Weekly Warm-up: Broadening Continues as Index Struggles

Since our mid-year outlook published in May, we have been advocating for a re-emergence of the broadening trade driven by continued strong earnings and our expectation for oil prices to fall and lead to a subsequent cooling off in fears about Fed hikes. Since then, oil prices are down significantly from April highs despite recent volatility. Meanwhile, the average stock is outperforming again along with our preferred cyclical industries for the broadening trade—Consumer Discretionary Goods and Transports. Below is the full list of the key drivers of our broadening call over the past 2 months:

• 1. The most significant acceleration in earnings growth we have seen for the median stock (mid-teens growth) since the post-Covid recovery, driven by the return of positive operating leverage.
• 2. The underperformance of Semiconductors as earnings revisions breadth for the group reached upside extremes.
• 3. Despite a recent bounce, we see oil prices lower over the next several months. We first discussed our views on this front in April as the commodity was peaking.
• 4. An underappreciated AI adoption tailwind that is gaining momentum. 25% of S&P 500 companies are seeing quantifiable benefits from AI adoption, up from 14% a year ago.
• 5. A Fed on hold this year versus the bond market's expectation for rate hikes.

The primary risk to our call in the near term is that the unwind of the momentum trade turns into a more significant de-leveraging that leads to an overall risk-off environment. Furthermore, any de-leveraging could be exacerbated by the fact that liquidity is just "ample" at the moment and no longer abundant. This creates risk because the demand for liquidity continues to increase at a rapid rate from the record issuance of equity and debt (sovereign and corporate credit) that is being used for capital spending—i.e., capital is no longer just going into financial assets but also into the real economy. Ultimately, we believe the Fed and Treasury will be responsive to any stress from liquidity shortfalls, but this may come in a more reactive, rather than proactive manner.

The second point discussed above—the recent underperformance of Semis—has been the most talked about topic among investors recently. In early June, we first laid out our case for why the momentum trade and Memory stocks, in particular, were likely to see a meaningful correction (A Healthy Reset). We then noted that earnings revisions breadth for Semis had reached historical extremes, and was likely to mean revert. We can now confirm that earnings revisions breadth for Semis is starting to roll over from those extremes ( Exhibit 2 ). In addition to our notes on this topic over the past month, see here for Shawn Kim's note (Shawn is our Lead Asia and Europe Tech Hardware and Semis analyst) last week on the Memory stocks that supports our views (see Exhibit 4 below from his note). In addition, we highlighted the commodity-like characteristics of memory and the price analog versus silver stocks that appeared to be tracking fairly closely. In June, our QDS team highlighted the significant leverage in the long momentum and global Semis trade, which has also played a role.

Fast forward to today, and earnings revisions breadth for Semis has started to decelerate from historical extremes as noted and price performance continues to track the silver analog quite closely ( Exhibit 3 ). This analog implies another ~15% downside for Semis in the near term. We think it's reasonable for Semis to see a tradable bounce once the lows are in, but we're not convinced they will regain their leadership position in the second half of this year. Instead, we think the broadening has legs and a wider range of industry groups will lead the market higher into year-end once this correction is finished. With regard to the S&P 500, it has been consolidating for the past 2 months, since the broadening began to re-emerge. This is in line with our thinking that the rotation would happen in a down or consolidating tape. If the momentum unwind spills over into other areas and/or the conflict in the middle east escalates, the S&P 500 could consolidate further toward 7000, where we see durable technical support, before the bull market resumes in earnest into year-end. We still think our year-end target of 8000 is very achievable.

Within the Technology sector, we have been recommending Hyperscalers over Semis for the past several weeks. As discussed previously, we think the Hyperscalers were early in discounting the market's renewed focus on Capex discipline ( Exhibit 5 and Exhibit 6 ) and already went through their period of underperformance. This enhanced relative value for the group as the equal weighted multiple across META, AMZN, GOOGL and MSFT got down to 21x (in line with the March lows). We also believe the Hyperscalers have attractive optionality within the AI ecosystem: strong core businesses, the ability to participate in/lead the agentic application layer development and implementation, as well as an underappreciated cost cutting lever. While the risk/reward for this relative trade is not as attractive as it was a couple of weeks ago, we still think a Hyperscaler over Semis posture makes sense for the time being, particularly given the price analog of Semis vs. Silver stocks shown above that suggests Semis still have approximately 15% downside before a tradable low is in for the group. While we don’t think the AI capex cycle is over by any stretch, there could be a modest cooling off in the rate of change in revisions for Semis as the hyperscaler companies potentially recognize the capex/sales factor is no longer being rewarded while credit and CDS spreads have widened a bit for certain stocks.

The recent underperformance of our high capex/sales factor does raise the question whether the market is moving to a higher quality bias as it did in 2021. Interestingly, the High Gross Margin and High Sales Stability factors ( Exhibit 7 and Exhibit 8 ; clearly in the quality realm) are showing strong earnings revisions breadth that points to a catch up in performance. We think there's something to the assertion that the market is slowly rotating toward a higher quality leadership base, but it could take a couple of months for quality to emerge as a leadership factor in earnest. Importantly, the S&P 500 is broadly a high quality index, especially compared to international peers. This should continue to attract capital to the US over the coming months, a trend that has picked up recently. In other words, the broadening can continue as the market moves toward higher quality leadership. Exhibit 9 helps to reinforce this dynamic by showing that the cash conversion ratio for the median stock in the S&P is actually outpacing and diverging from that of the cap weighted S&P 500.

As noted above, we remain constructive on Consumer Discretionary Goods and Transports, two groups that have continued to show relative strength both in terms of performance and earnings revisions. In fact, earnings revisions breadth for Transports is the strongest we have seen since 2021 (~50%). As Exhibit 12 shows, Transports earnings revisions breadth correlates closely with the ISM Manufacturing Survey and points to a catch up in the ISM toward the ~60 level. The regression in Exhibit 13 helps to illustrate this.

Bottom line, we continue to believe the AI capex cycle remains intact and far from over; however, the acceleration in earnings revisions for Semis reached a peak rate of change for now, while their stocks got over-priced in the short term and were due for a proper correction. This is the fourth time we have had such a correction in the stocks that benefit from the AI capex cycle and we believe this one is not yet finished for Semis. This momentum unwind is helping to fuel the broadening of performance in the equity market as money rotates to other sectors and stocks where strong earnings revisions have been underappreciated. Finally, there is also a growing interest in companies with higher quality earnings, in addition to those with positive revisions. The hyperscalers were the first to de-rate on this focus and price it in advance; their relative value continues to look attractive, in our view.

Lastly, June core CPI came in well below consensus at 0.0% month-over-month. This supports our house view that core inflation can remain benign enough for the Fed to stay on hold this year as opposed to the consensus view it will hike rates.