If AI is all it’s cracked up to be, winners in the stock market should go far beyond the large-cap tech hyperscalers currently building AI infrastructure.
As BofA’s Savita Subramanian wrote in June 2023: “The biggest benefit can be gained by inefficient old-economy firms that can increase more permanently profit-generating power from efficiency and productivity gains.”
It’s too early to say conclusively, but the market may be in the process of getting ahead of this phase of the AI ​​narrative, as small-cap stocks have recently outperformed large-cap stocks.
As Wells Fargo’s Ohsung Kwon argues, small-cap stocks (according to the Russell 2000, or RTY) could see a bigger tailwind from AI than large-cap stocks (according to the S&P 500, or SPY).
“We see signs that small caps have been slower to adopt AI than large caps,” Kwon wrote on Monday. “We believe the next step in AI adoption is in small caps – the long-term bull case for RTY. We estimate that every 1% savings in labor costs translates into a ~2% increase in EPS for SPX, but >6% for RTY.”
Small cap stocks will benefit greatly from AI. (Source: Wells Fargo) ·Yahoo Finance
This is what makes the promise of AI really exciting for investors: the beneficiaries are not limited to those who develop the technology. Companies across all sectors have been exploring AI applications and many are already implementing them into their operations.
To be clear, we are still in the early stages of the AI ​​era and it will be time before we better understand the real impact on productivity across sectors.
But if costs really do drop materially and productivity improves beyond tech companies, it would be consistent with past technological revolutions.
In a recent research note, Bridgewater’s Greg Jensen drew parallels between today’s AI and electrification in the 1920s and the Internet boom of the late 1990s.
“At least in the short term, it seems likely that AI will follow the classic J-curve productivity path of earlier general-purpose technologies like electricity or the Internet, requiring a large upfront investment that does not immediately improve productivity but eventually proves transformative,” he wrote.
(Source: Bridgewater) ·Yahoo Finance
As you can see from the graphs, it took years for the economy to realize the productivity booms promised by electricity and the Internet.
“We believe that capital spending on AI will significantly support US growth in the coming years and that many of the second-order consequences of this investment are not discounted,” he added.
Read Jensen’s full note. here.
Carlyle Group’s Jason Thomas took a closer look at those historic experiences. And he had no qualms about addressing head-on the risk that we are in a bubble like that of 1929 and 2000. In fact, the title of his note is: “Bubbles are a feature, not a bug.”
“Financial markets tend to be very good at detecting technological revolutions, but they have rarely proven capable of anticipating their second- and third-order effects,” Thomas wrote. “Bubbles deflate not because technology disappoints, but because much of their economy flows to the companies that employ it and the new industries it generates.”
He discussed the decades-long process of harnessing and deploying electricity from the 1880s to the 1920s. “Profits and valuations of power companies and equipment manufacturers tripled; between 1925 and 1929, industry-wide annualized returns exceeded 50%.”
These companies could not avoid the crisis of 1929. But what followed is remarkable.
“Electrified factories reduced manufacturers’ production costs, and electrified homes stimulated demand for their products, such as refrigerators, vacuum cleaners, and radios,” Thomas observed. “This is where much more economic value was finally accrued from electrification, with 11% annualized returns on stocks of durable goods makers over a decade stretching to the depths of the Great Depression.”
Electrification helped reduce the cost of producing durable goods. Manufacturing stocks outperformed during this period. (Source: Carlyle) ·Yahoo Finance
Thomas noted that after the dot-com bubble burst in 2000, companies that took advantage of the Internet saw similar results after the market crashed.
“These same phenomena were repeated in the Internet boom of the late 1990s,” he wrote. “Real capital spending grew at an annualized rate of 24% as investors focused on bandwidth, router architecture, and processing power bottlenecks. But the economic value of that IT and telecom hardware manifested downstream. Network computing enabled manufacturers and retailers to exploit new sales channels, more accurately calibrate production and inventories against sales, and optimize logistics networks and supply chains.
Companies that benefited from the Internet did better after the dot-com bubble. (Source: Carlyle) ·Yahoo Finance
“A technology doesn’t need to fail for its bubble to deflate,” Thomas continued. “Likewise, those inclined to focus on ‘irrationality’ or ‘market euphoria’ overlook how bubbles seem a natural consequence of changing times. If the market did not misjudge the importance of hardware bottlenecks and first-mover advantages, who would be willing to fund the research and infrastructure that ultimately make the technological revolution and the subsequent value of it possible?”
Read Thomas’ full note here.
As we have discussed before, history is littered with examples of innovative technologies leading to overinvestment followed by market corrections.
Unfortunately, it is not easy to predict when those corrections will occur and what they will look like.
But the bottom line is that investors need to be aware of the risk that hot stocks most directly exposed to the AI ​​capex boom risk being left behind.
In fact, this may already be happening.
On Wednesday, Deutsche Bank’s Jim Reid shared this chart of where various AI-exposed stocks were trading relative to their all-time highs, as the S&P 500 itself rose to new heights.
AI-exposed stocks continue to trade well below their highs. (Source: Deutsche Bank) ·Yahoo Finance
“What’s surprising about (the S&P 500’s) return to the peak, however, is how much leadership has changed in the last quarter,” Reid wrote.
By the way, this dynamic is a reminder that it is possible for the broader market to rise even when its leaders fall behind.
