Concerns about the valuations of US mega-caps have skyrocketed this year, but this is the wrong part of the market to worry about, according to Arun Sai, senior multi-asset specialist at Pictet Asset Management.
The artificial intelligence (AI) story has dominated markets this year, to the point that investors are increasingly worried about whether the US’ largest companies can continue to match high expectations.
The circular financing deals that make AI companies dependent upon each other have also spooked some, with major players such as Nvidia, Intel and OpenAI partnering together, as shown in the chart below.
While these are “red flags”, the bull case for AI is being underestimated, Sai said.
Circular deals between AI companies
Source: Pictet Asset Management. Bloomberg News Reporting
The ongoing case for AI
Some experts have compared the AI boom to previous market bubbles, but the comparison is not entirely appropriate, the Pictet strategist said, and valuations are not as extreme as most think.
The AI cohort currently trades at an average of 30x price-to-earnings (P/E) ratio – lower than the Nasdaq at the height of the dot-com bubble, which traded at 100x.
Peak bubble valuations
Source: Pictet Asset Management.
“Looking at markers of when bubbles burst, I’d say we’re only above a third of the way in,” the Pictet strategist said.
This means that there is still significant room for deregulation and sentiment to improve, which will lead to a continued rally in these stocks.
“AI stocks are not cheap, but equally, they’re not frothy either. I’m happy to pay an average of 30x for AI.”
Current valuations are also broadly supported by strong fundamentals, he said. The bulk of the AI capex boom has been supported by operating cash flows, which further distinguishes it from the dot-com bubble, where “equity investments were financing the capex”.
On top of this, the earnings picture for these companies is broadly “comforting”, as they are growing their earnings per share well above the average US stock, as shown in the chart below.
“These stocks are market leaders and have been for years. That’s a comforting backdrop,” he said. “Markets are expensive, but I don’t think AI is the reason for that and that should change your risk-reward perspective”.
12m forward earnings of AI Stocks vs S&P 500
Source: Pictet Asset Management.
The ‘Terrific 20’
The biggest risk in the US market isn’t in the tech stocks, it’s in the rest of the US mega-caps, particularly a cohort that Sai called the “Terrific 20”. This is a broader set of large-cap American stocks, which are more closely tied to the “real economy” such as Walmart, JPMorgan and Berkshire Hathaway.
These stocks have surged to an average of 25x forward earnings, above the average US stock and not far behind the Magnificent Seven, as seen in the chart below. In total, they have surged almost 60% in the past two to three years.
Valuations of Magnificent Seven, Terrific 20 and Median US stock
Source: Pictet Asset Management. The Terrific 20 include Broadcom, JPMorgan, IBM, Berkshire Hathaway, Visa, Netflix, ExxonMobil, Mastercard, Costco, Walmart, Oracle, AT&T, GE Aerospace, Home Depot, Wells Fargo, Bank of America, Palantir Technologies, Chevron, Philip Morris International and Goldman Sachs.
The problem with this is that the rally in these mega-cap stocks has been founded on “hopes” rather than fundamentals, which will backfire on investors, Sai said.
Unlike the Magnificent Seven, these stocks are not posting exceptional performances, but they’re being rewarded with much greater chunks of market share regardless, he said.
While some of these stocks have performed well, they have rallied because investors who were concerned about the Magnificent Seven valuations saw these as the next best thing.
“Investors who told themselves that they’ve missed the bus on AI looked at the US market and started searching for stocks that could attempt to replicate the success of the Magnificent Seven. That’s why the Terrific 20 have surged”.
As a result, it is these stocks that are “most vulnerable to a correction” within the US, because they have run up significantly but “lack the earnings leadership to justify it. Investors who poured into these businesses are taking on risks that “may not seem obvious at first glance”.
“I’m not worried about 30x on the Magnificent Seven. I think you should be worried about 25x on something like JP Morgan or Walmart,” Sai concluded.