Financial markets are notorious for their ability to surprise even the most seasoned investors. Time and again, we've witnessed asset prices soar to unimaginable heights or plummet to unfathomable lows, defying conventional wisdom and challenging our understanding of value.

This phenomenon underscores a critical lesson for investors: the importance of patience and a solid grounding in investment fundamentals.

Consider the current frenzy surrounding artificial intelligence (AI). As AI technologies advance at a breakneck pace, investors have flocked to companies associated with this transformative trend. In 2023, Nvidia, a leading manufacturer of AI chips, saw its stock price more than triple, pushing its market capitalization above $1 trillion. Similarly, C3.ai, an enterprise AI software provider, experienced a 300% surge in its stock price within just six months.

While the potential of AI is undeniably exciting, the extreme optimism surrounding these companies echoes past market manias.

It's reminiscent of the blockchain and cryptocurrency boom of 2017, where companies simply adding "blockchain" to their name saw their stock prices skyrocket overnight.

Or the more distant memory of the dot-com bubble, when any company with ".com" in its title could command astronomical valuations regardless of its business fundamentals.

These examples highlight the market's tendency to overreact to new information and emerging trends.

The Drivers of Return

Savvy investors understand that while sentiment can drive short-term price movements, long-term investment success is rooted in three fundamental factors:

For stocks, these components manifest as the dividend yield, earnings growth, and the price-to-earnings (P/E) ratio, respectively.

The first two elements are relatively predictable and can be researched thoroughly.

Take Microsoft, for instance. As a major player in the AI space, it has seen significant investor interest. However, its appeal goes beyond just the AI hype – the company has a strong track record of consistent earnings growth and a steadily increasing dividend, providing a solid foundation for long-term investors.

The third component – the valuation multiple – is where things often get dicey. During periods of extreme optimism, like the current AI boom, investors may be willing to pay astronomical multiples for growth potential.

For example, as of mid-2023, C3.ai was trading at a price-to-sales ratio of over 10, despite not yet achieving profitability. This valuation assumes enormous future growth and flawless execution – a risky bet in the fast-moving tech sector.

Optimism Often Turns Into Pessimism

Conversely, during times of market pessimism, even strong businesses can trade at bargain prices. We saw this during the COVID-19 market crash in March 2020, when high-quality companies across various sectors saw their stock prices halved or worse, only to rebound strongly in the following months.

The key to navigating these extremes lies in maintaining a balanced, fundamentally-based perspective on the risk and return profile of your investments.

This means doing your homework on the underlying business economics, understanding industry dynamics, and having a clear grasp of what constitutes a fair valuation.

Some Examples to Consider

Amazon: Throughout its history, the e-commerce giant has experienced numerous periods of extreme valuation swings. In the early 2000s, many investors dismissed the company as just another doomed dot-com, with the stock price plummeting below $10.

Those who understood Amazon's long-term potential and the economics of its business model were rewarded as the company grew to dominate online retail and cloud computing, with shares trading above $3,000 two decades later.

Now, Amazon is once again at the forefront of a technological revolution, heavily investing in AI to enhance its e-commerce recommendations, improve Alexa, and bolster its AWS offerings. While these initiatives are promising, investors must weigh the potential benefits against the costs and competitive landscape, rather than simply buying into the AI hype.

Cisco: On the flip side, even great companies can become dangerously overvalued. During the dot-com bubble, Cisco Systems was briefly the world's most valuable company, commanding a P/E ratio of over 100.

While Cisco remained a profitable and innovative company, it took over 15 years for its stock price to recover to its 2000 peak, underscoring the importance of not overpaying, even for quality.

The Big Picture:

• Investors experienced a pretty good 4th of July week.

• Only Real Estate and Small Caps experienced a down week.

• The big winners last week were holders of international investments especially those with exposure to equities. The US dollar experienced a down week for a change thus enhancing currency returns.

• Year to date US Large Cap Equities and Commodities remain the best-performing asset classes.

• US Small Cap Equities remain inexplicably in the dog house barely registering a year-to-date return of 0.7%

• The investment environment remains risk-on. Aggressive asset allocation strategies continue their outperformance.

Economy:

• The US economy continues to be whipsawed by changing growth and inflationary expectations.

• Both growth and inflation seem to be marginally trending down.

• Investors seemed to infer that any interest rate cut by the Fed would be further delayed. The probability of a rate cut in September is increasing but just like in Europe, monetary authorities are letting the inflation data speak for themselves.

• Among the G7 countries, the US is growing the most at the moment with only slightly higher rates of inflation. That’s a good thing!

Equities:

• US Large Cap equities were up 1.6% last week with the Russell 2000, our preferred Small Cap Index, was down 0.6%.

• International stocks had an up week with Developed Markets losing 1% and Emerging Markets down 1.5%.

• In terms of sectors, Consumer Discretionary performed best last week rebounding from deteriorating retail sales.

• The worst-performing sectors were Health Care and Energy.

• On the international front, all major markets experienced gains last week.

• The resurgence of the Japanese market continued with the MSCI Jpan index up nearly 4% for the week. The actions by the Bank of Japan in normalizing monetary policy seem to be well-received despite the ongoing depreciation of the Yen.

Bonds:

• Returns to bond investors remain significantly below historical norms.

• The asset class is currently experiencing negative sentiment and many investors remain underweight in bonds.

• We think that it’s time to go back to Neutral as the time for interest rate cuts by the Fed is coming and inflation is trending down.

• High Yield is the best-performing sub category with a 2.6% return year to date.

• Not surprisingly, long treasuries remain the worst part of the market. The 20+ Year Government Bond proxied by the TLT ETF is down 4.5% for the year.

• The best-performing strategies remain credit-focused and short-term in terms of bond maturity.

• Investors should be focused on yield as the primary source of return.

• As such the short-end of the yield curve looks more attractive than buying into long-maturity bonds.

• Credit is also more attractive than Treasuries in light of solid economic growth.

Signal Versus Noise

What’s Coming on Premium Wednesday😀 

• Asset Allocation Performance - Portfolio Implications

• Is Tech cheap or expensive? A look at some key players in the sector.

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