How Much Longer Can the AI Leaders Last as a Defensive Trade?
Interest rates aren’t hurting AI, and that has made the group a safe haven despite inflation concerns.
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The S&P 500, the Nasdaq and the Invesco QQQ Trust (QQQ) are all close to all-time highs Wednesday morning, but much of the market is lagging badly. Investors must consider whether this trend continues or the performance gap starts to close.
The S&P 500 hit its 28th record of the year Tuesday, while the S&P 500 Equal Weight Index dropped to one of its lowest levels against the regular S&P 500 in years. The equal-weighted index, which the Invesco S&P 500 Equal Weight ETF (RSP) tracks, gives every company the same weight, so the smaller companies in the benchmark count for more.
The ratio of the equal-weighted index to the S&P 500 ended the day at 1.1003, the lowest since May 14. If it slips just a little more, the ratio will be at a 23-year low. The S&P 500, driven by mega-cap names such as Nvidia (NVDA) and Apple (AAPL), is at a record, while the equal-weighted version is 4.6% below its high.
The AI Leaders Are the New Defensive Names
This performance disconnect largely reflects how investors are reacting to interest rates. As Interactive Brokers put it, the indexes rally when rates tick lower but yawn when they rise. Higher rates don’t matter much to the AI leaders. That dynamic could change as we move into earnings season, but for now the inertia will likely continue.
Interest rates have risen sharply and quickly. Normally that would undercut market leadership and push money into defensive names like the big pharmaceutical companies. This time the big-cap AI leaders are being treated as the defensive names. The growth they forecast is so much larger than the increase in bond yields that a move of a couple of percentage points in rates does little to change their outlook.
Will Earnings Change the Dynamic?
The lack of rate sensitivity in big-cap AI is what is driving the market to new highs, and the question is whether that dynamic can survive the upcoming earnings reports. Will the continued need for huge capital spending cause investors to take a second look?
There is an illustration Wednesday morning of how spending may still be an issue for the AI group. SpaceX (SPCX) is down nearly 2% premarket after reports that Elon Musk’s rocket and AI company is looking to raise $40 billion to buy chips from Nvidia. If the market were confident that those chips would produce a new stream of profits, wouldn’t we be seeing the opposite reaction?
Game Plan
I’m not going to fight the AI leadership inertia, but I want to be ready when it changes. The big banks kick off earnings season next Tuesday, and once guidance starts to flow, the focus shifts from rates to individual companies. That is when the gap is most likely to start closing.
Until then, I’m watching the equal-weight ratio and building a list of laggards that are holding up on the weak days. When the turn comes, those are the stocks I want to own. My main focus right now is optimizing my watch list so that I can move quickly as we start to see reactions to earnings.
At the time of publication, Rev Shark was long SPCX.
