I have had a number of discussions with investors and the question keeps coming up. Can the AI frenzy, which appears to be in its early stages, carry the stock market to a new bull?
The AI frenzy begins
A narrative is emerging that AI will become a highly disruptive force, much like the internet was in the 1990s. Indeed, the emergence of natural language processing like ChatGPT has the potential to transform the nature of work in the coming years.
shovels of AI, much like Cisco and Oracle were during the internet gold rush. As one analyst aptly put it, “There is a war in AI, and NVDIA is the only arms dealer in town.”
But market breadth has become extremely narrow, worse than it was during the internet bubble. Can an AI gold rush propel the stock market to a net bull?
I think that may be the wrong question to ask.
Combining momentum and trend following
I base my conclusions on a study by a number of academics at the Bayes Business School at the City University of London. The study is entitled, “The Trend is Our Friend: Risk Parity, Momentum and Trend Following in Global Asset Allocation”.
My own research that uses sectors instead of individual stocks as a momentum strategy also confirms these results. Pile into the winners in an uptrend. Avoid momentum in a neutral or downtrend.
That’s why the question of whether am AI frenzy can carry the stock market to a new bull is the wrong question to ask. The right question is whether the stock market can achieve a bull trend and propel AI stocks to an internet-style bubble. For that to happen, a technical bull market where the index rises 20% from its low isn’t enough. Market leadership needs to broaden out.
Also don’t forget the venerable Dow Jones Industrials Average. Both the Dow and the Transportation Average are also well below their old highs.
An alterative explanation
If breadth were not to broaden in a definitive fashion, here is an alternative explanation of the current market structure. Recall Bob Farrell’s Rule #7: “Markets are strongest when they are broad and weakest when they narrow to a handful of names”.
The analysis of quality within value and growth is equally revealing. There are many ways of measuring company quality. One simple way is to measure the relative performance of the S&P and Russell indices. S&P has a much stricter profitability inclusion criteria than the FTSE/Russell indices. Consequently, the companies in the S&P indices are more profitable and have fewer money-losing companies than the stocks in the Russell indices.
In other words, the market structure is being dominated by a group of low-quality growth, while high quality is still dominant within the value universe.
Low-quality growth dominance and high-quality value? That should like a frothy market poised for a recession – which is the alternative and conventional explanation for the current market structure.
We began this publication with the rhetoric of whether AI frenzy, which appears to be in its early stages, carry the stock market to a new bull. Academic studies indicate that the right question is to determine whether we are in an equity bull so that AI stocks can take advantage of the bull trend. For that to happen, breadth participation needs to broaden out considerably.