Global Growth And Earnings Resilience Overpowering Unknowns
Equity markets continue to undergo a rotation from growth to value, high beta to low beta, U.S. equities to Rest of World (ROW) equities, large caps to small caps, market cap index to equal-weight index…where the Dow hits a new all-time high 50,000 while the Nasdaq Composite stumbles (hasn’t made a new high since the end of October). In what was a volatile week, the S&P 500 managed to close down just -0.1%, but continues to be undermined by its concentration in MegaCap Tech, which is undergoing a major investment cycle, thereby acting as a drag on the world's largest index being up by barely more than +1% for the year. But make no mistake – there are a lot of investors out there who are hurting. Not in Consumer Staples or Industrials. Not in Small Cap indices, Asia, Japan, Latin America, or foreign equities in general. Not in the Transports, nor Energy, nor Materials. Not in the Semiconductors. Not in Apple, Alphabet, or Caterpillar, for that matter. These segments of the market are doing great right now. But there are many mega-cap growth stocks that are in either steep corrections or outright bear markets, and the sharp reversal in silver and Bitcoin, which acted as risk-on trades, are still in the penalty box.
Friday brought a much-needed reprieve from what was otherwise shaping up to be a rough week for risk assets. Whether it was short-covering, a relief rally with legs, or some other narrative you want to apply to it, the reason matters less than the reality. And the reality remains that the global growth backdrop is constructive, earnings are solid, monetary policy accommodation (while moderating) retains a dovish bias, inflation is tame, and fiscal policy levers are being pulled around the globe. There was reason for the bulls to celebrate on Friday. The “buy-the-dip” theme is alive and well.
It’s the software stocks that have fallen under the microscope as the industry most at risk of disruption, as AI turns into a self-undermining loop for coders. The early signs of “creative destruction” were on full display last week after Anthropic released its new tool designs, sending the software space into a tizzy – so much so that the Tech subsector’s forward P/E multiple has contracted all the way down to 21x from that 100x nosebleed peak five years ago (according to Bloomberg). Whether the software space can and will be replaced by Agentic AI in the years to come is yet to be determined, but Mr. Market's initial assessment is to discount the value of any software company's earnings power in the years ahead at a much lower level. Markets are increasingly treating coding and software services as low-hanging fruit for large language models, while premium valuations migrate toward high-performance hardware from IT services. Time will be the ultimate arbiter if this is right or wrong, but for now, the market is drawing a line in the sand for how it's valuing the ‘intelligence’ economy.
What really caught investors' attention is the dramatic increase in capex expectations among hyperscalers. At the start of the year, the consensus estimate was that hyperscalers (Amazon, Microsoft, Meta, Alphabet, Oracle…) would spend $540 billion in 2026 (+35% YoY). Following Amazon’s earnings report last week, this number has surged to $650 billion or +60% year-over-year. The Daily Shot put this level of spending into context in the chart below, where as a percentage of GDP, this AI capex commitment is larger than the railroad expansion of the 1850s, the Apollo space program in the 1960s, and the decades-long build-out of the interstate highway system.
What stands out to me in all of this is that it raises more questions than it answers. In its simplest form, one could conclude that the Tech sector is commoditizing its own profit-generating skills quickly. The ultimate winners of the potential productivity gains from AI are highly uncertain, which is why I think all investors should approach any analysis with a high degree of humility and flexibility. What you think you know one day could be dramatically different the next. Consider the juxtaposition of Amazon and Alphabet last week, where the former sold off more than 10% following its announcement that it was raising capex spending to $200 billion in 2026 on data centers, satellites, and other items geared to the AI boom. While Alphabet was flat to up on its announcement that its capex spend was ramping to $185 billion.
My guess is that the market is much more comfortable with the view that Google can turn that capex into returns in the near term, while Amazon has lagged behind in AI recently and thus there is a longer time between spending and generating profits. Another interesting market signal that has me scratching my head as to what to make of it is the fact that Walmart (the stodgy low margin retailer) is trading at a P/E multiple (44x) double that of Amazon (22x). I believe Amazon will ultimately be one of the biggest beneficiaries of AI and robotics, but we’ll have to wait and see if that proves correct.
This goes to show how a new-found skepticism has emerged as to whether these massive investments will pay off and whether they will add or depress current ROI expectations. But what investors are now focused on is the flow-through impact on a range of other sectors that will benefit from this accelerating capital spending boom (as in 3M which soared +13% last week and Caterpillar with a +10% advance), even if it casts a cloud over the future returns of the companies engaged with all these expenditures.
That brings me to another thing investors should be thinking about, which is what impact this will have on growth and liquidity. That $650 billion spend has to come from somewhere – likely a combination of operating profits, debt issuance, and equity. As you can see from the chart below, the % of operating cash flows spent on capex (red bars) is at its highest level in the past decade while the % of operating cash flows used on buybacks is at its lowest level in the past decade.
That combination has two effects for markets: 1) it removes or drastically reduces a significant buyer of stock, and 2) it extracts liquidity from the markets as these companies tap the debt and equity markets to raise funds not covered by operating cash flows. Goldman Sachs estimates that the Mag7 will use over 90% of its operating cash flow on capex in 2026, versus buybacks being the recipient in prior years. That helps to explain why P/E multiples for the group have de-rated toward post-COVID lows, and cash-flow valuations continue to expand as investment intensity rises. Bottom line, the operating performance of these dominant monopolies remains strong, but this new capex regime forces a rethink of valuation. However, it does raise some important questions: 1) Will this capex earn an attractive return? 2) Does the scale of investment risk eroding core profitability? 3) Will capital intensity stay this high for longer than expected?
My two cents is that it's too early to write the obituary on the Mag7, and that this group has already seen a significant de-rating, with forward PEG ratios now trading near 5-year lows. The "froth" has largely come out of the sector despite the long-term growth story remaining intact.
These companies have proven over the last decade to be prudent stewards of shareholder capital and, as such, are deserving of getting the benefit of the doubt. Outside of Tesla (see table below), owning these companies at current forward P/E multiples of 24 – 30x with EPS growth estimates ranging from 25-55% is not a bad risk/reward setup.
While I’m sympathetic to the current concerns and unknowns casting a shadow over the MegaCap tech space as it pertains to AI and this capex cycle, my biggest long-term concern about this group is the target painted on its back from two fronts: concentration risk driven by passive flows, and political risk. To me, the U.S. stock market is emblematic of the inequality divide pulling at society for the past fifteen years. Recently, this has morphed into a new narrative titled the ‘affordability crisis’ or the ‘K-shaped’ economy, but they all describe a similar insecurity festering below the surface of the U.S. economy and financial system.
This is where MegaCap Tech comes in, because outside of the divide between the 0.1% and the bottom 50%, perhaps the most glaring K-shape to the economy is that of corporate profit margins, measured by corporate profit share to Gross Domestic Income. In the past three years, this metric has risen to levels never seen before, but to be fair, this really got underway at the turn of the century. The opposite side of the ledger to corporate profits' share of Gross Domestic Income is the labor share of Gross Domestic Income (see chart below, compliments of Rosenberg Research). What often doesn’t get referenced in the media (often times because we’re celebrating all-time highs in stocks – I don’t imagine this statement will endear me to my readers, who are asset-rich) is that the labor compensation share of the economy has correspondingly fallen to its lowest level in modern history. My guess is that as populism grows, it won’t be long before the disenfranchised will turn their sights to where the money is – corporate profits. Which puts a giant bullseye on the most profitable companies in the world – MegaCap Tech.
Another vulnerability for MegaCap Tech that is out of their control is an unwind of the U.S. exceptionalism trade. For decades, foreign surpluses have been recycled into U.S. asset prices, which has pushed the weighting of U.S. stocks in the global equity market to the highest reading in history at 67%. As U.S. domestic policy pivots towards mercantilism and away from globalization, with the rest of the world forced to do the same, this alters global capital flows. Where the rest of the world exports less to the U.S. (U.S. produces more), hence they have less dollar revenue or less dollar surpluses that they recycle back into U.S. assets. What’s more is that with the rest of the world stepping on the fiscal accelerator and getting less revenue from the U.S. economy, they are likely to repatriate some of their capital stashed away in U.S. asset prices. Likewise, we know that U.S.-based investor portfolios have been riding the passive wave and are chock-full of U.S. stocks, which, up until last year, have repeatedly outperformed foreign equities.
What if the expanding number of retirees start tapping their nest egg to fund their golden years at the same time as foreign capital parked in U.S. assets rotates home to fund local initiatives? With MegaCap Tech and the Technology sector making up nearly 40% of the S&P 500, they would stand to endure the majority of selling pressure if these capital tailwinds turned into headwinds. The chart below plots the S&P 500 relative to the MSCI All Country World Index ex. U.S. going back to 2007, which has been on a steady ascent up until just after Trump got elected in November 2024. Since then, it’s started to rollover. It’s too early in such a prolonged and sustained trend to conclude that it's definitely over, but if the last sixteen months (a reasonable time period) is any indication, this recent reversal needs to be monitored and exploited.
Let’s get to some closing thoughts before bringing this missive to a conclusion. First thing I want to hit on is Q4 earnings season, which continues to be impressive. We have nearly 2/3rds of the results in with the blended (reported and expected) revenue and earnings growth rates for the quarter tracking towards growth rates of +8.8 and +13.0 percent year-over-year. These results help to instill a little more confidence in the lofty Wall Street estimates of +7.3 and +14.1% top- and bottom-line growth in 2026. Valuations for the S&P 500 continue to trade at the high end of the range over the past 10 years (21.5x versus 18.8x), but as long as earnings and profit margins continue to match recent trends, it's hard to argue they are not justified. Ironically, besides the utilities sector, the Tech sector has experienced the lowest multiple expansion of all the sectors that make up the S&P 500. However, that hasn’t prevented Tech from being the best performing S&P 500 sector over the last 10 years, compounding at an average rate of +23.0 percent to the S&P’s +14.9 pct. Rather, it holds that title because it steadily shows incremental earnings power. Put another way, the expected future “E” routinely increases more than the market has discounted at any given point. Another interesting tidbit in digging through my earnings and valuation work is that the real story behind currently elevated S&P 500 valuations relative to history lies with the 10 other sectors outside of Tech.
So, while valuations are rich but arguably justified, a rundown of the sentiment and positioning helps to provide some useful context that investors are fully positioned in the bull camp. Hence, fundamentals improving from here shouldn’t come as a surprise and therefore likely don’t move the needle much. However, given where positioning and sentiment are, negative surprises would help explain the wild and erratic swings we saw in some asset classes last week amid negative developments.
The Market Vane bullish sentiment gauge, at 69, is pressing right against the high end of the historical range, and for households, the Conference Board measure rarely, if ever, has been as bulled up as it is today. The Investors Intelligence poll showed that cracks in the Tech trade didn’t dent investor confidence. The bull camp expanded further to 62.3% this past week from 61.5%, while the bear share has slipped to 15.1% from 15.4%. In the past, whenever this spread hit an extreme of over +40 percentage points (and today the differential stands in excess of +47 percentage points), we have seen a drawdown of significance. In the AAII survey of retail investors, we still see the bull share at 40% and the bear share at 29%. Not as extreme as the Investors Intelligence poll, but still a sign of these times. You could label it complacency or confidence; in this instance, they just may be one and the same.
As for markets, I don’t expect the troubles in the software sector or capex spending splurge by MegaCap Tech to spill over into a broader economic slowdown or significantly lower earnings (I do think estimates are too high, but by just a percent or two). I continue to see more tailwinds supporting growth than headwinds: data center and AI spending increases growth estimates, with most of the financing already accounted for. Additionally, fiscal policy and political momentum are committed to reshoring production in semiconductors, pharmaceuticals, defense, and critical minerals. All of which is incrementally expansionary and expected to be supported by a further pivot towards monetary policy accommodation when Kevin Warsh is confirmed as the new Fed Chair. Warsh, while labeled a hawk, is anything but, and I expect he’ll work hand in hand with Bessant at the Treasury through bank deregulation and creative financing schemes to stimulate interest-sensitive sectors that have been in a recession for the last several years.
Bottom line: it remains extremely hard to be bearish on the U.S. economic outlook and risk assets. The signals and metrics I monitor to measure and map the economy and asset prices align in a manner that, on the whole, are constructive. Sure, there are pockets of risks that worry me. I’m not excited about valuations, stretched sentiment and positioning readings, or elevated geopolitical frictions. But none of them are big enough, on their own, to topple the tailwinds at play. When/if this changes, I’ll change my mind. But until then, we’ll continue to move forward, but with caution. We are in a time of rapid change and transformation, so being diversified and committed to maintaining some defense in your portfolio, while remaining disciplined with your risk management guardrails, is more important now than it has been for many years.
As for next week, it’s a data heavy week on the economic front: December retail sales on Tuesday (consensus at +0.4% for the headline and +0.5% for the “core control” measure), January nonfarm payrolls on Wednesday (consensus at +75k and a steady 4.4% unemployment rate), and CPI for January on Friday (consensus at +0.3% for the headline and core). We’ll see how the market interprets what we get as to what it may mean for monetary policy, as markets currently have their sights set on June for the next rate cut.
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