Market performance has been good year to date, and we observe that the bears seem to have capitulated for the sake of their careers. Consequently, it would not take much to reset the greed (bullish sentiment) and fear (bearish sentiment) gauge back to fear.
To assess the strength of the market’s primary trend, we use several technical models. Right now, most of them are flashing caution. The risk/reward ratio for the second half of the year is the least attractive we have seen in a long time. To be clear, we still believe that the primary trend is up. We are therefore trying to protect against an intermediate correction in an uptrend. Needless to say, this is tricky. However, as the market has performed well so far, we have concluded that we can afford to play tactics and hedge a part of our equity exposure with options, in the hope that the resulting additional convexity in our portfolios will help us sleep better until the US presidential election.
A notable rotation from tech market leaders to small caps
Recently, a significant event occurred when the Japanese Yen (JPY) surged, likely due to Bank of Japan intervention, leading to the unwinding of US equity positions funded by JPY carry trades. This, in combination with lower-than-expected inflation numbers, caused a notable rotation from tech market leaders to small caps.
While it remains to be seen, we are not convinced of a swift and sustainable rotation towards a broad-based US equity bull market, where the equally weighted S&P 500 suddenly outperforms its market cap-weighted cousin. One piece of cautionary evidence that a sustainable rotation is not yet under way is the rather disappointing market action of both European and Chinese equities. If such a rotation is under way, European and Chinese equities do not appear to be profiting from it. We believe that the odds of a correction are higher than those of a sustainable rotation.
We cannot but also point out the civil unrest that would likely have swamped the US had the assassination attempt on former President Trump succeeded. This would have had severe knock-on effects on markets against which our insurance would have already offered protection. The US political landscape remains highly polarised and the path to the White House could prove quite volatile indeed.
AI is not an investment no-brainer
Meanwhile, in bilateral conversations, we keep hearing that AI is an investment no-brainer and that investment managers who did not understand the implications 18 months ago should reconsider their career choice.
In reality, we believe that no one knows the medium-term implications of the rise of generative AI to any remotely useful extent. Critically, it is important to recognise what we do not know. As we wrote a couple of weeks ago, when ChatGPT was revealed to the broad public in November 2022, AI experts were not surprised by the chatbot itself, but by the public’s burst of enthusiasm for something that they see as just another step on the long scientific road to human-like machine intelligence. In any case, together with immaculate disinflation, the race among hyperscaling US technology platforms to build AI computing solutions and capacity has triggered a gigantic capital expenditure cycle whose main beneficiaries so far have been, of course, the large chipmakers.
Even though we do not know where AI is taking us, we have not missed the AI train. However, we did not get on it because we know what the actual market for AI tools will be and what profit margins the hyperscalers will derive from it five years from now. Rather, we participate in the AI investment theme because our DNA is fundamentally oriented towards growth and we have an incredibly diligent risk management team when it comes to equity portfolio construction.
As you know, we believe that most active managers underperform, not because they own bad companies or overpriced stocks, but because they think linearly and miss the few remarkable companies that grow exponentially. Indices (the benchmarks for active managers) have the advantage of never being underweight those rare massive winners one cannot afford to miss. Therefore, we think about the current market from a position of relative strength, mindful not to get carried away by simplistic narratives. AI is big indeed, but it would be dangerous to consider it an investment no-brainer.