An artificial-intelligence frenzy has the US stock market captivated, powering the Nasdaq 100 Index to its best first half to a year ever. But with each tick higher traders are becoming increasingly skittish about soaring growth stocks.

Investors have yanked nearly $44 billion from US stock mutual funds and exchange-traded funds that track growth shares since the start of the year, according to data compiled by Refinitiv Lipper. In the second quarter alone, preliminary net outflows were $20 billion, the data show.

What’s driving the move? Concerns that an AI bubble has lifted stocks to unsustainable valuations and a Federal Reserve determined to tame inflation by raising interest rates further.

“There’s disbelief that the tech rally can last after a huge run,” said Todd Sohn, managing director of ETF and technical strategy at Strategas Securities. “Inflation is still an issue, and the Fed may still have to hike.”

While the Nasdaq 100 has surged 37% in 2023, just five behemoths – Apple Inc., Microsoft Corp., Google parent Alphabet Inc., Inc. and Nvidia Corp. – are leading equity markets higher. The group accounts for roughly 40% of the weighting in both the $91 billion Vanguard Growth ETF and the $70 billion iShares Russell 1000 Growth ETF, among the biggest large-cap growth funds. The funds are up 31% and 27%, respectively, this year.

“People are either taking profits, selling on the way up — or they frankly missed the big move because it’s been so rapid,” Sohn said. “The longer there’s concentration risk, the more investors won’t want to have exposure toward those stocks.” 

Big Tech Dominates First Half, But Growth Leads Exodus | Investors have pulled roughly $44 billion from US growth funds in 2023
In 2023, global investors have poured $752 billion into cash and $113 billion into investment grade bonds as hedges against equity risk with the trajectory of rates still a wild card, according to strategists led by Michael Hartnett at Bank of America Corp. Fed Chair Jerome Powell signaled this week that two more rate hikes were likely in 2023.

Still, despite the exodus from growth funds, the tech rally appears to have fuel remaining.

Index-tracking domestic equity mutual funds and ETFs hold just 18% of US stocks by market value, according to Investment Company Institute and World Federation of Exchanges. Actively managed domestic equity mutual funds and ETFs hold 14%. Meanwhile, hedge funds, pension funds, life-insurance companies and retail investors hold nearly 70% of the stock market’s value.

Mary Ann Bartels, chief investment strategist at Sanctuary Wealth, said her clients are adding exposure to large-cap growth funds and economically sensitive industries including cyclical stocks that tend to outperform in the early stages of bull markets.

“A sign of a market top would be massive inflows into growth stocks and equities — not outflows,” said Bartels, who like other money managers with a long-term view are reluctant to offload tech stocks due to the cohort’s reliable profit generation, healthy balance sheets and ability to ride disinflationary trends.

Index Fund Share of US Stock Market Is Small | Percentage of US stock market capitalization, year-end 2022
The market is at a key inflection point heading into the second half of the year. Big Tech companies like Apple and Microsoft will set the tone for the sector once earnings season kicks off in mid-July.

For Brooke May, managing partner at Evans May Wealth, rich valuations, tepid earnings growth and narrow concentration among Big Tech stocks has pushed her firm to shift back to an equal weight between value and growth factors recently, after boosting exposure to the latter earlier this year.

“Clients are getting a little nervous,” May explained. “A lot of the return for tech stocks is coming from multiple expansion, not earnings growth — so we feel like it’s time to mitigate some of the risk by rebalancing to equilibrium between growth and value. We want to see broad-based earnings growth to really justify those lofty valuations.”

However, the more important catalyst for growth stocks will be the direction of Treasury yields, according to Phillip Colmar, managing partner and global strategist at MRB Partners.

“The key to a broader participation in the stock rally will be where monetary policy is headed and its impact on bond yields,” Colmar said. If yields break out of their October highs, investors will start getting nervous about tech and growth stocks, he added.

Tech companies are particularly susceptible to concerns of rising rates and yields because many of them are valued on projected profits delivered years in the future. But for traders like Bartels who are looking for contrarian signals and betting against equity bears, the massive cash pile in both money-market and bond funds is the best hope for keeping the bull market in stocks running.

“Markets don’t peak on pessimism,” Bartels said. “They peak on optimism — and we just don’t have that. As long as there’s fear, the stock market won’t be at a major top.”

This article was provided by Bloomberg News.