Animal Spirits

Market Exuberance and the Return of Animal Spirits

I think it’s fairly safe to say that various parts of this year’s equity market have been experiencing exuberance, perhaps even excessive levels of exuberance.  Not that that’s necessarily a bad thing, but rather it’s worth noting and trying make sense of it relative to the broader market.

Animal spirits that are thriving are good in that they help to move markets higher.  We would much rather have enthusiasm being expressed in the form of more money coming into the markets than not.  An example of this can be seen in Schwab’s (SCHW) recent third-quarter results and the broad market’s third-quarter performance.  Schwab reported $134.4 billion in net new assets for the quarter and a strong increase in daily average trading, up 30%.  And the S&P 500 was up 8.11% in Q3 and 16.7% year-to-date.  Not bad, we’ll take it.

 

Quantum Computing and Clean Energy Fuel Market Speculation

But within the market, we’re seeing some areas where market participants are perhaps chasing returns.  Observationally, a couple of such categories include quantum computing and non-carbon-based energy.  The buildout for AI demand and its vast needs for power generation and computing power are fueling the strong rally in these two areas of the market.

Quantum computing offers the possibility of solving complex problems that are beyond the capabilities of current supercomputers.  Drug discovery is just one area that would be greatly impacted by breakthroughs in quantum computing.  And non-carbon-based energy sources, such as nuclear, small modular nuclear, and fuel cells, are being aggressively pursued in order to provide clean energy and lower energy costs.

 

The Challenge of Investing in Emerging Technologies

Many of the quantum computing and non-carbon energy companies, however, are unprofitable and are burning cash at a rapid clip.  Some of the prominent names are not even generating revenues yet.  This is rather normal for new, cutting-edge technology companies.  Two ETF’s capture these themes: QTUM and NLR – they’re up 38% YTD and 82% year to date, respectively.  Among the numerous pure-play names in these areas, there will likely emerge a couple of winners that capture dominant positions and market share.  This will take time to play out (likely a couple of years) and the rest will likely end up by the wayside. So, large amounts of capital that went into these names will be burned through with nothing to show for it. Are these animal spirits driving the market higher, or bets by investors looking to gain exposure to potentially game-changing technologies? Investments like these and the stock surges that follow are the nature of new technology development, but the wise investor looking for exposure in this area will take positions in a broad group of possible winners and avoid chasing those bid up too far and too fast.

 

Small-Cap Surge: Unprofitable Companies Lead the Rally

Further illustrating the animal spirits in action is the performance that we’ve seen since the market low in April caused by the Liberation Day tariff announcement.  The S&P 500 is up 37%, but the small-caps’ Russell 2000 is up 43%.  Among these small caps there are 806 unprofitable companies compared to 1120 profitable. Notably, the unprofitable companies are sharply outperforming the profitable names.  Chart below demonstrates this. This suggests investors are looking at more speculative investments beyond those in quantum computing and non-carbon energy.

 

High-Risk Bets: Unprofitable Tech and Shorted Stocks Outperform

Another example of this preference for risk taking is the performance that we’ve seen from the Goldman Sachs’ basket of unprofitable US tech companies (GSXUNPTC; GS Non-Profitable Tech).  It’s up 121% since the April low, dwarfing the S&P 500’s 36%.  And Goldman Sach’s basket of liquidity-optimized most short names is up 117% since the April low (GSXUMSAL; GS Liquid Most Short).

 

Defensive Rotation Signals Possible Market Reset

Clearly, the risk-on appetite has been alive and well this year and in particular since the April lows.  In the last month or so, however, we’ve seen some rotation into defensive areas of the market.  Health care, utilities, and the 10yr Treasury have rallied and are up 6.9% and 5.8%, compared to the S&P’s 2.4%.  And the 10yr Treasury yield has gone through the 4% level and now stands at 3.99% vs. it’s 4.40% level just three months ago.  This rotation to some defensive areas and the 10yr yield coming in could reflect growing concerns of a slowing economy or it could just be a pause in the tech heavy growth areas that may have become overheated. If so, a normal market reset is taking place.

 

Valuations Remain Reasonable Despite AI-Driven Gains

Third-quarter earnings to date overall have been healthy and without any significant signs of a potential slowdown.  Rather, I would point out that the S&P 500 Equal Weight Index looks reasonably priced at 18x forward earnings, while the S&P 500 (market-cap weighted) has been pushed higher by this year’s AI tech-fueled stocks.

 

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