2023-06-09 09:33:47 ET
Summary
- The stock market in 2023 seems to be primarily influenced by higher interest rates, artificial intelligence, and a renewed focus on balance sheets and cash flow statements.
- This has resulted in mega-capitalization technology stocks outperforming everything else, driven by their strong fundamentals and exposure to AI trends.
- In this market, investors should ideally continue to focus on companies with a combination of solid balance sheet, cash flow profile, and credible AI exposure.
- As the current market context persists, companies should be considered in light of these criteria over the next two quarters.
- This provides certain names that are tradeable now, such as Pinterest and IBM, and a framework for evaluating others.
Overview
This year’s stock market continues to be a unique one, with a return profile reflecting the multiple significant idiosyncratic forces now playing out in the present. High and increasing interest rates, the arrival of artificial intelligence, and the increasingly important balance sheet and cash flow statement all continue to play their part in determining which stocks are up and which stocks are down this year.
The result is our present market dynamic, one in which a well-publicized rally in ‘mega capitalization’ technology stocks continues to account for an outsized portion of overall returns. These 8 stocks have far and away outpaced other enterprises as well as major market indices this year. Collectively, appreciation in these stocks has pulled the NASDAQ Composite well ahead of the S&P500 and Dow Jones in terms of price return year-to-date.
SP500
Dow Jones
NASDAQ Composite
As this has been going on, an uncertain macroeconomic picture has persistently loomed overhead. A continuing tightening of the money supply, ongoing inflation, and high consumer credit utilization together point to a precarious overall economic footing amid widely-held expectations of recession. There is a lack of consensus in how severe this upcoming recession will be as well as its degree of impact on corporate earnings and/or the stock market as a whole.
The forward picture, then, is a complex one. It is difficult to be certain about the way that things will go in the next two quarters and beyond. Yet, there should still be persistence in how current economic forces continue to play out in the near to medium term. The prevailing idiosyncratic factors are slated to persist. This should allow for an appraisal of the market ahead across a range of scenarios.
Irrespective of the price behavior that we are going to see over the next two quarters, I believe that current economic and technological forces are creating long-term winners at an accelerating rate in the present. Businesses that are slated to succeed, many of which also exist in the middle market, have fundamentals that will carry them forward to a continually growing earnings profile in the newly emerging market. This centers around their economic and fundamental positioning in what will be a materially changed market, which is being brought about by the current slate of idiosyncratic factors.
Ongoing 2023 Idiosyncratic Factors
As mentioned in the introduction, the four significant factors that I believe are driving the market today are higher federal funds rates, artificial intelligence, and the balance sheet/cash flow statements in particular.
These four factors end up boiling down to two when we consider them as a whole.
- Higher rates are creating higher financing costs market-wide, which are driving investors to have a renewed focus on balance sheets as a way to assess leverage/carrying costs and on cash flow statements as a way to assess self-sufficiency, operating leverage, and return.
- Rates are a central factor affecting capital flows across the market overall. These cost of capital effects are partly responsible for the flight to the largest technology firms, the financial statements of which look good in light of these fundamental factors.
- Artificial intelligence is being acknowledged as a significant economic force and driving investor capital allocation pro rata into firms based on their exposure/expected benefit.
Considering these two forces together, it makes complete sense why the largest technology firms are seeing such outsized buying this year. They are well-positioned in a higher cost of capital context, while also having the best relative exposure as to the AI secular trend.
There are also other companies that are also well-positioned as to these factors. Given the relative lack of breadth in this year’s market so far, it is likely that some of these companies are also trading at opportune price points for medium to long-term investors. The next section will outline what to look for while also discussing select names that are tradeable.
Picking Winners In This Market
The best stocks in this market embody both of the factors that I outlined above while also demonstrating durable growth. This means a good balance sheet and cash flow profile, credible upside exposure to AI, and no recent down quarters for the top line.
The company that first comes to mind here is Pinterest (PINS). While it isn’t trading cheaply, it is well-attuned to both current factors and should continue to do well . The company has a robust fundamental footing, with a particularly strong balance sheet, and it also operates in a business credibly set to benefit from AI. Pinterest also brings to the table large amounts of data and clear near-term goals for leveraging artificial intelligence.
As to companies with robust balance sheets and cash flow statements, yet lacking credible exposure to AI, I would first venture that they are trading at relative premiums already. Getting a proxy read on this through the value factor, however, indicates that this may not be the case – the Vanguard Value Index is down 0.21% year-to-date .
This indicates that future growth prospects are what’s really driving the premium price performance in some stocks – and that means artificial intelligence.
For a stock that has credible exposure to artificial intelligence without much consideration of the other factor, look no further than IBM (IBM). IBM has a long-dated AI competency and enterprise relationships that could very well give it a seat at the table in a very significant growth market – and bring it back to prominence as a result. It is trading at a discounted valuation, with the market not pricing in this possibility to a significant extent.
Risks In This Market
In this market, I would continue to avoid companies that have shaky balance sheets as well as unproven or distant cash flow generation capabilities. Even for companies with ostensible artificial intelligence offerings, I would be very cautious with stocks that fit these criteria. While there have of course been sell-offs across a lot of these stocks, many of them have the potential to decline further as this market environment persists. Given the economics of building artificial intelligence systems, I am skeptical that companies with market capitalizations of less than $10B have credible artificial intelligence offerings.
Overall, I do believe there will be outsized economic returns to the mega capitalization technology stocks as a result of artificial intelligence. To that end, I think these stocks’ appreciation is warranted; they are still worth purchasing now for investors with a 10-year horizon. This is driven by the economics of artificial intelligence and material disparities in AI/data competencies between these firms and the market median.
Conclusion
I think it is highly likely that this current market context will persist over the next two quarters. This assumes that rates will not decline, although they may plateau. It also assumes that AI will continue to be a significant force driving market valuations.
To that end, I think investors are good to purchase the mega-cap stocks that have already done well this year, as well as select companies that are aligned to the two core forces under girding this market. Even though my near-term sentiment around the entire market nets out to a hold, this set of firms appears best-positioned to experience share price appreciation over the next two quarters.
For further details see:
June 2023: The Market Today And Where It's Headed