What We Think

As the calendar turns from March to April, many sports fans are eagerly awaiting the college basketball finals. While the tournament has seen some exciting overtime games, market watchers are also feeling as though the bull market (for tech stocks in particular) is running into overtime. A wave of excitement for artificial intelligence-related stocks kicked off in late 2022 and has helped the market surge ahead in four of the last five quarters— including a 10% rise in the first three months of this year.

This quarter’s client letter will examine the potential for growth stocks to keep running into overtime, or whether the AI excitement is about to take a time out. We’ll also look beyond the AI theme as we evaluate other factors impacting markets, such as the economy, the Federal Reserve, elections, and company profits.

What’s fueling the AI frenzy?

AI technologies such as ChatGPT may create new text, images, music, and videos, driving demand across a wide swath of the tech sector to get in on the action. Marketing software companies are using AI to stimulate new business, while cloud computing companies are buying massive amounts of high-tech semiconductors to process all of the data needed to execute AI functions. Rising demand within this AI food chain is boosting sales and stock prices higher.

Will this momentum continue? On one hand, bulls argue that we are in the early stages of rolling out new AI tools that may increase productivity across the economy—similar to what we’ve seen in prior technology cycles with PCs, the Internet, smartphones, and cloud computing. What’s more, the broader market is still less expensive than it was in late 2021, despite the introduction of AI-related growth drivers.

While the growth stock upside may continue, bears worry that we are in a hype-cycle with rising execution risk. In this downside scenario, companies may disappoint relative to sky-high investor expectations, triggering a wave of declining sentiment.

So which path is more likely? At this point, we have yet to see any significant slowdowns for the tech titans in the areas of cloud computing, AI-related semiconductors, or even online advertising. These trends suggest to us that a diversified approach to owning higher growth tech companies could continue to add value to portfolios balanced out by exposure to other defensive and cyclical stocks.

What else is going on in the economy and markets?

Speaking of cyclical stocks, there are other dynamics impacting the business cycle and the economy that are worth watching. The biggest trend in the economy over the past two or three years has been a wave of inflation that crested in mid-2022 with Consumer Price Increases (CPI) of 9%. The dangerous part of this inflation force is behind us, but investors are grappling with the Fed’s approach to keeping inflation contained. Inflation is lingering around 3%, though the Fed sees a number closer to 2% as more sustainable.

With a relatively tight and fully employed job market, Jay Powell and the Fed are squarely focused on the timing of an interest rate cut which could help the economy avoid a recession. Currently, the Fed is putting its foot on the brakes by keeping interest rates relatively high. However, the Fed is trying to thread the needle of cutting rates to promote economic growth on one hand, while also avoiding sparks that could ignite another round of inflation if the economy overheats on the other.

We generally agree with a mainstream view that the Fed will boost monetary policy with two or three interest rate cuts this year, potentially starting as early as this summer. In the meantime, we are taking advantage of higher interest rates by locking in high quality government and corporate bonds that should help balanced portfolios more than offset low single-digit inflation over the next 5-10 years.

How are we positioning?

Uncertainties with tech stocks, Fed policy, and even the election cycle may lead investors to become risk averse, prompting a reduction in stock and bond holdings or thoughts of market timing. While we are aware of a wide range of outcomes related to AI and tech stocks, along with the broader economy, we generally prefer a fully invested approach through these cycles to increase the likelihood of clients achieving their long-term financial goals.

Over long periods of time, stocks tend to chase corporate profits. While near-term pressures may impact companies, we believe management teams have the incentives to generate growth and improve efficiency, boosting profits (and stock prices) over the long term.

As excitement continues for both the college basketball tournament and the rise in tech stocks, we are watching for any signs that time may be running out for AI-related stocks. Our due diligence suggests that this new wave of growth may add onto a broader base of companies that are growing earnings and supporting favorable stock performance over the long run. We continue to support a fully invested approach, while favoring investments in companies and management teams that meet or exceed investor expectations and remaining ever mindful of your long-term goals and objectives.

We wish you all the best this Spring.

Michael Bailey,
Director of Research

CFA Michael Mussio, CFA, CFP®
President