The S&P 500 is just 3% below its recent record high, yet 60% of its constituent stocks are already in a bear market.
This is a striking picture, highlighted by Goldman Sachs trader Bobby Molavi. As he noted, the paradox is that shares in both the tech giants, whose capital expenditure is at the heart of the AI-fuelled stock rally, and the companies that absorb that spending are falling at the same time.
“I cannot see how both sides can be punished at the same time, particularly when the base case remains that AI will change everything,” wrote Bobby Molavi, Goldman Sachs’ head of execution services for Europe, the Middle East and Africa (EMEA), in a note to clients. He described the situation as a “hidden bear market”.
A sharp rotation of capital away from AI-linked stocks, amid concerns about the sustainability of huge spending, has hit technology shares in recent weeks.
By contrast, most S&P 500 stocks have risen over the past month as money has shifted from overcrowded positions into defensive sectors and under-owned stocks.
Since 15 October, the seven tech giants known as the Magnificent Seven have lost a combined $4tn in market value. For the first time in his memory, corporate earnings were “not good enough”, Molavi said.
Last Thursday, when Alphabet lost $500bn in market value, its biggest one-day decline in 20 years, the S&P 500 fell just 0.3%, as healthcare, real estate and consumer staples offset some of the losses.
Semiconductor makers had no such cushion. The Philadelphia Semiconductor Index closed 7% lower on Friday, falling below its 200-day moving average for the first time in a year.
Meanwhile, valuation multiples based on forecast earnings have returned to their lowest levels of the AI cycle, at around 16 times earnings.
Demand is not the problem, according to Molavi. The latest earnings reports show that Alphabet’s Google Cloud revenue doubled, Microsoft’s Azure revenue rose 48% and Amazon’s AWS revenue rose 39%, its fastest growth rate in five years.
The market’s concern is the cost of AI investment and how long it will take to pay off. Major cloud providers (hyperscalers) are turning from cash-generating machines into major consumers of liquidity, potentially for a period extending beyond a year or two.
The four largest groups generated a combined $26bn in free cash flow, a tiny fraction of the levels they had reached in the past.
At the same time, they are increasingly financing their AI investments through borrowing and share issuance, in addition to using their cash reserves. Amazon’s long-term debt has risen to $173bn from $66bn in nine months, Molavi wrote.
As the Goldman Sachs trader put it, last week the bill for AI capital expenditure came due. Investors are now focusing on returns rather than ambitions, and cash flow rather than capital expenditure.
The S&P 500 fell 0.5% on Monday, its third consecutive decline, while the Nasdaq lost 1.4% as investors continued to pull money from technology stocks at the start of the new month. The indices rose in early trading on Tuesday.
The credit market is the most pronounced warning signal, according to Molavi. The yield spread between B-rated and CCC-rated bonds reached 8 percentage points, a level recorded fewer than five times since 1996, by his count.
In every one of those instances, the S&P 500 was at least 11.5% below its 52-week high, while in two cases it was close to 30% below.
Before last week, the index was less than 2% below its high, despite the emergence of the factor that triggered the turmoil. “Friday, hold my beer,” Molavi wrote.