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Is Generative Artificial Intelligence the Next Big Thing?


Will Generative Artificial Intelligence (GAI) live up to they hype?

Since early 2020 the economy has undergone a series of shocks. First came the Covid-19 pandemic, which continues to impact the economy more than three years later. Next came the war in Ukraine, affecting global oil and wheat markets.

Most recently the emergence of Generative Artificial Intelligence (GAI) is a technological development that some have said could be as profoundly positive as the invention of the internet, mobile devices and cloud computing. Only time will tell if GAI lives up to the hype, but these shocks have brought tremendous volatility to the economy and financial markets.

The stock market has had a great year from the combination of GAI excitement, moderate economic growth, falling inflation, and the belief that the Fed is close to ending interest rate increases. The S&P 500 is up more than 20% since its low last October but has followed a strange path to get here. In the year to date through May, the seven largest tech companies in the U.S., most of whom are associated with GAI, drove a 9.7% increase in the market-cap weighted S&P 500.

However, the rest of the market did not participate as the equal-weighted S&P 500 fell 0.6%. Since May the gap between the two indexes has narrowed, with the market-cap weighted S&P 500 through mid-July up about 17.5% and the equal-weighted S&P 500 up about 9%. This narrowing has occurred as investors have pivoted to companies expected to benefit from a moderately growing economy with falling input costs that can expand profit margins.

Still, the market may be ahead of itself as earnings remain under pressure. According to FactSet’s Earnings Insight published on July 7th, earnings are expected to sink 7.2% for the second quarter, the third straight quarter of contraction. Revenues are expected to fall 0.3%, the first decline since the third quarter of 2020. Sharp declines for the energy and materials sectors are the main culprit behind the revenue and earnings shortfalls.

As is typical of optimistic analysts, third and fourth quarter earnings are projected to grow 0.3% and 7.8%, respectively, while full year 2024 rachets up 12.4%. The combination of this year’s market advance and expected earnings growth has left the forward P/E multiple 18.9, above the average of 18.6 and 17.4 for the past 5 and 10 years, respectively. The market’s valuation is even richer in a world where investors can earn more than 5% on safe, short-term Treasuries compared to almost nothing as recently as early 2022.

While financial markets have been volatile since the pandemic, equity investors in stocks who stayed fully invested have made money. As always, picking growing companies at reasonable valuations is eventually rewarded.

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The commentary has been excerpted from the issue of Investor Advisory Service published in late July. To receive commentary like this in a more timely matter and receive actionable stock ideas each and every month, subscribe today. The Investor Advisory Service stock newsletter was named to the Hulbert Investment Newsletter Honor Roll for the 13th consecutive year for outperforming every up and down market cycle since 2002.

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