An AI Minefield

In the past few weeks, and specifically the past few days, it feels as though the market landscape is full of AI landmines.  The software sector, then insurance brokers, wealth managers, and real estate brokers succumbed sequentially to fears of being decimated by advancements in artificial intelligence that could impair their business models.  Should we be surprised that a disruptive technology is creating disruptions?

The outsized downward reactions in software stocks like AppLovin (APP), insurance brokers like AON, wealth managers like Raymond James (RJF), and real estate brokers like CBRE are a testament to a momentum-driven market’s ability to overreact to bad news as well as good.  It is also a testament to a huge change in market psychology.  For most of the past three years, investors took a “glass half-full” approach to AI.  It was, “What can AI do to make a business or industry more efficient?”  It now seems to be “How can AI ruin a business’s or industry’s profitability model?” – and rather than searching for winners, investors are hunting for potential losers.

This change in mindset fits with a trend we discussed last week.  We wrote about the rising dispersion between the returns and volatilities of index components as swift undercurrents underneath the market’s relatively placid surface.  Higher dispersion implies that investors are more actively trying to distinguish between winners and losers, rather than simply assuming that a rising market tide will provide sufficient lift. 

Thus, we now need to think about businesses that are less likely to be disrupted by AI.  Knowledge-based business models have now become sources of risk, meaning that heavy industry is more likely to experience relative benefit.  Perhaps that is one reason for the recent outperformance of the transportation sector – an AI bot can’t take stuff from point A to point B.  It also can’t build a tractor, mine for ore, farm a field, etc.  At least not yet!  The rotation away from growth into value might be seeing acceleration as investors migrate away from purely knowledge-based industries into bricks and mortar. 

Sometimes, in the time it takes to write these pieces, market movements force me to change their tone.  This was not the case today.  Indeed, stocks were modestly higher when I started typing and began to fall sharply once the report was fully underway.  The proximate cause was likely the 10 AM ET release of a much worse-than-expected January Existing Home Sales report (-8.4%, well below the -4.6% consensus), which led to bond yields falling about 4-6 basis points across the curve.  But as the chart below shows, traders have been tending to shift into another gear – forward or reverse – around 10:00 or 10:15 ET.  Note the activity in the S&P 500 (SPX) over the past two weeks, where we have placed vertical lines at 10:15 ET:

SPX, 2-Weeks, 5-Minute Candles with vertical lines at 10:15 ET each day

Source: Interactive Brokers. Past performance is not indicative of future results.

While today’s selling is indeed broad-based, growth stocks overall, and the previously mentioned sectors specifically, are faring relatively worse.  Among the stocks noted above, APP is down 18% (earnings are the main culprit), RJF is off by 3.3%, and CBRE is plunging 14%.  To be fair, AON is roughly unchanged.  Furthermore, transportation stocks are hardly immune.  That sector is about 6% lower, thanks to a brutal selloff in companies that specialize in logistics.  Indeed, while AI can’t move goods from point A to point B, perhaps it can dent the knowledge-based franchises of companies like CH Robinson (CHRW), which is down over 20%!  We also see underperformance from the Russell 2000 (RTY).  Smaller companies, particularly if they are marginally profitable (or worse), are generally not equipped to handle economic weakness – especially if interest rate cuts are not expected to come quickly or forcefully.

The inability of SPX to pierce 7,000 and move to new highs might simply be the result of technical and psychological resistance.  But the underlying turbulence and fragile investor psychology might indicate something more concerning.  We recently wrote:

Market volatility tends to increase around turning points.  The increasingly huge moves in … commodities may mean that the musicians are preparing to take a rest.

That sentence was written amidst the plunges in gold and silver, but it could also apply to equities.  We are not seeing a huge lift in overall index volatility – VIX is still below 20, for example – but the moves under the surface could be indicative of something more than just rotation.  Rotation means that one sees better values in other sectors, but a minefield indicates significant underlying volatility.  We’ll need to move back to simple rotation or improved psychology for the market to resume its advance.

6-Months, DSPX (daily candles, right scale), VIX (blue line, left scale)

Source: Interactive Brokers, past performance is not indicative of future returns.