Talk Your Book: Consternation About Concentration

0:00Ben Carlson:Today's Animal Spirits Talk, your book, is brought to you by State Street. Go to statestreet.com slash IM to learn more about the original OG, ETF, SPY. Also check out Uncommon Sense for all the research insights. That's statestreet.com slash IM to learn more. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:39Ben Carlson:Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:47Ben Carlson:Welcome to Animal Spirits with Michael and Ben. Returning guest, Michael Aroni, Chief Investment Strategist at State Street Investment Management. I feel like we could just wind him up and let him go but we talked about everything going on in the market today winners, losers, AI it's funny, we didn't get into geopolitics until 60 % of the way through our conversation I feel like which is kind of surprising these days because that's all anyone cares about except for maybe the market I think the most interesting thing is the fact that earnings estimates just keep going up and want nothing to do with what's going on in the Middle East don't care I guess as long as companies keep making money, the market won't care.

1:25Michael Batnick:We had our earnings from Goldman this morning. And David Solomon said, we're only a couple of weeks into the quarter, but the quarter started with very significant engagement across all aspects of the business. The quarter started in a positive way. We'll see. The level of certainty is higher. But at the moment, the engagement is pretty high. And we're seeing that. I mean, it's early. But you heard that from Delta. And of course, they're wildly exposed to higher jet fuel. And the market is looking forward past it. Corporations are looking past it. and the market's been right so far. Yeah.

1:55Ben Carlson:So we had to throw a bunch of questions to Michael about like, what are the risks? Give us the actual risks that could derail this thing because nothing seems to be able to derail.

2:02Michael Batnick:Nail the top, please.

2:04Ben Carlson:Yeah. So we got into all that and more. A little history on the ETF game. Here's our talk with Michael Aroni from State Street.

2:14Michael Batnick:Michael, it was always great to see you. Good to see you, Michael. Good to see you, Ben. I saw a tweet from Bouchounis this morning. ETFs as a group set a quarterly record with 22 trillion worth of shares traded in Q1. March was also the biggest volume month ever. Volume is on pace to beat last year's record by 50%. Really is an incredible moment for the ETF industry. SPY, Spy, needs no introduction, was there from the beginning. I think it was the first ETF launched in 1993, correct me if I'm wrong. Do you remember where you were? What do you think about the early days of the ETF industry when this thing was launched?

2:58Michael Batnick:You were probably in high school, actually. Forgive me. No, no. I graduated high school. I was in college, actually. So I was probably a sophomore at Bentley College. It's now Bentley University back in 1993. So I probably wasn't thinking too much about the ETF industry and SPY at that point. But certainly from our perspective, again, way back then, if you wanted to own the S &P 500, you had to buy all 500 stocks or a mutual fund. And neither were particularly convenient or accessible from that perspective. And so, of course, since that time frame, as you're highlighting, the ETF industry has grown to more than$13 trillion in the US, more than$20 trillion globally.

3:37And Michael, you were mentioning those stats. This is the quickest point we've reached up to$500 billion in new flows, the fastest in a new year ever. That's coming off of records in 2024 and 2025. And that's for the industry. Let me be clear, that's not just for SPY or for SPY, but this is the fastest the industry's gotten to half a trillion dollars in just the first few months of the year. Adoption continues to be incredible.

4:05Ben Carlson:If you had to try to narrow it down, how much of this is just cannibalization of current funds, like money's coming over from mutual funds or individual stocks or whatever, as people go to advisors or just go on their own and try to make allocations easier versus new money? Do you have any sense of that? How much is new money versus how much is just money that's already been invested in different vehicles? It's hard to quantify, but I do think it's clear that the mutual fund industry itself, in terms of the assets have been falling. That's no secret from that perspective. And investors have voted with their feet.

4:37And they voted to take to the ETF in terms of its low cost, its liquidity, its transparency, accessibility, its tradability, all those types of things. But in terms of kind of new money, I think there's kind of an intersection of a few things. Certainly, as we move from a more commission-based wealth management platform to one that's more goals-based financial planning. The wealth management community, the RIA community, the broker-dealer community has adopted ETFs enthusiastically. And ultimately, you're seeing, I think that is where a lot of the new money continues to come from. And Ben, when we look at the breakdown in terms of where is new money coming from in terms of assets generally, whether we look at like US wealth or institutional, defined benefit, defined contribution, these types of things, retail investor, the US wealth community continues to be the fastest growing pool of assets and they are the biggest adopters of the ETF.

5:38So I think it's fair to say it is a balance, but I think that given the incredible kind of creation of wealth and the growth in the wealth management, US wealth management industry, a lot of this is coming from new money.

5:52Michael Batnick:So obviously a combination of money, coming, rolling out of the 401k into the IRA, getting out of the funds. The mutual funds are going to the ETFs as part of it. There's a lot of new money still coming to the market. I'm flabbergasted every time we hear these numbers. I'm like, because of the acceleration, it's not just the staggering amounts, it's the acceleration. But getting to SPY and the market generally, there has been a lot of concern, anxiety, consternation, whatever you want to, however you want to describe it, about the concentration in the market and the lack of participation from the 493.

6:34Michael Batnick:And there was a lot of people over the last couple of years saying, if the engine of the MAG-7 slows down or stalls or heaven forbid goes in reverse, watch out below. It just did not come to pass. In fact, the opposite is true. Yeah, the MAG7 had a terrible quarter. They were down 16 % year to date at the lows in April. They've rebounded since, but they're down 7 % on the year. And the S &P is flat. Obviously, the 493 is up. Can you talk about the dynamic of the incredible rotation that we're seeing? Seemingly on a day-to-day basis, like we're recording on Monday, April 13th, and software is having an incredible day.

7:15Michael Batnick:Now, it had an incredibly bad three-day stretch. Like in particular, there was a puke last week. But alternative asset managers nobody wants to own, and they're bouncing bigly today along with software. And it just seems like it's happening. Every day, there's a new leadership group. And of course, if you zoom out, there's things that have worked over a longer period of time outside of the intraday stuff. But the rotation inside of the index is really incredible. It's been phenomenal. And it actually started, Michael, back in November of last year, I think, is really when the AI bubble fears, the fears around whether all this hyperscale or capital expenditures were going to achieve the return on investment.

7:57Would businesses and consumers, you know, what is the rate of adoption for AI? Like, what use cases are we going to use? All that began to come under question. And of course, we would have seen it reflected through kind of examples like Oracle increasing its CapEx. And then ultimately, rather than funding it from operating cash flow, having to go back to the debt markets to do it, Meta increasing its CapEx and really disappointing investors. To me, it was a critical turning point. But what you're describing, the good news is, is that really from that period on, up until the US-Iran war broke out, you saw a significant shift in leadership.

8:35and the markets actually performed well in January and February. Small and mid-cap outperformed, industrials outperformed, international and emerging markets outperformed last year and in the early stages of this year. And you saw a tremendous amount of rotation. For me, I think what's driving that is there's been a clear kind of shift in the underlying market dynamics. And what I mean by that is really if the kind of environment has been driven by globalization, by efficiency, by global trade, free trade, by this notion of global cooperation, peacetime dividend, low rates, benign inflation. If all of that, I think, is kind of slowly churning under the kind of the system here, and now we're moving to a more deglobalized framework where it's kind of, you know, we're remaking the global trading system.

9:34Of course, there's been more geopolitical risk, higher rates, stickier inflation. So we're moving from efficiency to resiliency. and through that transition, you're seeing a rotation in leadership and you're seeing kind of real assets and gold and industrials, energy, materials. It's exciting. These are the leadership and I think ultimately that structural underpinning is what's changing now and really leading to kind of this dynamic. And I think a lot of times investors lose sight of that. Like we focus on what's happening day to day and we're kind of losing sight of the fact. And I don't care, Michael, if you go back to whether it's 2016 and it was Trump and Brexit, whether it was the pandemic in terms of its kind of exposing what global supply chains look like, or if it's kind of the trade war, all of these things have led to a real shift in the underlying investment environment.

10:30And I think as a result, you're seeing some real differentiation amongst winners and losers and a real rotation now that's got some legs to it.

10:38Ben Carlson:I think the loser piece is the most interesting to me because typically when there's a new innovation like this, all investors want to do is find out what's the big winner going to be, right? And it seems like this cycle for AI has been who are the losers going to be. So Michael mentioned software. That's the one everyone's focusing on. I'm looking at, even today, like consulting firms, Booz Allen and Accenture and Gartner. They're down like 50, 60, 70%. And I just think, I don't remember a time like this when there was such a fast re-rating for the losers. I've seen it for the winners before.

11:11Ben Carlson:But the separation among people trying to figure out what is AI going to disrupt in terms of making losers, that to me seems like a new part of this kind of cycle. But I think it's an incredibly healthy part of the cycle, Ben. And I think it's an important part of the cycle. Not if you're on those stocks. Well, yeah, I hear you. Well, what can I tell you? I do think that this is a critical transition point in the CapEx cycle that I believe began back in November and is continuing to unwind. And I think naively back in the early stages of the AI phenomenon, markets kind of believed that everyone was going to be a winner.

11:46And that's not how capitalism works. We know that. So of course, out on the horizon, there's these exceptional returns. and all of this capex is chasing that potential. I think where we are now in the cycle is investors have come to realize that some of that, dare I say, most of that will be spent wastefully and only a small portion of it will be spent productively. And now I think we're trying to determine those winners and losers. The one I've been kind of using as an example, Ben, is that back in the TMT bubble days, right? It's our most recent corollary. You have the four horsemen, and I think you could probably add a fifth.

12:29It was Cisco, it was Dell, Microsoft, Intel, and you could probably add Nortel networks. Now, Michael, if we think about that list, only one of those companies has really reinvented itself and added value to shareholders. Four of them continue to struggle to this day to recoup those highs. I think we're in the part of the cycle for AI now where that is happening. And I think it's a healthy transition. We can't all be winners. There will be winners and losers. And I think the market is trying to find that out. And given where valuations were, I think ultimately they're kind of selling first and asking questions later.

13:11But I think they're laying the groundwork for kind of ultimately who will be the next winners. And we'll see. This is creating a great deal of opportunity, in my opinion, for those that could get this right.

13:22Michael Batnick:Over the last couple of years, we've played this game from time to time, like, which Mag7 stock would you least want to own? And sometimes you could throw out Apple, like, I just think, you know, whatever, why are they so expensive? Or you could throw out Meta, whatever. And I had always been on the side of, I know what history says. I know that the names at the top 10 do not persist from decade to decade. But we've been having this conversation about these hyperscalers for so long. They've continued to reinvent themselves because there's no precedent in history to these names. They're not AT &T.

13:58Michael Batnick:They're not General Electric. I understand those are big companies. But these are monopolies. They're conglomerates. They just buy all their competition. They just seem impenetrable. And of course, I couldn't see. and the story is still being written, but I couldn't see the AI thing coming and the transition from asset light to asset heavy. I saw a chart this morning from Bank of America showing that a lot of these companies are projected to spend 90 % of their operating cashflow on CapEx. Of course, that's a moving target, but let's just say it's directionally correct. Investors don't like that.

14:37Michael Batnick:And you're seeing that. You're seeing the rotation away from these names. Yeah, absolutely. And so we were joking around up front about SPY, where I was. You were teasing me saying I was in high school. You go back to 1993, and we look every five or 10 years, and we look at the top 10 names in SPY, just over that 30-plus year period, you're certainly seeing the shifts from the Ciscos, the General Electrics, the General Motors, the ExxonMobiles. There's been a number of dramatic shifts. And Michael, I think in every one of those periods, people would say, boy, these companies will never be displaced.

15:16They have a comparative advantage, a capital advantage, a structural advantage to everybody else. And yet it happens every single time. And so, you know, I kind of joke around this notion around if you think about what happened in the TMT bubble. Again, it's the most recent corollary in terms of all that spending that went on. And I've been using kind of Netflix as a little bit of the example here, where that massive amount of spending on broadband capacity ultimately laid the foundation for the new companies, the new winners. Netflix, I don't know, Ben, you and I were receiving the CDs in our mail when Netflix started.

15:57It was only the laying of all that broadband capacity and all of that bubble investing that allowed them to become the streaming giant that they are today. So all these hyperscalers are laying the foundation through all of this investment and the data center infrastructure build out for someone to come along and get that access capacity and take it in a different direction. Now, hey, I work for an ETF provider, so I'm not exactly sure who that winner and losers will be, but ultimately I'm confident that that's kind of where this cycle is heading. And in this MAG-7, there's a few Nortels, Intel's, Dell computers, and Cisco's.

16:37And there's probably only one or so Microsoft's as if we're going to use that example of kind of moving forward in terms of creating value. And I think that that will happen yet here again. And I think the market has started and investors have started to realize that. And they're kind of looking towards areas of adjacency that will benefit, like in industrials with the kind of modernization of the power grid and the investment. that's being made there for a time.

17:05Michael Batnick:It sounds like you don't think, with the caveat that, of course, we're all just guessing the best we can, it sounds like you don't think that the MAG7 will get to like 50 % of the index. I don't believe so. I think that, again, ultimately what will happen is that, and you're already seeing this happen a little bit. Early on, to your point, they were funding a lot of this investment from operating cash flow. Those dynamics are shifting, and we're seeing that kind of free cashflow margins, they were getting squeezed. And ultimately that was putting some pressure on the companies. It was the notable shift.

17:42They can't grow at these rates in perpetuity and others will seek to kind of displace them.

17:47Michael Batnick:I agree, but they have. It's so crazy that they have. We've had this conversation forever. And yes, of course, at some point, like the numbers get so big that they will just collapse on the way of themselves and not literally, But man, it's just been like a persistent conversation like this. But one of the great things about an index is that you don't have to obviously select in the winners and timing it is exceptionally difficult. But at 35 % of the weighting or whatever it is, you're going to need industries and sectors to reinvent themselves. You're going to need financials, which are a huge weighting, to pick up the slack, like energy, which I think is still less than 4%.

18:27Michael Batnick:I mean, it's had an incredible run, but you're going to need other areas of the market to see some of the benefit of the efficiencies that we're hoping are generated by this AI stuff. Yeah. And you were asking me about that rotation. So for us, we were probably a bit premature and suggesting that investors begin to think about diversifying away from that concentration, right? And I think that in many ways, that confrontation with concentration was underway since November. Remember, it really took up speed in January and February, certainly with the outbreak of the US-Iran war at the end of February and throughout the month of March year, now entering its seventh week.

19:05It has disrupted some things. But our view was that ultimately, when we looked at the 493, or we looked at small caps, or we even looked at emerging markets, what was now beginning to happen was that their earnings growth rates were closing the gap with technology in the MAG7. Now, Michael, I do think, right, as we're chatting, you mentioned you marked it April 13th. We're on the cusp of earnings season. And to your point, we're still not there yet. Technology companies are expected to deliver 45 % earnings growth here over here this quarter on revenue growth of 27%. And they trade barely above a market multiple, given some of the things, this rotation that we've chatted about.

19:48And yet in some ways, they're insulated from inflation and higher rates and geopolitical risk, not completely. And so at a time when growth is slowing, boy, technology is starting to look a little bit more attractive. And interestingly enough, we just upgraded in our sector work. So despite my concerns long term, like any good strategist, Michael and Ben, I could talk out of both sides of my mouth. Some of my concerns about the MAG-7, I certainly think at least today in an environment with sticky inflation, geopolitical risk, slowing economic growth, getting that kind of assured growth rate on the earnings growth side and the revenue growth side and paying roughly a market multiple for it.

20:34that doesn't seem like too bad of a trade-off, at least in the here and now.

20:39Ben Carlson:So do you think that the earnings story in AI is the reason that investors haven't really freaked out about the geopolitical situation? Because we had a minor correction. But I've been telling Michael for a while that it seems like most investors would have assumed if you would have given them the setup of war in the Middle East, oil supply and demand dynamics totally messed up, and oil shooting up 60 % in a couple months or whatever, that would have had a much bigger impact on the markets. And the market has kind of looked past it. Is it just like, hey, until we see this hit earnings, the market's not going to care as much as it would have in the past?

21:14I think that's part of it, Ben. I do think that so far when we aggregate the economic data, it doesn't paint a strong picture, but it certainly doesn't paint a picture of recession. And so I think that when we look at the earnings growth, where it's forecasted to be and likely to come in, combined with the continued business fixed investment, and by the way, AI CapEx spending is carrying the heavy load on that, it's rare for us to get an economic contraction under those two conditions. And so I think the market has largely shrugged it off from that perspective. I think also the other thing that the market has convinced itself, and this may pose the bigger risk or the biggest risk, is that this war will be measured in weeks, maybe a couple months and not in quarters in years.