Shifting Sands: How Investors Can Find Their Footing in 2024

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Stacie Jacobsen: Thanks for joining us today on The Pulse by Bernstein, where we bring you insights on the economy, global markets, and all the complexities of wealth management. I'm your host, Stacie Jacobsen.

2023's equity rally has continued through the beginning of 2024, but it's not necessarily the same market. Last year, the defining story was AI, as we discussed with Bernstein senior investment strategist Roosevelt Bowman a couple episodes ago. Thanks. The market's return in 2023 was dominated by some of the largest companies positioned to benefit from AI technologies, otherwise known as Magnificent or Mag7.

And as a quick reminder, those companies include Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla. But leadership in the market often changes, so it's not a surprise that a few of those stocks have posted less than impressive returns year to date in 2024. Does that mean the AI frenzy is cooling off, or have investors started to identify a broader range of potential AI winners beyond those seven?

Alternatively, are macro concerns playing a bigger role in market movements? Finding opportunity in 2024 shifting environment is what we're exploring today. Bernstein's chief investment officer of strategic equities, Shri Singhvi joins us to assess the current investment landscape. Hey Shri, thanks so much for being with us today.

Shri Singhvi: Stacie, great to be here.

Stacie Jacobsen: I want to have a conversation about the opportunities beyond 2024, but before we get there, we've got to talk about the AI theme run that's coming up. dominated the market returns last year. So there's no question that companies that comprise the mag seven did have a phenomenal year.

And when you look at the data, it accounted for 58 percent of the S&P 500 return last year. So I've got two questions just to start us off. Were those returns warranted and maybe you can compare them to the dot com era of the 90s? And then my second question would be, how should investors think about including these tech-themed or AI-related companies into the portfolio?

Shri Singhvi: Stacie, that's a great question. And if you look back on ‘23, AI as a theme really hit its inflection point as soon as ChatGPT came out, and then it was further perpetuated by the kind of earnings companies like NVIDIA had. Now it's very hard to call exactly whether this trade in itself fades over the next 12 to 24 months, or we see this persistent strength.

I mean, the interesting thing is just today in the markets at one point NVIDIA was up 4 percent and now it's down 6%. So this is a very fickle environment, but what I do have great confidence in is that AI is a generational disruption and it's here to stay. And I would compare it to exactly what you just mentioned.

Two of the biggest disruptions or innovations we've seen in the past couple of decades, one was around internet and the other one was around iPhone. And just like internet really was disruptive to brick and mortar commerce and led to Ecommerce or things like iPhone gave birth to companies like Uber and maybe impacted adversely the medallions or whatnot.

AI is also such a disruption that will create very significant winners and losers. And so I think as our clients think about investing to this exposure of AI, they should think of it as just not one or two companies that are in the media. And most people are talking about them, but really in a holistic basic approach way because it's too early to call who the winners or losers would be.

And the way we think about this, there's a broad ecosystem of companies that really benefit from this innovation. for a decade or more to come.

Stacie Jacobsen: Yeah. And that's a great point because many investors were just attracted to some of the biggest and most obvious companies. So Shri, what other sectors might AI create an investment opportunity besides the obvious ones?

Shri Singhvi: Yeah, so one of the things about AI is the breadth of the impact that it is going to have in terms of use cases and productivity, that the broad impact on economy is going to be tremendous. Very recently, I think McKinsey had this very extensive publication where they had done bottom-up estimates by function and by sector on how AI might impact.

And just your traditional AI and machine learning before generative AI, which is what has been the theme. Post-ChatGPT ran into like 10 to 15 trillion of economic impact. And then if you add generative AI, it nearly doubles that impact. So where do we see this impact by sector and function? So first, let me start with functions that will face very strong impact sales and marketing.

Customer operations, uh, software engineering. So if you think the thing that AI can do is there is code writing code, so you don't really need developers who write this code. We've heard a lot about chat bots already where you call in and there's not a customer service rep. It's an AI-driven bot as well or for sales and marketing.

There's this opportunity to use AI tools which you know some of the creative companies like Adobe are already putting out there. Which makes the creation of those campaigns much faster. Let me highlight a couple of sectors where we may see pretty significant impact from what AI might help those companies to achieve.

So first, just starting with healthcare, which is a sector that deeply impacts all of us, our health, our prosperity, that are going to be meaningful, meaningful impact. So just in pharmaceutical industry, using AI tools can. improve and accelerate drug discovery, which tends to be very serendipitous. So it brings a lot more method to the madness and how you harness that data.

It will run trials more efficiently, how those drugs are marketed to patients and doctors. It will streamline that process. And so the drugs get to the market quicker and in a more effective manner. The other industry I'll highlight, for example, is financial. So, Jamie Dimon from JP Morgan has been very vocal about how JP Morgan is investing tremendous amount of resources in people and technology to develop AI applications.

And you would think of a very similar thing. There are customer service operations that they can do. These banks have very, very old technology systems, which run trillions of dollars of capital moving around, but these are not robust, so you could overhaul them much more efficiently with AI, or even do things like fraud detection, where AI algorithms can do a much better job of detecting fraud or money laundering and so forth.

So, you know, what I want to leave you with is, yes, a lot of people focus on tech companies as winners of AI, but it's going to determine a lot of winners and losers in various other industries, depending upon how companies harness AI in their businesses.

Stacie Jacobsen: That's a great point because it's not just about incorporating AI into the business, but it it needs to be revenue generating as well. Yes, when we look back at the market here as an active portfolio manager I wonder how do you think about managing for risk at a time when there is such a high concentration in the market?

Shri Singhvi: That's a great question, Stacie, because, you know, often the way people have thought about investing is this choice between active and passive and what's dominating right now is the Mag7. And so first, let me talk a little bit about how to think about risk of these stocks and there are various measures of risk if you will so first and foremost all of us have to understand that the risk is not just there in active but also in passive So passive is not riskless.

Yes, passive may be riskless versus its benchmark, but not versus cash or some other asset allocation options that our clients may have. And there's a way to think about risk in three dimensions. And that's how we then translate into how we do it in active or in, in my fund. So first is the obvious one that everybody focuses on is the concentration of the seven stocks as it kind of all-time highs, almost 30 percent of S&P 500 is in these seven stocks, but that's just first level of risk.

The second level of risk is. How correlated these stocks are with each other. So not only they're big, they almost move as a group. So, if you look at 2023, it was almost having a single stock at 30 percent rather than having these magnificent seven stocks at 30%. And then the third piece is also the premium valuation that these stocks get, because these are long duration growth stocks, a lot of their cash flows.

Come much farther away in time, which also makes them more susceptible to things like inflation and interest rates. And that makes the whole S&P 500 index in some ways susceptible to those as well. Now, as I mentioned, these risks, I do want to emphasize that these are not bad businesses and they're not about to, you know, go under tomorrow or they're not like dot com companies with no profits. These companies are growing in a profitable way. But the way I think about active investing is more as an agile investor. So these are companies that we are invested in, but we are selective in how we are investing in these companies.

So, for example, we do own some of these names, but then there are others where we think either the fundamentals from a long-term perspective are not sustainable or there might be more competition. Those modes might be under threat. Or maybe from a valuation perspective that they are overextended. So we think about in our portfolio as being more agile and selective when it comes to these stocks, and then also look for opportunities beyond these seven in the other 493.

Which often have been ignored in this environment.

Stacie Jacobsen: All right, Shri. So you mentioned the three main risks, and I want to break those down for just a second. So your first one was about concentration, and then we talked about how those seven are highly correlated to each other, and then the premium valuation.

Can you take each one of those and give us a little bit more on that?

Shri Singhvi: Yes, absolutely. The first risk about concentration is that, you know, as I spoke about that, that these stocks are nearly 30 percent off S&P now. So in some ways your indexes performance, your portfolio's performance is pretty much driven by the direction of these stocks and a lot of other Stocks within technology sectors, which is beyond this is a much bigger sector.

A lot of, say for example, semiconductor stocks, software stocks are highly correlated to these stocks. So historically people have thought of these quality big companies could be more defensive, but going forward, if they are the drivers of the market and they drive the market down. The risk of the concentration is they will not be as defensive.

So that's one thing I want our clients and investors to be aware of. The second important thing is the correlations. And these stocks were highly correlated in 2023 and all of them significantly outperformed S&P 500. But these correlations of the past are not necessarily indicator of the future. So for example, in ‘24, we have already seen some of these correlations break down.

Now, ideally, that's a good environment as an active stock picker, because you can be selective in this group. And as an active manager, you can add value through stock selection. And the third piece I want to go back to is this concept. The valuation gap between this cohort of seven stocks and the premium they get because of their growth potential relative to the other 490 or so stocks in S&P 500 is about as wide as ever it has been.

And what that creates is that this group and S&P 500 is likely to be more sensitive to interest rates going forward. So particularly if there is any negative surprise on inflation being longer or interest rates being higher for longer, we will see that these can become risks for investors who are invested in these stocks.

Stacie Jacobsen: Got it. Thank you for breaking that down. As we were talking about active investors versus passive, I think we have to say that for active investors, the episodic return nature of the alpha seeking strategies does take some patience. So at a time when many investors might be thinking about passive style of investing, what words of encouragement can you give to investors that are staying in actively managed portfolios?

Shri Singhvi: So obviously, as we spoke about, when you get this kind of concentration and very narrow leadership where the biggest stocks do the best, the passive indices tend to outperform some of the active managers. But I would encourage investors to seek strategies. That are not just active, but also agile, which what I mean by that is that they're not trying to be different for difference sake.

One of the challenges that a lot of active managers have had recently is in their efforts to be different from the benchmark. They did not own enough of these companies that were levered to some of the most promising themes or even teams like AI. The way we would like to think about active investing is being agile.

When there is an opportunity, we will own these kind of stocks. We will be selective about them. But when the opportunity set is much broader and as I know we're going to probably talk about this as where else do we see opportunities? There are a lot of other parts of the market that are underappreciated.

And as active managers, we can add tremendous amount of value for our clients.

Stacie Jacobsen: So let's go there right now, then what are some of those other opportunities beyond the AI universe?

Shri Singhvi: One other unique thing about the current environment that we have been in since pandemic, that even though we have not had like this one single recession where all industries, sectors or companies have traded off, but instead what we have had is a series of rolling mini recessions.

So let me give you a couple of examples for how that has played out. So during pandemic, when people were home and they were not going outside, they spent tremendous amount of money buying certain goods, furniture, sporting goods, or whatever that may be. In response to that, what those companies did is they built a lot more capacity to make those goods.

They built up huge inventory. And then as the economy opened, they People started again going out, they started spending on restaurants and travel, and suddenly we had this big glut of goods. The Ecommerce sales, which were very strong during the pandemic, kind of fell off the cliff, if you will. Now what we have seen in ‘23 is a number of those companies disappointed, and slowly now we have worked through some of those excesses of capacity inventory and some of those demand patterns are normalizing So one of the areas where we see opportunity is that coming back or normalization of the goods economy, if you will the Ecommerce sales normalizing and starting to come back another example along the similar lines is in medical tools, diagnostics and devices.

So what do I mean by that? A number of these companies build tools or diagnostic tasks, which were heavily used during COVID. So these companies had tremendous profitable growth during the COVID period. But as COVID has faded, a lot of that growth and earnings have faded away. And these companies have gone out of favor with the investors.

So a number of these companies underperformed the broader market in 2023. But when you look at the long term, these are really good businesses. They make niche products. These are high margin. They generally tend to be very steady, not volatile. They generate tons of free cash flow and they grow faster than the GDP.

So now as we have worked through those excesses and there's very little COVID revenue left in some of these companies, there's opportunity for active investors like us to pick some of those stocks at very attractive valuations. And then the final example I want to talk about is we have been in a very unique environment from an inflation perspective.

And one of the areas where inflation has hit really hard is auto insurance. And what that has resulted in is the claim costs for a lot of auto insurers have risen much, much faster than the rate at which they have been able to take pricing on the insurance. And so another way as an active investor is to really look from a company specific perspective and see which companies have the best technology.

Best visibility into the data that they can see real time in terms of how their claims, how their costs are proceeding and are able to reprice their business much quicker than others. And so what we have seen is the best in class asuto insurers have been able to do that and have picked up significant amount of market share in this kind of environment.

And so again, what I want to highlight is that the stock picking opportunity right now is much broader, even though a lot of the airwaves have been hogged by the AI stocks or the magnificent seven.

Stacie Jacobsen: I wanted to ask a little bit about the recent economic data on inflation and interest rates. It seems that we're getting that soft landing that many economists have been talking about.

How does that shape your thinking?

Shri Singhvi: Stacie, the way I would frame this is there are two biggest uncertainties facing the market still. One is what path of inflation and interest rates do we see from here on? And then the second is do we get a hard landing or a soft landing? Which means do we even get a recession?

Shallower, deeper, or we just kind of power through it without having a recession. So as we digest the data that we get almost on a daily basis, these days with jobs, with inflation, there is no denying that there is disinflation in goods. However, on the services front, we have seen that the inflation is tending to be a bit stickier because the wage growth, while it has come down is still pretty robust and the labor markets are still tight with even today's unemployment rate at about 3. 9

So this raises the question That while the direction of travel is clear in terms of inflation and rates And Federal Reserve has spoken about this but the destination to what level of inflation and rates do we get to by when is not clear. And so from my perspective we are not willing to declare you that Fed has gained the inflation for good and the risks or the range of outcomes remain reasonably why and it is not clear that we are very quickly reverting back to pre-pandemic inflation or rates regime.

So what that means for me as an active portfolio manager is we're not positioning our portfolio for a specific inflation or interest rate environment. We have companies that would win in the scenario that where we have soft lending and interest rates come down. So for example Reads or real estate is a good sector that, you know, we have exposure to in the, in that sense, but at the same time, if the inflation data disappoints and it's higher than expected, there is a risk of recession.

Then, you know, we have defensive companies in healthcare, for example, that would do well in that environment. So staying on that balanced path and not trying to make that big macro call is one of our key focus areas.

Stacie Jacobsen: Shri, I have one more question for you that I do hear from our listeners and like it's the fact that we continue to hit market highs.

So what do you say to those investors that think it's best just to wait to deploy their cash until the market takes a downturn?

Shri Singhvi: That's the trillion dollar question, Stacie. So answer to that question really depends on the time horizon for our clients. And here I want to share two factoids, which hopefully highlight why trying to time the market market.

Is a very risky proposition. So first on the time horizon, and I'll share some data on any given day, the odds of market being up or down as a coin toss, it's down 45 percent of the time. But if your time horizon moves to one year in any rolling one-year period. The chances that markets are down is 20%.

Once that investment horizon expands to five years, the chances of some investor being down over a rolling five-year period is less than 10%. And then once you go to the 20 years, it almost there's zero period where that has happened. So that's a very important thing that investors should think about. If they have a long term time horizon, probably trying to time the market is not prudent.

The other interesting factoid is if you look at the past 20 years or so, if you missed the 10 biggest days in the stock market, and a lot of them happened during pandemic in 2020 or 2008. The returns investors would have realized would have been cut in half. So I think for investors who are nervous, but who have this long term time horizon should keep this in mind and try to stay invested.

It's, it's almost, you have to be in it to win it.

Stacie Jacobsen: In it to win it. I'm going to add one more fact to all of that great data that you just gave us. If you go back to January 1950, the market has actually been at an all time high 43 percent of the time. So waiting for a potential downturn could take a while.

So I will say what we recommend to our clients and investors that are worried about entering at an all time high. to use dollar cost averaging to lessen the fears more than waiting for a potential sell off. So with that, Shri, I will say thank you so much for joining us today. I really appreciate your insights.

Shri Singhvi: Thank you, Stacie. It was a pleasure to join you in this discussion.

Stacie Jacobsen: Thanks to everyone for tuning in. We'll be back in two weeks with another episode. So don't forget to like, share, and subscribe to The Pulse by Bernstein, wherever you get your podcasts. I'm your host, Stacie Jacobsen, wishing you a great rest of the week.