‘Fundamentals still matter’: Portfolio manager of firm managing $17 billion warns stocks should sink 15% as AI hype fuels current rally and drowns out recession alarm bells

  • The shares are up more than 23% since last October.
  • But the rally isn’t likely to last, warns Rayliant’s Phillip Wool.
  • Wool said a probable recession, tight market breadth and rising interest rates threaten the stocks.

Stocks are once again in a bull market, with the S&P 500 now up more than 20% from its October lows.

Phillip Wool, a portfolio manager at $17 billion wealth management firm Rayliant, would add four letters to that description: “Stocks are in a bull market@#$!” he wrote in a June 12 note to clients. , his censors.

The market has been in a slump over the last few months due in large part to investor enthusiasm for AI and what it means for the profit margins of the most involved stocks. But Wool says the AI ​​hype is drawing investors’ attention away from fundamentals and fueling a rally led by only a small percentage of stocks.

Weak market size

“We see this year’s rally in AI stocks on the heels of the ChatGPT hype fanning the flames of investor greed, stoking a ‘fear of missing out’ that accounts for no small part of the recent run-up,” Wool said in the note. .

He continued: “This view is supported by data on individual investor trades, which point to a marked increase in exposure to tech stocks in recent weeks. In fact, VandaTrack stats show that retail investors bought US stocks for a worth more than $1.5 billion in a single day in late May, focused on technology stocks, while the volume of single-stock call options has significantly outpaced put trading in recent weeks.”

Looking at the Wilshire 5000 index, Wool found that money is more concentrated in major stocks than it was during the dot-com bubble just over two decades ago. Almost all of the recent rally can also be attributed to the index’s top 10 stocks, she said.

“During the tech bubble of the late 1990s, more than a third of returns came from these large-cap stocks,” Wool said. “In the recent bull run, by contrast, nearly the entire market return was accounted for by the performance of just ten companies.”

wilshire 5000 market concentration


Weak breadth has been a hot topic on Wall Street in recent weeks as it can signal that a rally is unsustainable.

“Historically, tight leadership has been a hallmark of late-stage bull markets rather than the start of a more sustained recovery,” UBS Chief Executive Officer Solita Marcelli said in a recent note.

According to research by LPL Financial, when 0-48% of S&P 500 stocks are trading below their 200-day moving averages as is the case today, index returns are typically negative over the next one, three, six and periods of 12 months.

market breadth and consequent performance

Financial LPL

Alarm bells still signal a recession to come

The excitement that drove some traders off the sidelines and pushed the market higher has Wool worried that investors have overlooked recession warnings.

He said Rayliant’s models show a “very high probability” of a recession.

Classic signs of recession such as an inverted Treasury yield curve and the Conference Board’s Leading Economic Index have signaled that a recession has been brewing for months now. Both are shown below.

yield curve inversion

Federal Reserve Bank of St. Louis


The conference council

Wool pointed out that the Federal Reserve’s recession probability model, which is based on the Treasury yield curve, now assigns a 70% probability of a downturn in the next 12 months.

probability of recession

Federal reserve

Consumers are also burning on savings built up in recent years, Wool said, as indicated by rising credit card debt and loan defaults.

“Fundamentals still matter in the end,” Wool said.

This sentiment that investors are ignoring the fundamental signs of a recession is shared by other strategists.

“THE the excitement around generative AI has distracted investors from the possible risks of an impending recession,” said Lauren Goodwin, an economist and portfolio strategist at New York Life Investments, in a statement this month.

Morgan Stanley’s Mike Wilson echoed those thoughts, although the bank isn’t calling for a recession for the broader economy.

“Investors are more bullish than they were in early December, or at least much less bearish given optimism about the diffusion of technology, especially artificial intelligence,” it said in a statement. “While we believe AI is real and will likely lead to some big efficiencies that help fight inflation, it’s unlikely to prevent the deep earnings recession we expect this year.”

However, some see a soft landing scenario for the economy. The job market continues to impress, with the US economy adding 339,000 jobs in May, well above expectations. Inflation has also dropped to 4%, prompting the Fed to suspend its rate hike campaign this week.

However, Wool doubts that the Fed has decided to hike, citing market sentiment. According to the CME Group, traders allocate nearly 75% to the Fed which hiked another 25 basis points at its July meeting.

The Fed’s continued aggressiveness will weigh on the economy and earnings, Wool said.

Where the shares go from here

Wool said in an email to Insider on Friday that it expects the S&P 500 to drop 15% in a “simple downside scenario” or return to its October lows (closer to a 19% decline) in a landing scenario. harder.

This is probably less severe than during a normal recession because the economy is still there, he said. However, it is still a bearish result. A 15% drop would take the S&P 500 to 3,800.

In addition to recession concerns and tight market breadth, Wool said the Treasury’s issuance of what could be more than $1 trillion in new debt this year would also drive up interest rates, hurting stocks. .

Wool’s view is slightly more bearish than the average Wall Street strategist’s year-end price target of 4,000 for the index. But there are bigger bears.

Morgan Stanley’s Wilson has a year-end target of 3,900, but said the index could drop to a range of 3,000 to 3,300 before then. Piper Sandler’s Michael Kantrowitz also expects the S&P 500 to fall to 3,225 by the end of 2023 as a recession sets in in the second half of the year.

Incoming data in the coming months will tell whether the bearish forecasters are right or not. For now, a new bull market is raging.

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