AI glitter is flattering markets

The story of stocks this year is unambiguously sparkly but the mood is fragile.

The story of stocks in the first half of 2024 is unambiguously sparkly. The US benchmark S&P 500 index is up around 15 per cent. Its tech-heavy cousin the Nasdaq Composite has climbed even further. Most of Europe is having a decent run, including even the UK (but not you, France), and Chinese stocks have finally stopped bleeding out.

Central banks are indulging in an only slightly cautious victory lap on the mission to defeat inflation without tanking the global economy, judging from the annual economic report from the Bank for International Settlements, which praises policymakers for having “done their job” and “delivered” in supporting a soft economic landing. High-fives all round.

And yet the mood in markets is still fragile as investors struggle to shake the feeling that things are simply dusted in glitter. The rally in US stocks has slowed down, with barely any movement in the past two weeks. Crucially, Nvidia — not the best-performing US stock of the year but certainly the most important, in terms of broad market direction — has taken a heavy knock. Since the peak on June 20, it has dropped by 13 per cent.

Torsten Slok, chief economist at private equity group Apollo, said the index is looking “more vulnerable”. The top 10 companies in the S&P 500 make up 35 per cent of the entire value of the index, he noted, but only 23 per cent of earnings. “This divergence has never been bigger, suggesting that the market is record bullish on future earnings for the top 10 companies in the index,” he wrote. “In other words, the problem for the S&P 500 today is not only the high concentration but also the record high bullishness on future earnings from a small group of companies.”

Sometimes this works out. It was, after all, a decent set of delivery numbers from Tesla that dragged the overall market up to this week’s new record high — the 32nd this year. But the focus on the highly uneven nature of the market is itself intensifying.

Charles Schwab points out that only 17 per cent of stocks in the S&P 500 have outperformed the index itself over the past year. For the Nasdaq, it is just 11 per cent. “The dramatic outperformance of a small handful of stocks at the very upper end of the market capitalisation spectrum has greatly flattered index-level performance among cap-weighted indexes,” wrote analysts Liz Ann Sonders and Kevin Gordon at the retail broker. “There has been a tremendous amount of churn and rotational corrections occurring under the surface.”

This is the glitter in action. Anything to do with artificial intelligence has rocketed, including chip designer Nvidia with its 155 per cent gains so far in 2024 but also the even more stellar Super Micro Computer, which has gained more than 200 per cent. A clutch of energy and industrial stocks that help AI tick are also on a tear, including Vistra and Constellation Energy.

Another alarming possibility presents itself in a new paper by, among others, Jean-Philippe Bouchaud of hedge fund Capital Fund Management. The paper, somewhat provocatively titled “Ponzi Funds”, challenges anyone who clings to the quaint notion that fundamentals — earnings and the like — are what really matters for how stocks behave.

Instead, to summarise the paper very crudely, funds go up because investors cannot resist buying things that are going up, and when they do, the underlying components go up too, pushing up the funds, and drawing in new buyers. Momentum feeds momentum in “self-inflated feedback loops” and clusters around shiny narratives. At a certain point, “the constraint on the rationality of fund investors . . . leads to Ponzi-like reallocations of capital among fund investors that unravels when the price impact in the underlying securities reverts,” it argues.

The study focuses on exchange traded funds because the quality of data on purchases and sales of these instruments is strong, but the principle applies to stocks more broadly. The momentum of US stocks and the dominance of a single theme mean the current market environment smells awfully similar. “The US market has gone up because people have bought the US market,” said Bouchaud.

This line of research is certainly not new. “We’re in a long tradition of many giants before us,” he added. None of this makes it easy to see what breaks the spell and prompts markets to drop back down to earth or when.

But if US stocks do not slot back into their smooth upward glide soon, it is easy to imagine gnawing doubts over intense market concentration, and reminders of the unsustainable nature of fads and trends, to rub some of the gloss off stocks in the second half of this year.