Meta-morphosis

A metamorphosis is happening before our eyes. What started as "FANG", coined by CNBC's Jim Cramer, turned into the "Magnificent Seven", anointed by B of A's Michael Hartnett. Lately, markets have been more discerning. AI has concentrated its attention on a different set of stocks. Now that the Magnificent Seven has been effectively whittled down to 5 components, it's time for a new catchy acronym.

Glen Katcher of Light Street Capital's new theme is a good one. The "AI 5", is composed of the 'arms dealers' to the AI boom, NVDA, MSFT, AMD, TSM, and AVGO. These 'pure plays' on the evolution of AI technology into a productivity tool are on fire. In the same way Microsoft's Windows and Lotus 1-2-3, transformed the workplace, AI tools now being deployed in corporate and consumer software will change many business models. But make no mistake, in the land rush phase that defines this market theme, somebody's gonna get burned. I just don't know who that is.

As for the remnants of the Magnificent Seven, Meta stood out as the clear favourite along with Alphabet and Amazon as quality growth candidates that have retained leadership. I've already opined on Tesla's fall from grace in my "Runnin' on Empty" piece. But what of the left-behind AAPL? Stuck in no man's land of a year-long trading range, it's the $2.9 Tn elephant in your portfolio. A mass-market retailer whose best product innovation is a $3,500 goofy headset, trading at 29X earnings just can't compete with the compelling AI narrative. That's a lot of market cap that is now looking for a new home.

We saw one beneficiary of this already. Last week. I argued for a 'take profits' strategy. Meta's huge upside surprise earnings report and surging stock price completely caught the market napping, cooling the sellers and causing a reflexive beta chase. Again a case of too much money chasing too few stocks. Then came a blowout employment data and the market pullback was cut off at the pass. The focus shifted back to the Growth/AI mania trade as the implications of a stronger for longer economy negated the lower rate assumptions.

The sharp rise in 10-year yields should have compressed the multiples of the growth stocks. Unfortunately, all it did was help blow up another regional bank and suck money out of the nascent small-cap rally that started in December. So much for the hoped-for rotation!

But I stand by my contention that the popular 'growth at any cost' trade is now vulnerable to rising rates. But I also said:

"Valuation itself isn't a timing tool. This expansion phase of the price of risk assets can persist as long as the underlying narrative that promulgated it persists".

As well, I floated the notion of:

"But if we get anything like a ‘no landing’ or reaccelerating economy, then the switch will pay off in spades. Rates will stay higher and the multiple expansion theory driving the Mag 6 is vulnerable."

I think these statements will eventually prove out, but a transition to broader participation by Value and Small Caps, let alone Cyclicals, has once again been thwarted in the short run. But this to me looks like a 'second chance to get in. The real question is are we seeing signs of a switch in the economic narrative from a presumed 'soft landing' to a 'no landing'? Won't that eventually push out the path to lower rates and help to expand the breadth of market leadership?

One short-term economic indicator that should flag this is shown below. Who had Q1 above 4% on their dance card?? Answer = nobody!

Atlanta Fed GDPNow

That's the new narrative that I expect to occur. A reaccelerating economy that catches everyone by surprise similar to last year. It has been aided by the loose financial conditions generated from the rally in risk assets. The current Fed Funds rate is not restrictive enough to offset the strength of the U.S. economy. I see inflation bottoming out above the 2% target in the 3 - 3.5% range. That puts real rates not much above 2%, hardly enough to generate a slowdown given the structurally tight labour market and strong productivity gains. The consumer is remarkably resilient and still willing to spend now that labour has pricing power. And the fiscal support from Washington in the Infrastructure Bill, the onshoring capital boom, and the semiconductor surge don't hurt either.

But this rotation won't happen without a few more gyrations first. The broadening will not be generated from lower rates but from higher cyclical growth. In that scenario, the presumed Fed rate cuts will be pared back, but the earnings profile of the economy will expand, and with it, the market leadership should rotate as well. But be careful, higher for longer rates will claim a few more victims first.

The distribution phase for the growth trade has begun with the demise of TSLA and APPL as leadership stocks. The accumulation phase of Value/Small Cap/Cyclicals has begun but will take more work to play out. Patience with this transition is key, but either way, what most investors now should welcome is a metamorphosis of a different kind than the one we saw last week.

Risk Model: 4/5 - Risk On

The Risk Model has only one dissenting voice and it relates to the narrative battle that I discussed above. Copper/Gold is gyrating from a hoped-for soft-landing vs. a Fed's reluctance to ease. Today's China rally on the back of some as-yet-unannounced stock market support may not be enough to successfully turn things around in the still shakey Middle Kingdom. It will be expectations of a U.S. economic rebound that does it in my view. Still no confirmation yet, but seasonally, the base metals usually rally from late January into May. I say take a punt on the red metal this week.

CU/AU Ratio

Copper Seasonality