To The Moon

Summary

• AI powerhouses like NVIDIA and Microsoft have soared higher recently, while value and dividend stocks have been left behind.
• However, we believe there are reasons why the market is likely to undergo a massive reversal in the near future.
• We share some of our top picks of the moment to profit from this reversal.

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The stock market is becoming increasingly bifurcated, with AI powerhouses like NVIDIA (NVDA) and Microsoft (MSFT) soaring ever higher while value stocks and dividend stocks (SCHD) are, for the most part, floundering. However, there is reason to believe that a massive market reversal is increasingly likely to occur in the near future. In this article, we will discuss why.

The AI Stock Market Bifurcation

If you look at the overall S&P 500 (SPY) and NASDAQ (QQQ) performance, you get the impression that the stock market is booming.

However, when you look under the hood, you realize that the stock market's strong performance recently has been driven by the increasing dominance of the largest components of these indexes. NVIDIA, in particular, has been on an incredible run, now closing in on a $3 trillion market capitalization and may end up passing Microsoft as the world's largest company by market cap in the not-too-distant future if it continues on its current run. This massive outperformance by the AI mega-cap winners is resulting in a huge gap in performance and valuation metrics between them and the rest of the market.

Meanwhile, with interest rates likely to remain higher for longer, dividend stocks, in particular, yield-sensitive securities like REITs (VNQ), utilities (XLU), infrastructure businesses (UTF), and even some of the more regulated asset-heavy midstream businesses like Enbridge (ENB) and TC Energy (TRP), have significantly underperformed. This is because these stocks generally have capital-intensive business models and are largely viewed as bond proxies by investors. As a result, when interest rates rise, investors expect higher dividend yields from these companies, or the higher cost of capital makes it more expensive to run their capital-intensive business models.

In contrast, the mega-cap technology stocks are generally more capital-light in nature and tend to pay no to very low dividends. Therefore, they are not compared to bond yields. Additionally, significant optimism around the future of AI and its ability to drive enhanced profitability at these companies is also creating major market enthusiasm for their stock prices.

The Fed Is Further Widening This Gap

The Federal Reserve could also potentially further widen this gap, as it appears unlikely to cut interest rates anytime soon. In fact, Minneapolis Fed President Neel Kashkari recently said that interest rate hikes are not fully off the table, even if his bias leans towards cuts before raising rates.

So far this year, inflation data has been conflicting. Some metrics indicate that inflation continues to decline gradually, while other data has sparked concerns about a potential second spike in inflation rates. Moreover, employment data is mixed. Although the jobs market remains quite strong overall, the unemployment rate has risen year-to-date, there are indicators that consumer spending may begin to weaken significantly as pandemic-era savings have been depleted, and consumer debt continues to hit new highs, with delinquencies and defaults rising as well.

Why This Gap Will Likely Close

That being said, there is reason to believe that the gap in the market between the high-flying tech stocks and the beaten-down high-yield stocks could close in the near future. One big reason is that the headline CPI numbers may be misleading and that inflation could actually fall significantly soon. The shelter component of the CPI makes up over one-third of it, yet there is a considerable lag in how it's calculated and reported. In fact, there is evidence to suggest that it is far lower than what is currently being reported in the CPI. Given that the apartment sector is largely oversupplied in the United States, with many apartment REITs, including Mid-America Apartment (MAA) and Camden Property Trust (CPT), guiding for low growth to even declining rents this year, once this data catches up and gets reported in the CPI, it should lead to inflation falling significantly.

According to Truflation, real-time CPI on a year-over-year basis is actually 2.68%, which, while still above the Fed’s 2% target rate over the long term, looks quite reasonable and should enable the Fed to soon get on the glide path to gradually cutting interest rates, allowing inflation to gradually subside over time. Notably, Truflation's metrics also predicted a surge in inflation before it occurred, indicating that their model is not biased towards lower inflation either.

Additionally, the FedWatch tool by CME (CME) predicts a 51% chance of a rate cut by September and an 83% chance of a rate cut by the end of the year, with a non-insignificant 42% chance of at least two rate cuts by year-end. While this seems to imply that interest rates will remain somewhat higher for longer, between the Truflation numbers and the CME FedWatch predictions, we see a likelihood that rates will begin falling sooner rather than later. If we do get some indicators suggesting that inflation truly is not going to spike and is likely to gradually subside over time, this should provide a very strong tailwind for yield-oriented securities.

Meanwhile, valuations are so stretched in the AI mega-cap space that investments at this point look to us like pure speculation. Prices could continue to soar higher due to continued market euphoria, but on a risk-adjusted basis, it seems unlikely they will continue to do so. As a result, we are at best neutral on AI stocks and are very bullish on yield-oriented stocks, as we believe they are meaningfully undervalued right now. We also believe there is a strong likelihood that the Fed has finished hiking rates, which puts the risk-reward on the interest rate front firmly in favor of high-yield stocks.

Investor Takeaway

While the AI boom has sent the likes of NVIDIA soaring to the moon over the past year, rising interest rates and sticky headline inflation numbers have beaten down high-yield stocks. We see this bifurcation reversing course soon and lifting the high-yield sector with it. As a result, we are investing aggressively in the high-yield sector, though we are being very selective to insist on high-quality businesses, especially in more niche areas of the market, to ensure that we are maximizing our risk-reward in case our thesis on interest rates does not play out as expected. Some of our favorite picks at the moment include Enterprise Products Partners (EPD), Virtu Financial (VIRT), and W. P. Carey (WPC).