The Views from the "Mag 7" Deck Have Been Spectacular, but it is Getting Very Crowded on That Side of the Boat
Curt R. Stauffer
January 31, 2025
Are the S&P 500 and Nasdaq 100 indices at risk of being an Artificial Intelligence (AI) "house of cards?" AI has been the dominant investment theme over the last two years following the initial introduction of Chat GPT in late 2022. Since that time, AI applications and development spending has propelled Nvidia (NVDA) stock and the other so-called "hyperscales" such as Microsoft (MSFT), Meta (META), Oracle (ORCL), Alphabet (GOOGL), and Amazon (AMZN) to new highs and lofty valuations.
The conventional thesis that has propelled these mega-cap technology hyperscalers companies has been that NVDA had both durable and dominant market share in terms of designing and selling advanced Graphic Processing Unit (GPU) semiconductor chips used in AI server computers, which were being aggressively purchased by the hyperscaler mega-cap technology cloud computer companies to compete in the rapidly expanding AI marketplace.
The following chart from ICIS's Paul Hodges at the end of June 2024 clearly illustrates, using the stratospheric advance of NVDA stock since the end of 2022, just how pervasive and powerful the AI theme has been since Chat GPT was initially introduced:
This chart from mid-2024 showed Nvidia at a stock price that translated to a market capitalization of roughly $3.6 trillion. This was approximately the market capitalization of Nvidia at the end of trading on Friday, January 24 , the day before the stock saw its market cap decline by over $600 billion on the news that Chinese company Deep Seek announced that its AI system outperformed the best system from the U.S. hyperscales without using Nvidia's most advanced chips and at a development and energy consumption cost much lower than comparable AI systems developed by U.S. companies. See the following chart capturing the percentage sell-off of NVDA stock, Nasdaq, and the S&P 500 following the Deepseek announcement:
Some Seven Summits Capital managed accounts hold NVDA stock. However, NVDA stock is underweight overall, and the January 27 AI sell-off had minimal influence on our portfolios. We have been wary of the "house of cards" risk with the "AI trade" that has so substantially driven market returns since the introduction of Chat GPT in late 2022. See the following segment of a June 14, 2024 article by CNBC titled The S&P 500 would be nearly 20% lower without AI mania, says this chart.
As I have stated and written many times over my career, no one can consistently and successfully time equity markets. All a professional investor can do is recognize market imbalance and valuation risks and be informed by historical market data to take non-market timing precautions to address the recognized risks. Having managed investment portfolios for over 27 years, I have seen and managed through many periods of equity market imbalances and unusually high valuation multiples. I have also seen the increasing evolution of the professional investment management industry that has resulted in professional money management moving from seeking to identify and take advantage of market pricing inefficiencies to simply overtly or covertly mimic the composition of the major broad market indices. The following chart is from a Franklin Templeton paper published on March 18, 2024, titled Historic Concentration Forges Emerging Asset Class in U.S. Growth Equities:
Since I have been managing investment portfolios professionally spanning the entire time frame shown in the chart above, I can speak to how the market has changed over that time because of the increasing prevalence of passive investing. This chart does not show that within the "active" fund category, a meaningful number of those funds, particularly those in the very popular large-cap category, look and act more like passive index funds than not. See the illustration below from Morningstar published January 8, 2025, titled Pot Kettle Black: Active Funds and Index Concentration Problem.
Many are advertised as active large-cap mutual funds and ETFs today, but when you look under the hood, they have a very similar concentration in the same 7-10 stocks that now make up over 30% of the S&P 500's weighting. This practice is known in the industry as "closet indexing." A hyper-focus on short-term benchmark comparison has increasingly taken over the industry over the same period that passive investing has become much more dominant. To try to compete with passive indexing, many active managers have decided that they cannot afford to have their portfolios deviate significantly from their assigned benchmarks. Thus, they have consciously chosen to manage the portfolio in a way that they can still call themselves an active manager and charge active manager level fees, but at the same time hold many of the top positions of their assigned benchmark as their funds' top positions to largely tether their funds' performance to that of the index. Therein lies the risk that I see in the overall market. For those old enough to remember watching Louis Rukeyser's Wall Street Week show on PBS or various other investment shows during the late 1980s through early 2000, you will recall the legendary investor Jim Rogers, co-founder with George Soros of the Quantum hedge fund. Jim is quoted as saying about the markets and investors. "When everybody is on one side of the boat, you should go to the other."
Right now, as I have illustrated above, the boat/market analogy has never been more glaring. This imbalance has persisted longer than most people who pay attention to such matters would have predicted, and it could continue to persist this way for a while longer. We will never try to time the capsizing of the boat or the significant shift that would bring the markets into better balance, but through our investment choices, we attempt to try to enjoy the views on the crowded side of the boat while staying as far from the crowd as we can get.
Overall, we were very pleased with the equity performance of our accounts in 2024 and with largely avoiding the Nvidia (NVDA)/AI ash crash on January 27th. I know that this January commentary is being published much later than usual. I will attempt to get back on the more normal middle-of-the-month schedule in February.
Advisory services are offered through CS Planning Corp., an SEC-registered investment advisor.
