The companies driving the record surge in stocks might be peddling artificial intelligence products, but the impact they’re having on the market and investor sentiment is very real. The Standard & Poor’s 500 has soared past 5,000, and the supersonic performance of companies such as chipmaker Nvidia has financial advisors fielding calls from clients eager to jump on the next big tech thing.
“We really don’t get many calls from clients when the market’s plunging,” said Greg Halter, director of research at Carnegie Investment Counsel in Cleveland. “We get calls when the market is strong, and they’re like, ‘Why don’t you buy more of this stock?’ Nvidia. That kind of stuff.”
Halter’s advice to those pining for high-flying stocks: Curb your enthusiasm.
Despite the urge to chase galloping stocks, neither advisors nor clients should get overwhelmed by the explosive rally. Instead, advisors are telling clients it’s more important than ever to stick to their life/investment goals—and invest appropriately. The most important numbers to remember are the DOB on clients’ birth certificates rather than those flickering on the ticker.
Savvy asset allocation is critical to keeping a balanced portfolio in such frenzied buying, say advisors. Depending on the client’s time frame, of course, some managers are rebalancing, or de-risking, portfolios, putting new money into steadier, alternative investments such as T-bills, private credit or buffer ETFs.
“You can’t have a balanced portfolio [when you] have 10% or 20% in one company,” Halter reminds clients who might be looking to bolster their investment in stocks that have tripled or quadrupled.
Furthermore, advisors must know and appreciate the downside risks to the current rally, especially those lurking below the headlines. Some of the concerns atop the minds of advisors and market strategists are high valuations, stubborn inflation, as well as continued high interest rates and a possible bad loan crisis in commercial real estate.
Stuart Chaussee, founder of Stuart Chaussee & Associates, a fee-only firm in Palos Verdes, Calif., with $375 million in assets, is among the market observers who think we’re in a stock market bubble.
“By any traditional valuation measure—price-to-book, earnings, whatever—the market’s very expensive again,” stresses Chaussee, who’s endured six bear markets and more than two crashes in his 38 years managing money. Pointing out that stocks in the S&P overall are trading for 21 times forward earnings, above the 20-year average of 16 times, the advisor contends these risks aren’t priced into the market.
“Right now, everybody’s incredibly bullish, putting money into stocks, and they don’t seem to have any concern,” he said.
Maybe they should.
There are several risks to be wary of.
Bubble, Bubble Tech Trouble?
It’s not boasting if you can do it, the saying goes, and to their credit, AI-related companies, most notably the so-called Magnificent 7 led by Nvidia, are posting Michael Jordan-like profit performance, smashing analysts’ expectations.
The triple-digit surge in Nvidia over the past year has sparked the jump of more than 20% in the S&P from its low last October. Market strategists at major firms have raised forecasts for the S&P, with Bank of America seeing the index hitting 5,400 by the end of 2024.
Stephanie Lang, chief investment officer for Homrich Berg, a wealth management firm based in Atlanta with $14.5 billion of assets, sees a strong economy and rate cuts acting as tailwinds for stocks this year. She also cites the “AI halo” effect.
“I think we’re in the early innings of AI,” Lang said. She noted that AI firms are seeing “extremely strong earnings growth,” unlike money-losing internet companies during the dot-com bubble in 1999.
Torsten Slok, chief economist at Apollo Academy, begs to differ.
“I absolutely believe this is a tech bubble really by some measures,” he said, noting that the forward price-to-earnings ratio for the top 10 companies in the S&P is about 40, above the levels of the 1990s.
“AI might be good in some individual firms, individual small cases, but I still have not seen anything that convinces me that this is going to be a dramatic change to the broad economy.”
None of the advisors nor strategists interviewed by Financial Advisor see AI’s stock surge shorting out anytime soon. But the sharp, explosive jump in share prices for some of these firms does suggest overexuberance—or downright speculation. Any slipup in quarterly earnings could send shivers throughout the whole market. And history shows, eventually, there will be slipups. For the week up to March 6, investors withdrew $4.4 billion from tech funds, the largest outflow on record, according to Bank of America. That suggests investors are indeed getting nosebleeds riding these sky-high tech shares.
Get A Grip On Inflation and Interest Rates
The stampede of market bulls to all things AI is so ferocious that it’s left prior market drivers, especially interest rates, in the dust. But what might happen to interest rates and consequently inflation understandably remains a significant risk for the market.
“Interest rates are a risk if they don’t come down as quickly as many market participants are planning on,” said Chaussee. “And then perhaps [there could be] an inflation surprise on the upside.”
Investors went into the year anticipating that the Federal Reserve would cut rates six times as it fought inflation, which remains elevated at 3.15%; now the market is pricing in three cuts, beginning by June. Jerome Powell, the central bank’s chairman, suggested recently that rate cuts will come cautiously as the Fed seeks its inflation goal of 2%.
The balancing act is that the Fed wants to curb inflation without hurting the economy. And no matter what side of the political spectrum you reside on, you’d have to squint pretty hard to find holes in the economic tapestry being weaved by the current administration, save for sticky inflation and low wages. Forget worries of a recession.
Many strategists, such as Slok at Apollo, expect a “soft landing,” where inflation eases amid a sturdy economy. He puts the risks of a soft landing at 60%, and a “hard landing” at 20%.
In a March 1 market report, he declared “The Fed Will Not Cut Rates in 2024.”
He stands by that sentiment, regardless of the broader market’s expectations. Stocks initially traded higher Tuesday after the Bureau of Labor Statistics said consumer prices rose 3.2% in February from a year ago. Core inflation, which strips out gas and food, also saw increases.
“This is a problem for the Fed,” said Slok, whose firm focuses on alternative investments. He sees inflation sticking at around 3%.
“If interest rates have to stay higher for longer, because inflation is higher for longer, that does mean the Fed may continue to keep the cost of capital high and that will continue to weigh on consumers,” he added. “This could be the number one problem and the number one risk to the market at the moment.”
Commercial Real Estate Debt Impacts Regional Banks
The problem in the commercial real estate sector is akin to a bad house in a good neighborhood: Many neighbors pretend it doesn’t exist. Savvy money managers, though, are keeping an eye out for cracks in the foundation.
Those cracks will form when the billions of loans on the books of developers come due in the coming months—at the same time a slumping office market prompted by hybrid work arrangements has created ghost offices. Two-thirds of all commercial real estate is held by regional banks, according to Apollo’s Slok, and when interest rates remain high it adds to the capital burden for the sector.
Five banks failed last year, and early this month the Federal Deposit Insurance Corp. warned that bad commercial real estate loans posed “significant downside risks” to the banking sector.
David Auerbach, a veteran REIT market strategist at Hoya Capital Real Estate in Norwalk, Conn., doesn’t see the equity market likely suffering from the woes of commercial real estate. He noted that REITs represent less than 10% of the capitalization of any of the significant market indices, notably the S&P 500. And even so, many of the publicly traded REITs own good properties, maintain manageable debt levels and work with some of the largest banks.
Slok isn’t so sure, nor is Larry Luxenberg, principal at Lexington Capital Management, a small firm in New City, N.Y.
“What happened in the financial markets is linked today,” Luxenberg said. “What happens in [commercial real estate] could certainly spread. CRE is probably the biggest source of concern at this point.”
He points out that Fed officials misread the scope of the single-family housing crisis in 2007. “So no one knows how widespread and where it’ll go.”
Election Surprise?
The general presidential campaign officially got underway with President Biden’s State of the Union address last week. But many voters and even some financial advisors have a wake-me-in-November yawn.
“We’re just kind of skating along, waiting until the election at this point,” said Halter of Carnegie, adding that he thinks the market isn’t worrying much whether it’s incumbent Joe Biden or Donald Trump in the White House. “I think the numbers show that it doesn’t really matter, at least for the overall market.”
Polls generally show a toss-up race, and it’s frequently posited that the markets regard a split government, where one party controls the executive branch and the other the legislature, as neutral for business, though Republicans are seen as more business-friendly. That’s notwithstanding the fact that stocks are hitting record highs, as are corporate profits, under the current Democratic administration.
If investors here aren’t betting on who the next POTUS will be, betting sites across the pond are, according to Chaussee. He noted that betting sites in London favor Trump by 65% to 70%.
“Is the market [here] anticipating a Trump victory?” he asked. “Could that be factored into why the market’s been up at such a fast clip?”
In that case, a Biden victory could cause a sentiment shift—and possibly a market reaction, he said. “No one’s talking about that.”
What most advisors are talking about, though, is the need to de-risk clients’ portfolios as the market continues to climb whatever wall of worry that might exist. Many are opting for alternative strategies for diversification.
“I would take some chips off the table in tech, growth and AI and allocate more to value,” said Torsten. He cites sectors with companies with lower leverage, stronger coverage ratios and strong cash flow.
“Investors should buy shorter duration fixed income with a spread above Treasurys such as credit, including private credit, private equity,” he added.
Chaussee has positioned his high-net-worth clients, most of whom are nearing retirement or are retired, into defined-income vehicles such as buffer ETFs. (He is penning a self-published book on the subject.) Buffer ETFs provide protection on the downside but cap upside gain potential.
“They’re liquid, trade just like stocks or other ETFs,” Chaussee said. “They’re transparent; they’re tax efficient.”
The advisor has also put new money into T-bills.
In his hypothetical portfolio, a client would include three-month T-bills paying 5.4%, while 20% to 25% of the portfolio would go to “straight” tech ETFs like the Vanguard Information Technology Index and the other 75% would go to the S&P 500 with protection in Innovator Buffer ETFs. Since 2018, investors have poured $30 billion into more than 160 of these investment vehicles. One of the best performers over the past year is FT Vest Nasdaq-100 Buffer ETF-September (QSPT), a $261.54 million fund that is up 38.62%, according to etf.com.
Such a diversified portfolio would allow clients to participate in the AI-powered rally and sleep well at night should a correction come, as it inevitably will.
“Are we setting up again for something ugly?” Chaussee asked. “I don’t know. But I don’t like the feel of this market. Look at the charts of the semiconductors. What’s going on in crypto. It’s like, goodness, have we learned nothing?”