Why The Market May Be About To Get Turned Upside Down

seekingalpha03-28

Tech stocks, especially AI-related stocks like NVIDIA, have soared to new heights so far in 2024, while several other sectors have been left behind.The underlying fundamentals and several macro trends...

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While tech (QQQ) - especially AI-related stocks like NVIDIA (NVDA) - has boomed year-to-date, high yield (SPYD) has floundered: Data by YCharts For some high yield sectors in particular, the underperformance has been even more acute and long-lasting. For example, REITs (VNQ) have declined year-to-date: Data by YCharts This continues what has been a miserable 27 months for the sector and has fueled investor disappointment after a strong year-end rally for the sector ignited hopes that the sector may have finally turned the corner: Data by YCharts Utilities (XLU), infrastructure and renewable yield companies (UTF), and many other yield-related sectors have been floundering as well, though midstream (AMLP) and BDCs (BIZD) have been two notable exceptions and have delivered exceptional returns over the past year in particular: Data by YCharts In this article, we will look at the recent winners (tech, MLPs, and BDCs) as well as the recent losers (REITs, utilities, and infrastructure) and share why we think that recent market trends are about to be turned upside down. We will also conclude with some of our top picks of the moment. Why The Winners Are Nearly Out Of Runway A.I. related stocks like NVDA, Microsoft (MSFT), Meta (META), and Amazon (AMZN) have been winning big since the advent and increasingly widespread use of large language models like ChatGPT and other corporate applications of artificial intelligence technology have hit the scene over the past few years. Meanwhile, the aforementioned market underperformers such as REITs, utilities, and infrastructure have been left behind due to the fact that they are expected to not benefit nearly as much from this new technology, especially in the near term. Moreover, interest rates have continued to rise and the market's expectation continues to be that they will remain higher for longer due to a more resilient than expected economy and sticky inflation. This hurts capital-intensive businesses like REITs, utilities, and infrastructure businesses since it increases the cost of capital and their cash flows tend to be more bond-like in nature, therefore declining in net present value when interest rates rise. Meanwhile, midstream companies like Energy Transfer (ET) and Enterprise Products Partners (EPD) have little to no dependence on capital markets since they have strong balance sheets and are fully funding their capital expenditures with internally generated cash flow. Moreover, their business models are well-hedged against inflation since many of their pipeline contracts have inflation-linked escalators and energy prices tend to rise with inflation. BDCs like Ares Capital (ARCC) and Main Street Capital (MAIN) have also held up better than other high yield stocks in the current environment due to the fact that they invest primarily in floating rate loans. As a result, their earnings have increased substantially in the current rising rate environment, while the resilient economy has fueled strong performance in their counterparties, keeping nonaccruals and defaults low. That being said, there is growing reason to believe that these winning sectors are nearly out of runway. The A.I. space now trades at nosebleed valuations that have legendary investors like Jeremy Grantham predicting that it will begin deflating soon: A new bubble within a bubble like this, even one limited to a handful of stocks, is totally unprecedented. The best guess is still that this second investment bubble - in AI - will at least temporarily deflate. Moreover, the very rich valuations of megacap tech stocks like NVDA and MSFT thanks to the AI bubble now have SPY trading in clearly overvalued territory based on numerous market valuation models. As Grantham pointed out: The long-run prospects for the broad US stock market here look as poor as almost any other time in history Furthermore, while AI stocks have soared due to bubbly optimism about its potential to fundamentally revolutionize the world in the coming decades, there is still a dearth of practical use cases of the technology and it may be some time before highly profitable use cases hit the market en masse. As a result, until this next level of innovation hits, it is increasingly difficult to rationalize the bloated valuations in many of these AI companies. Meanwhile, while midstream stocks do not look like they are in a bubble, the valuations are not particularly cheap either at the moment. Moreover, inflation is trending down, even if at a slower pace than the Fed would like it to. Additionally, energy demand may face some headwinds from recent indications that the U.S. economy is slowing, and China's recent massive oil discovery and large-scale renewable power production projects. As a result, while think midstream will continue to deliver solid returns and attractive income yields for years to come, we no longer view it as a sector that will likely drive outsized total returns. We are also increasingly bearish on BDCs due to the surge in competition in the direct lending space from major players like Blackstone (BX), BlackRock (BLK), Brookfield (BAM)(BN), Ares Management (ARES), KKR (KKR), Carlyle (CG), Apollo (APO), Goldman Sachs (GS), JPMorgan (JPM), and Blue Owl (OWL). As a result, there is growing concern that this could lead to weaker underwriting standards and less favorable terms for lenders. Moreover, sticky inflation and persistently high interest rates combined with a gradually weakening economy are beginning to pinch BDC counterparties, leading to a sudden spike in non-accruals at BDCs like FS KKR (FSK) and Oaktree (OCSL) and even ARCC's CEO recently warned that \"defaults will go up this year.\" Last, but not least, valuations in the sector are looking pretty frothy right now, with virtually all blue-chip BDCs trading at premiums to NAV. Moreover, BDC NAVs are often overstated during periods where underlying borrower challenges are brewing due to the discrete and choppy manner in which NAVs are determined and updated. As a result, this dynamic tends to create a false sense of security among investors and if/when the economy falters, it is likely that we will see BDC NAVs (and stock prices) suddenly crash just as they have in the past. Why The Losers Are Bound To Recover Soon Meanwhile, we are increasingly bullish on the outlook for REITs, utilities, and infrastructure stocks. We think that REITs may be on the verge of recovery because REITs are very undervalued relative to the private market value of their underlying real estate, major asset managers like BX are very bullish on REITs (even calling them a \"generational buy\" recently and taking several private recently), and there is significant dry powder in cash right now ready to flow back into REITs if/when interest rates begin to decline. Meanwhile, utilities have also been attracting a lot of attention from major institutional investors, including from the likes of BLK, BX, BN, and Enbridge (ENB) who have each poured tens of billions of dollars into acquiring utilities businesses recently. This is not surprising given the need for more electricity generation to power the fourth industrial revolution and green the grid in line with government and corporate clean energy agendas. Moreover, utilities look relatively inexpensive right now due to elevated interest rates and should bounce back sharply if/when rates decline. Finally, infrastructure stocks are benefiting from an $18 trillion tailwind that is being driven by five major macro trends: aging demographics in major economies that are driving increased demand for stable and inflation-resistant assets like infrastructure, the urgent need for additional and updated infrastructure in both developing and developed economies, the fourth industrial revolution which is driving demand for increased data infrastructure, the rise of deglobalization which is driving demand for manufacturing infrastructure in the United States and Europe, and the need for a lot more renewable power infrastructure as part of the decarbonization trend. Additionally, as with REITs and utilities, a potential decline in interest rates would also benefit infrastructure assets immensely due to their bond-like and capital-intensive nature. Investor Takeaway AI stocks, midstreams, and BDCs have delivered strong returns for shareholders in recent years due to some very favorable macro themes. However, the rallies in these sectors appear likely to have run their course with valuations now looking full if not rich, a lack of practical AI applications relative to frothy market expectations, weakening economic conditions, and the likelihood that inflation and interest rates will gradually decline moving forward. In contrast, REITs, utilities, and infrastructure appear ready to rip higher as they are better suited to weather an economic downturn, their valuations are very attractive, and these sectors are beginning to attract a lot of \"smart\" money.  Some of our top picks in these three sectors include W. P. Carey (WPC) (an undervalued triple net lease REIT that is yielding 6.2%, has a BBB+ credit rating, and is poised to benefit from the deglobalization-driven growing demand for industrial real estate in the U.S. and Europe), Brookfield Renewable Partners (BEP)(BEPC) (a 6.2%-yielding renewable power and utilities business that generates stable cash flows, has an exceptional track record, and has robust growth potential with 10%+ FFO per unit CAGR guided by management for the foreseeable future), and Brookfield Infrastructure Partners (BIP)(BIPC) (a 5.5%-yielding global infrastructure business that has a great track record of delivering market-crushing total returns and a high single digit distribution per unit CAGR, a BBB+ credit rating, and strong growth potential moving forward).","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2422134161"}