Second Quarter 2023 – Artificial Intelligence Dot Com

Market Recap 

Stock benchmark indices rallied in the second quarter, driven largely by a handful of large technology companies.  The S&P 500 index of large US stocks gained 8.7% in the second quarter and is up 16.9% year to date.  The Nasdaq Composite index, composed mostly of large US technology companies, was up 13% in the second quarter and is up an astonishing 32% year to date.  Developed international stocks (MSCI EAFE Index) gained 3% for the quarter and 11.7% YTD.  Emerging market stocks (MSCI EM Index) rose 0.9% for the second quarter and a 4.9% return year to date.  Core bond returns (Bloomberg U.S. Aggregate Bond Index) were slightly negative for the quarter, as interest rates rose a little and prices fell.  Actively managed flexible nontraditional bond funds (Morningstar Nontraditional Bond Category) gained around 2% and are up over 5% for the year.  Gold was down 2.5% for the quarter, but it holds onto a gain of over 5% year to date.  

Investment Outlook and Portfolio Positioning

The average year to date return for Amazon, Google, Meta, Microsoft, NVIDIA, and Tesla is 96%.  The gains in these six mega cap tech stocks are responsible for almost the entire S&P 500 return for the year.  These stocks were also some of the most hard-hit decliners in the market sell-off last year.  It is important to keep in perspective that a small handful of technology companies are driving the widely followed benchmark indices of stocks and this is not the result of exceptional economic growth or profit growth.  The primary driver has been the story around Artificial Intelligence (AI) and the hope of future profits from its implementation. 

Macroeconomic data remains mixed. On the one hand, the U.S. economy has been more resilient than most expected, with the labor market remaining strong and supporting consumer spending.  Inflation has been dropping, thanks in part to a sharp decline in energy prices.  On the other hand, key leading indicators of an impending recession are still flashing red, including a deeply inverted yield curve and tightening credit conditions. Moreover, core inflation (excluding food and energy) remains stubbornly high, with the Fed signaling it will resume rate hikes later this year, further raising the likelihood of a recession.  We maintain our view that a recession is the most likely outcome over the next few quarters.  We can’t predict the future and it is entirely possible to avert a recession, but that is not our base case.  

Over the last six months, Artificial Intelligence (AI) has become Wall Street’s favorite new shiny toy.  This is not a particularly new technology.  We have grown accustomed to algorithms being used to follow you around the internet with targeted ads and we know our software continues to get smarter and more capable.  These algorithms have long been used to review more and more data, to spot correlations and improve their own functioning.  The process of “machine learning” has been advancing for the last twenty years and has been steadily replacing tasks that require human interaction at progressively higher skill levels.  The more recent advancement has been the use of AI to imitate art, and communicate in more nuanced language (“plain speak”).  

On November 30, 2022, a program called ChatGPT was released to the public, which allows the user to ask any question and receive thoughtful articulate answers back from the algorithms.  This demonstrated to the general public the power of these advancing tools.  It also gave investment bankers, starving from the pandemic lull, something to create investment buzz around to hawk their services.  Investors have been eager to speculate heavily on anything even remotely associated with AI.  Corporate earnings conference calls have been saturated with the term “AI,” whether the company has any real connection to it whatsoever.  It is very reminiscent of the “dot.com” era that I grew up in.  Do you remember the Pets.com Super Bowl commercial with the sock puppet?  The company paid $1.2 million for the commercial in 1999.  Investors poured over $100 million into the company, despite the fact that they earned $619,000 in revenue in 1999 and spent $11.8 million on advertising that year.  They finalized bankruptcy in 2001 along with countless other hyped up “internet” companies.  There is no doubt that machine learning will continue to advance and be transformative technology for many industries, much in the same way that the internet was transformative or that social media changed the way we coexist with others.  Nobody has a monopoly on the technology, or on how it can be utilized.  Nobody is assured of being the winner in this technology’s continued advancement, much like AOL, Napster, Worldcom, Adelphia, Microstrategy, Palm Inc., Webvan, Yahoo!, Pets.com and others of the internet craze never survived being the heir apparent.  

While our portfolios maintain significant exposure to U.S. stocks overall, and many of the mega cap tech stocks, we remain relatively underweight U.S. stocks in favor of foreign stock markets where we believe valuations and return potential is more attractive. Meanwhile, our view of the U.S. fixed-income markets is more positive. With rising yields over the past year, most bond market sectors now offer attractive expected returns relative to their risk.  In addition to our core bond exposure, we continue to have a substantial allocation to higher-yielding, actively managed, flexible bond funds run by experienced teams with broad investment opportunity sets. These funds are currently yielding in the high single-digits, and while they carry more credit risk than core bonds, all our active bond managers are very attuned to risk management and have the flexibility to tactically vary their portfolio exposures in response to market risks and return opportunities. 

Closing Thoughts

Successful investing over the long haul requires a balance between offense and defense.  Earning long-term returns does require one to take calculated risks when opportunities present themselves, but to also exercise caution during periods of market exuberance and hype.  By maintaining a disciplined and balanced investment approach, we are well-positioned to weather the inevitable market storms and capitalize on the opportunities that are sure to continue to arise. 

As always, we thank you for your trust and welcome any questions you may have.

Cordially, 

Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®

The views and opinions presented in this article are those of Shane Alsworth only

Sources: Morningstar/Ibbotson data, Ned Davis Research, BCA Research, iMGP Research

^{*US large stocks (S&P 500 Index), US large cap growth (Russell 1000 Growth Index), US large cap value (Russell 1000 Value Index), US small stocks (Russell 2000 Index), (Developed international stocks (MSCI EAFE Index), Emerging Market stocks (MSCI EAFE EM Index), Core investment-grade bonds (Bloomberg U.S. Aggregate Bond Index), Floating Rate Loans (S&P/LSTA Performing Loan Index), US Dollar (DXY Index), Gold (Aberdeen Physical Gold ETF), Commodities (Bloomberg Commodity Index)} 

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