in the index, so why bother? Yet energy is of the best performing sectors in the marketplace right now. Same thing with the AI trade.

You know, we've done some work internally where we try to estimate what the total exposure is for the S&P 500 related to AI and AI-themed derivatives, if you will. And that's almost 60% of the market based on our estimates there.

BRIAN HESS: Wow.

JACK JANASIEWICZ: So again, if you're underexposed to the AI theme, which again, 60% of the market is some sort of version of the AI trade, you can see how you can get left behind.

BRIAN HESS: Or put another way, it's very easy to be underweight the AI theme, even accidentally.

JACK JANASIEWICZ: Right. So you can certainly see how these tracking errors, the volatility that we're talking about can certainly come into play and be exaggerated because of these extremes. And so to your point, we're simply trying to manage that, tighten the reins in a little bit, and try to prevent those wide dispersions to really have an adverse impact on the portfolio.

BRIAN HESS: All right, that makes sense. Thanks for the details. Thanks for those statistics. I think it really creates a much more tangible image for people in terms of what's going on this year and what stock pickers have been dealing with underneath the surface.

All right, so this is actually a good segue into our next topic and our last topic for today, which has to do with the potential for a broadening in the stock market. I kind of teased this idea when we were highlighting rates earlier.

But like you said, so far this year, performance has been dominated by technology stocks and energy stocks. And then even within technology, it's been hardware and it's been semiconductors while software stocks have really struggled. Within healthcare, it's been biotech.

So there's been – even within the few sectors that have been leading, subsectors within them that have been leading too. So there's a lot of room for various areas to be left behind within the marketplace. So market leadership has been narrow. And that's reflected in some of the different technical indicators people look at to assess this sort of thing, whether it's the percent of stocks above their 50-day moving average, or the cumulative advance decline line, or the McClellan summation index, which you showed in one of our meetings recently.

All of these things are at low levels, or they're negatively diverging with price, where price is either going up or staying high and these indicators are moving lower. So first off, what do you think has caused – I mean, this is kind of a big question, we've probably covered it before as well – but let's quickly recap, why do we have this concentrated performance and narrow leadership in your opinion?

JACK JANASIEWICZ: Yeah, and I think it just goes back to these themes that we're talking about. It's sort of a winner-take-all mentality. And you're having these names that are in the spaces of the AI trade that are basically the dominant players in there. And so their backdrop for earnings have just gone through the roof.

And so I think you've had that being the big driver in terms of that narrow market breadth, so to speak. And, you know, where we're seeing scarcity, that's where the winners are. Those winners are in the tech trade. And I think that's really where it's all coming together. And that's why you have such a narrow leadership for the markets right now.

BRIAN HESS: Now you've been pretty constructive on the idea that this AI buildout has a lot of runway behind it, and that demand for memory will hold up, and that there's a lot of CapEx in the pipeline, and this is a durable theme. So with that as background, do you think there's enough pieces in place right now for investors to start, like, reorienting their portfolios toward the idea of a resumption of broader leadership?

JACK JANASIEWICZ: Yeah, and I think this is the important theme that might be shifting right now. And we're sort of seeing that play out in the marketplace. And I think it's two things. The market is telling us that CapEx is certainly going to be a predominant theme, but funding that, the financing that's related to that CapEx backdrop is shifting.

It's no longer just willing to write blank checks to anybody. Borrowing is now certainly being more distinct in terms of who the money is going to be allocated to. And as you get these weaker credits, the ones that are more leveraged, less clarity in terms of those revenue streams going forward, the market is assigning a higher probability of potential downside, right? So i.e., spreads are widening out.

So you think about, for example, the hyperscalers, if you look at the benchmark 10-year bonds for the hyperscalers, they've been fairly well contained. But when you start to move out to someone like the neoclouds, for example, the neoclouds like Nebius, CoreWeave, you're seeing those spreads widening out.

And well why is that? More leverage built into the system, there's a little bit of a duration mismatch between what they have to spend on, relative to the revenues. So the market is now becoming a little bit more discerning in terms of who the winners and losers are going to be. And you're starting to see that change the dynamics there. So that's one.

The second one is simply the relationship between basically excess returns coming out of the AI trade relative to the bond market. And that all might come back to the CapEx backdrop. Whereas if the market is becoming more discerning in terms of who's going to have the ability to borrow, that probably slows the cycle down a little bit.

So as the CapEx cycle slows, that means the growth backdrop probably slows, which means the inflation impulse, the growth impulse, softens. And that's probably good for bonds. And so you're starting to see that relationship come back where you get, sort of, the concerns over the CapEx spend backdrop in the marketplace, i.e., tech is selling off.

And at the same time, you're seeing bonds rallying. And I think that's partly maybe what we're seeing right now is – the market is sort of digesting, saying, hey, maybe the CapEx cycle does slow. And as a result, the growth impulse slows. Bonds rally. And you're seeing that manifest its way through the system.

So again, what did we talk about the last podcast, what do we need to see for the broader market to participate? Probably lower rates. So if we start to see lower rates as a result of the CapEx slow, maybe that does mean we're going to see a pivot away from the AI trade into the broader market. Growth is still decent, so it can still hold up. And that helps for the broadening trade.

BRIAN HESS: And so that last point is an important one, because when I'm listening to you talk, I'm thinking, gosh, this is a complicated concept because the first thing you said makes it sound like we could be set up for even more narrow leadership within the AI trade as the weak hands start to gather, the weak names start to get squeezed out. So that would be like a continuation of the current theme, but just even more narrowing.

But then your idea that, well, if they're locked out of the bond market or of the capital markets, so to speak, and that forces less CapEx spending, then you can see how that would create less demand for capital overall and allow Treasury rates to come down, which has been a problem for some smaller capital stocks, capitalized stocks.

But at the same time, we know that the AI trend has been dominating growth. And consumption has been rolling over or slowing. And wages have been slowing. But yet this AI contribution to GDP growth through CapEx has been really important.

And we also think about smaller capitalization stocks as being cyclical. So it's like on the one hand, if rates come down because AI CapEx slows because these weaker hands within the AI theme are locked out of the markets, that's great for small cap companies who have a lot of debt.

But if it means that GDP gets 0.5% or 1% shaved off it, that starts to make me worry about the market overall. And yeah, maybe we'll get a change in leadership, but it will be in the context of a down market, which we're not really positioned for in the models. So is that a legitimate concern? Or do you think that's less of a risk?

JACK JANASIEWICZ: Yeah, I think the rotation still stays up in cap, though. So I think to your point, yeah, the down cap still struggles because you're facing higher financing costs. And I don't think we're going to see a material break from 5 and 1/4 on tens all the way down to 4, which I think would be the more appropriate backdrop for small caps to really start to catch a bit in here.

But to me, it's more just the rotation up in cap and large cap area. So you could certainly see, I think, the winners will certainly be the guys who have cash flow. And who are those players? It tends to be the hyperscalers. So I wouldn't be shocked if mega-cap tech still works, but it's just the broader tech space starts to see the rotation hit them and it goes into the broader markets there.

BRIAN HESS: Okay.

JACK JANASIEWICZ: But again, just to be clear on that backdrop, though, this is not necessarily the funding market shutting down. It's just charging a higher price for those who are perceived to be weaker credits. So big difference there. If we start to see the capital markets shut down, that's a problem. But we're just seeing basically the availability of credit being rationed. And that's probably what it should be. The market's sort of parsing out winners and losers.

BRIAN HESS: And I guess the cost could move to a level where it discourages some of these players from taking on that marginal project.

JACK JANASIEWICZ: Exactly.

BRIAN HESS: This is a nuanced view. And it's essentially saying avoid small caps for now, focus on mega caps probably, particularly hyperscalers who are well capitalized, be cautious of less well-capitalized, more debt-dependent AI participants, but then be open minded about some of these names within the S&P 500 that have been ignored while all the capital rushed into these speculative AI names, and maybe they'll have some life breathed back into them, because we no longer have to worry about the 10-year rate going up and up and up, and no one having any idea where the top might be.

JACK JANASIEWICZ: And all of this manifests in the factor quality. We're seeing quality performing well. So that's probably the summary of the factor.

BRIAN HESS: Quality is not an unprofitable small cap. It's not a neocloud, probably, but it is some of these names that have been ignored within the S&P 500, which fortunately, is where our active managers tend to be positioned.

They tend to have a tilt towards quality and a bit of value as well. So hopefully they'll participate or they'll benefit from this trend if it emerges. All right, well, thank you very much. I think we'll leave it there for this month, Jack. This was a good catch-up. And next month, we'll be back with an outlook for 2027, I think.

JACK JANASIEWICZ: Sure.

BRIAN HESS: So viewers can look forward to that. I look forward to that. And we'll see you then. Thank you.

JACK JANASIEWICZ: All right, thanks, Brian.