A significant shift is underway in the financial markets as investors aggressively reduce their exposure to crowded trades centered on chip stocks and artificial intelligence winners. This rebalancing of portfolios has accelerated recently due to heightened competition risks from China, though the sell-off may still be premature despite its intensity.
This month has witnessed a dramatic reversal of the AI trade. A basket of stocks linked to AI spending, including semiconductors, tracked by UBS has underperformed a basket of stocks considered vulnerable to AI disruption by a record 42 percentage points. While this reversal follows months of strong outperformance, it highlights a sudden liquidation of overextended positions, particularly within the semiconductor sector.
In terms of investment factors, momentum investing has been suffering severely. The previous environment of rising prices and rising volatility has vanished. Instead, volatility is climbing toward pandemic-era levels, while prices are sharply declining. Given that momentum was one of the most crowded trades and has now erased all its gains since February, the bottom may be near. Brian Garrett, head of equity execution at Goldman Sachs, stated that his team believes the "momentum collapse is in its later stages." They argue that given the high correlation between AI and momentum trades, increasing exposure is reasonable, while noting that the realized volatility of momentum baskets remains "stunningly high."
Regarding ASML Holding NV (ASML), the recent decline triggered by a report that a state-owned Chinese company has begun manufacturing immersion deep ultraviolet (DUV) lithography equipment appears to be an overreaction. Firstly, DUV equipment is considered a "workhorse" of the semiconductor industry, significantly less advanced than the extreme ultraviolet (EUV) lithography machines that ASML uses to produce the most critical AI chips. Industry analyst Masahiro Wakasugi noted that while ASML faces a potential 20% threat to its sales and operating profit, this seems far off. He wrote, "China has a precedent of achieving nearly 100% localization in strategic chip manufacturing. If costs are not a constraint, domestic suppliers could potentially build immersion DUV equipment. However, completely bridging the technological gap with ASML may still take about 7-10 years."
This is not a liquidation of overextended positions that could trigger a broad market sell-off. Instead, it is a rotation and rebalancing of portfolios away from an over-reliance on a single trade. The value factor has become a primary beneficiary of this rotation. Even within the technology sector and among mega-cap stocks, investors are rotating into value-oriented names. Bank of America derivatives strategists, including Arjun Goyal and Vittoria Volta, noted, "The tech pullback is again playing out as a rotation, not a blanket sell-off, with sectors like healthcare and financials significantly outperforming. Consequently, despite the decline, correlation levels remain extremely low, even within the 'Magnificent Seven.' Stocks with lower AI exposure and more 'value attributes,' like Apple (AAPL), are rising, while recent winners like Alphabet (GOOGL) and NVIDIA (NVDA) are falling." They added that the long-term trend of tech stocks rising remains a core theme. However, given catalysts like mega-cap earnings and the Federal Reserve's interest rate decision, the risk of further momentum liquidation prompts investors to "rent" rather than "own" a rebound through options asymmetry. They recommend a call option spread strategy on the Semiconductor ETF (SMH), offering an attractive, limited-risk way to position for a semiconductor rebound while locking in downside risk.
Market attention is now focused on the earnings and guidance of major tech companies. Microsoft (MSFT) and Meta Platforms (META) are reporting after the market close today, followed by Apple and Amazon.com (AMZN) tomorrow. While earnings expectations have risen sharply, companies are still beating estimates by a wide margin. Among S&P 500 companies that have reported so far, 85% have posted positive surprises, the highest percentage in five years tracked by Bloomberg Intelligence. Yet, this has not driven the market higher. Daniela Hathorn, senior market analyst at Capital.com, stated, "Investors are becoming increasingly picky this earnings season. Strong revenue growth is no longer enough to satisfy the market unless accompanied by evidence that high spending is translating into sustainable profitability. This makes the upcoming results from the remaining 'Magnificent Seven' companies particularly important for the overall direction of the stock market."
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