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Diversification In The Long Run

By Scott Poore, AIF, AWMA, APMA
Chief Investment Officer, Eudaimonia Group

There may be some consolidation at the top of the equity market taking place this week, which may be bad for AI-related names, but good for the rest of the market.  The AI-related inspiration for this week's musings is the 1991 movie, "Terminator 2:  Judgment Day" where the Connors seek to prevent Skynet's take over of the world.  This movie was a massive cultural and commercial success.  Here's some trivia about the film:

  • While the film generated a massive box office, more than $520 million worldwide, what is lesser known perhaps is that the sequels (largely panned by critics) were also successful.  Here's the box office for all the movies in the franchise.
    • Terminator ($78.3 million)
    • Terminator 2:  Judgment Day ($520.9 mil)
    • Terminator 3:  Rise of the Machines ($433.4 mil)
    • Terminator 4:  Salvation ($371.4 mil)
    • Terminator 5:  Genisys ($440.6 mil)
    • Terminator 6:  Dark Fate ($261.1 mil)
  • This movie was the first film starring Edward Furlong, who plays a young John Connor.  After achieving much fame and recognition for his breakthrough role, Furlong struggled with substance abuse and incarceration.  In fact, Furlong was supposed to reprise his role as John Connor in Terminator 3, but was replaced for unknown reasons.
  • Linda Hamilton's twin sister, Leslie Gearren, was used in the film when there were two Sarah Connors in the same scene - for example when the T-1000 is imitating Connor.
  • Unlike its predecessor and subsequent sequels, this is the only film in the franchise to be nominated and win Oscars.  

Here's what we've seen so far this week...

Come With Me If You Want To...Diversify?  We could be witnessing a consolidation of some of the top names that have driven markets over the past 14 months into some other sectors and asset classes of the market.  This is why we warn the average investor to remain diversified when it comes to investing.  It reminds me of the iconic and often quoted scene in Terminator 2 when Sarah Connor is confronted by what she thinks is the same terminator machine from the first film, only to find out that her son from the future, John Connor, sent the T-800 back to help protect her when we hear Arnold Schwarzenegger say, "Come with me if you want to live."  It's a lot of fun when investors bet on a handful of stocks and come out winners in the short-term.  But, when those names start to falter versus the rest of the market, it's not as enjoyable.  While the Mag 7 stocks still lead other sectors year-to-date, the last two weeks we've seen even the more evenly diversified S&P 500 Equal-Weight Index out-perform.  We'll see if that turns into a more broad trend.  Small caps stocks have also seen a resurgence over the past 30 days.  As a whole, small caps have been in a range-bound bear market for the past two years.  However, on February 15th, small caps broke above a two-year bear market and are now trading close to the last high made on March 29, 2022.  If the trend continues, it could mark the beginning of other asset classes flourishing while Mag 7 takes a bit of a back seat.  As another example, mid-cap stocks are out-pacing large caps recently.  Over the last 30 days, the Russell Mid-cap Index is up 4.9%, which is just ahead of the S&P 500 Index at +4.7%.  As we have been the past few weeks, we need to look yet again at market bubble formations.  One thing the past few bubbles have had in common is the rolling 3-year returns.  As bubbles form, going back to 1987, the 3-year rolling return on the S&P 500 Index reaches at least 100%.  As you can see from the chart, that was achieved in 1987, 1999, and 2021.  That was not evident in 2007, but as you can see, currently we're sitting at the historical average of 29%, which is still a far cry from 60% evident in 2007.  In other words, AI is facing a setback given some of the recent news of user issues with AI chatbots providing inaccurate information.  We are in the very early stages with AI, so it's likely to go through some growing pains once in a while.  We don't want AI getting too savvy, like Skynet, do we?

Hasta La Vista, Inflation.  The permabears and inflation mongers have been pounding the table about a resurgence in higher prices.  While there are still areas of concern among certain products and services prices, the PCE Index came in as expected, yet lower on a year-over-year basis.  The Fed's favorite measure of inflation, The PCE Price Index, fell for the fourth consecutive month to 2.4% and is now more than 440 basis points lower than the peak of 6.8% in July of 2022.  Durable Goods fell for the 2nd consecutive month, and while the Services component of the index is lower on a year-over-year basis, that component did increase on a month-over-month basis.  Personal Spending was flat last month, however, we saw a large jump in Personal Income (+1.0% in January vs. +0.3% in December).  This means consumers still have room to spend on a discretionary basis.  Stable inflationary data and improving consumer metrics means the Fed can wait on cutting rates - something the market will need to adjust to in the coming months.  Another positive note is the improvement in small cap companies and their relative earnings results.  For the first time since the 3rd quarter of 2022, small cap companies have seen positive earnings growth (quarter-over-quarter) from 4th quarter earnings releases.  This fact may also lend to other sectors of the market beginning to out-perform relative to Mag 7 or mega-cap equities.  It's also helpful to revisit the Fed's National Financial Conditions Index.  As it was positive in the months before major recessions, we see a very stable number in the negative column, indicating loose financial conditions.  The index takes into account more than 100 different economic and market metrics and helps us see the financial situation in one snapshot.  Similarly, we see credit spreads jump prior to recessions.  Currently, the spread between high yield credit bonds and treasuries is very low.  In 1999 and 2007, we saw the spreads increase substantially off lows and continue to climb in short order in the months that followed.  This is another indicator that a bubble had not yet formed to the point of risk getting out of control.  While we expect a seasonal pullback in equities soon, the underlying health of the markets and the economy seems to be solid at this point.

Here's the iconic scene from Terminator 2...


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