The New AI Trades

If you look at an index like the S B 500, you'd think it's been a quiet start to the year for U.S. stocks, but there have been seismic shifts under. with soft four stocks in particular moving dramatically. So what's behind these moves and what do they tell us about the state of this long-running bull market? I'm Allison Nathan and this is Goldman Sachs Exchanges. Today I'm sitting down with Ryan Hammond, a portfolio strategist in Goldman Sachs Research.

Ryan, welcome back to the program. Thanks for having me. So Ryan, let's start where the price action has been really volatile in recent days. Software stocks. Put some numbers around these moves. Give us some context about what we've seen.

Yeah, a group of software stocks is down about twenty-five percent to start the year. Uh some of that selling pressure started earlier than twenty twenty six. These stocks are down more than thirty percent from their highs in October. But most of the selling pressure has really occurred in the last week or two. If you think about it in a valuation context, these stocks are super popular among investors, in part because they're fast growing, high margin businesses.

But that is coming under some scrutiny from investors. And so, you know, a couple of weeks ago, these stocks traded at a forward earnings multiple of about 35 times because of those attributes. As of the latest readings they trade at about twenty times forward earnings. So a huge valuation derating.

And when you think about it relative to the rest of the market, they went from trading at a premium of more than 100% to the rest of the market to just 20% today. And if you look historically, that valuation premium is now approaching levels you reached in the global financial crisis. And so when we think about it relative to fundamentals, to us it seems like investors have gone from valuing this group of stocks.

in the fifteen to twenty percent growth range to five to ten percent growth in the span of a couple of days. It's not clear whether or not that will or will not pan out, but that's certainly what the price action is suggesting to us.

That is a major, major move. But it's not just these software stocks that have seen a lot of action in recent days. Other stocks, really for I think similar reasons, which we'll talk about, have also come under pressure. Talk to us a little bit about what other sectors are getting hit. Yeah, we've seen big selling pressure in spaces like publishing, advertising, media, legal services, IT consulting services.

You know, anything that's involved in data and services is really coming under pressure. And these are traditionally industries that have not traded with a very high correlation to the software space. And so it's clear that AI disruption risk. is really the common thread throughout a lot of these industries selling off in recent weeks. Right. But this AI disruption risk, it's been on investors' minds for some time now. So why now for these moves?

That's right. We've been discussing this with investors for many years. And, you know, we've identified a couple approximate risks that we think are are really key. Google released its Gini 3 model, which had some tools around gaming. So you saw some selling pressure among the gaming and advertising stocks. Uh following the launch there.

You then had Claude's cowork tool that had a bunch of plugins related to some of these services industries. That led to the selling pressure you saw in legal services and some of those other industries.

And even as of the last day or two, you've seen insurance companies release products that can compare insurance uh quotes. And so you've seen selling pressure in insurance companies. And so To us it seems like you're starting to see more industry specific applications be rolled out from some of these large language models that is really uh leading to investors questioning the long term sustainability of some of these business models.

Now, you know, if you think about it from an equity investor perspective Inequity is a discounted stream of future cash flows and the debate that investors are having right now is what kind of value do you assign to that terminal value, that long term terminal value for a company? Right. And our answer is we we don't know at this point, right? A lot has to happen for us to understand how that's going to evolve.

Yeah, these tools have just been rolled out. Uh still early in the timeline for adoption of those tools, their efficacy, all of these types of questions have to be resolved. But it seems to us like investors are saying these stocks traded at high valuations and have been popular for a long time. Let's reposition our portfolios first and then start to work through some of the questions at later.

And let's take a step back for a moment, Ryan, because you've done a lot of research on historical episodes around disruption. So what did you learn from that type of research that could be applicable to how we think about today? Yeah, well we're trying to help investors think through when is the right time to buy these stocks or you know where is maybe the selling pressure overdone. Uh and so we did look historically to try to find periods where you had analogs of disruption risk in markets.

The two that we identified were newspapers in the two thousands alongside the rise of the internet, and then tobacco in the nineteen nineties, related to legislation more than technological disruption, but still kind of a relevant analog. In both of those uh situations, we found two common threads: large price declines, in many cases over multiple years rather than the span of a couple of days. Uh but in terms of the forward path, it was really earnings that held the key.

the prices of those industries bottomed more closely to periods when earnings started to stabilize. You saw downward revisions to earnings in both of those episodes and only when you saw earnings estimates start to stabilize did you see prices start to recover.

I think you can tell a similar story today if you talk to our equity analysts. They similarly feel like earnings are a very important driver of the software space in the near term. We've seen it in the last couple of days. Software stocks have actually rebounded a little bit.

And there have been a couple of earnings announcements from these companies uh that have been better than feared and supported some of the price action. And so, you know, this is a broader view from our team that earnings are really key to this market in general, but I think that's also true for the disruption risk. Now The hard part is this may not be resolved in one or two quarters.

This is a multi-year debate that I think investors will be having. Uh but I think signs in earning seasons that the fundamentals are still strong I think will help assuage some investors. Right. I mean just to be perfectly clear, as long as these companies are still Delivering on earnings and growing, then investors are going to be able to have more confidence again in them. So that's what we're watching closely over the next. Several quarters.

I think that's right. I think the hard part is just the long term earnings outlook maybe under more pressure, right? That could be true for the next couple of quarters. It's really the tension between good near term fundamentals and what kind of long term fundamentals you can assume for these companies. in part because for equities, that long term value is really where a lot of the value of the equity is.

Understood. If we zoom out a little bit to the broader AI trade and theme that's been so dominant in the markets the last couple of years, it's a little bit confusing because some of the big AI centric stocks haven't been rallying this year. And it so that kind of suggests that this isn't just about investors deciding AI is going to have a bigger impact than we all expected. So when we look at the performance of these AI centric stocks, what's driving that in the recent period?

Yeah, I think after a couple of years of AI being the growth engine for SP 500 returns, broader markets, to us the AI trade just looks a lot more complicated in 2026. I think one thing that is for certain is companies are spending a lot on CapEx to fuel uh the AI build out. So, you know, to put some numbers on that, the five large public US hyperscalers

spent about four hundred billion dollars on capex last year. At the start of this year, analysts were expecting them to spend about five hundred and forty billion dollars on CapEx in twenty twenty six. A further increase in spending, large dollar amounts, but a slowing growth rate.

Following earnings season, where you had a couple of these companies announce big upside surprises to their capex numbers, that estimate is up to$660 billion. So you've added$120 billion of incremental capex expectations in the span of a couple of weeks. The growth rate is now sixty percent in twenty twenty six rather than thirty five percent at the start of the year, based on analyst expectations.

Our view is there's probably room for those numbers to keep going up. These companies continue to message that they plan to invest. They have very uh strong balance sheets and cash flow generation and there are many supply constraints out there that is constraining some of that spending. But I think

Point number one is a lot of spending is happening. The hard part is the stock price reactions to those announcements was very disparate, right? You saw all of these companies saw their CapEx numbers go up. But you saw some stocks go up ten percent, some stocks go down ten percent, and some stocks basically stay flat on the day of the an announcements. So why is that?

To us, that's because investors are taking a closer look at monetization of AI and the fundamentals of the underlying business. So You know, if a company was able to message to investors that they are monetizing AI, that could be through their cloud business, that could be through their ad business, then those stocks responded favorably because investors have confidence in uh the return on that investment.

if you saw some pressure in those estimates for those businesses or their sales or earnings, then you saw those companies come down. And so To us, it looks like the group is just going to be have a lot more dispersion within the group. No longer is it going to be one big group of stocks powering the index higher. You will see periods where some stocks are doing better or worse than others.

And again for us it's really how is CapEx translating into revenues and earnings for these companies, I think that will determine uh which stocks are benefiting uh from this the most. And is there an aspect as well in terms of how is that CapEx being funded? Because we are hearing reports that more and more is coming through leverage and debt.

Yeah, I think the good news is for a long time, uh these companies were cash flow-rich companies that were generating very strong cash flows in their underlying businesses that could afford to spend on this capex related to the AI build-out.

As we get to 2026 and these numbers have come up a lot, I think that story is coming under a little bit of pressure. If you look at 2026 estimates, based on the level of CapEx and cash flows that analysts are forecasting through these companies, it's expected to reach about ninety percent of their cash flows from operations that they're generating.

They still have cash on the balance sheet, but you're getting to territory where it's exhausting a lot of their cash flows from their underlying businesses. And so you have seen headlines of more debt issuance. You know, they pulled back on some of their other uses of cash like buyback.

And this will be a theme going forward. I think the good news for for markets as a whole is corporate and consumer balance sheets remain very strong. Even these companies have very, very strong balance sheets, effectively no leverage on their balance sheets to start. with a few exceptions uh among the group. But yeah, I think how you're monetizing it, how you're funding it, all of that will lead to a lot of dispersion at the top of the index.

So if we think about the rally broadly in like cyclical stocks that's also occurring amid all of this, is there just sort of a rotation going on? How do you explain the overall performance of the SP 500 amid all of this volatility?

Yeah, I think the hard part is the sell-off in some of the software names and AI disruption risk comes at a time when investors were already looking to own other parts of the market besides those leading companies that have done well for so many years. So We would say the defining word of the twenty twenty six market so far has been broadening. You can see that in the outperformance of non US equities versus US equities.

small caps doing better than large caps for the first time in a while, uh and and cyclicals doing better than defensives. And Our view is there's a good macro reason for that broadening. Economists here at Goldman are forecasting that economic growth will accelerate in the first part of 2026 as you get a fading headwind from tariffs. Building tailwinds from financial conditions and fiscal policy. All of that will lead to above trend, above consensus, accelerating economic growth.

And that is good for cyclical parts of the market that for a long time have not really been the ones driving markets higher. And so, you know, pockets of the market like consumer discretionary companies or uh transports or some of the industrial complex, those stocks are really driving markets higher.

And we think there's probably room for that to continue if the macroenvironment continues to be friendly. So you have kind of this confluence of factors happening at the same time that lead to some of these rotations under the hood of the index. So putting this all together, what does this really tell us about the US bull market? Can it last? I mean you think it can.

Yeah, so uh if you look at our S P five hundred index level forecasts, we do have further upside to the index from here, but the magnitude of returns relative to the past couple of years is starting to get smaller. The underpinning for our forecast is earnings, right? Valuations are very high relative to history. We think those are mostly supported by the macro and fundamental outlook for these companies.

But we think multiples will stay roughly flat around current levels and instead earnings will be the thing driving markets higher. And so the good news is as we leave fourth quarter earnings season, we feel very confident in the earnings outlook for large cap US companies. You know, if you look at fourth quarter earnings, they're on track to grow by about 12 percent. You've had four consecutive quarters of double digit earnings growth for the index.

Even if you take out the largest companies, the median company is growing earnings by about nine percent in the fourth quarter. So very healthy earnings growth for most companies in the index, even outside of the AI trade. should give you a very strong underpinning for continued equity market upside. But high multiples,

high concentration, all of that means the starting point is one where uh the bar is a little bit higher for big gains to the equity market. And so we do think you'll see further upside, but at a slowing pace relative to the past couple of years.

And I think this rotation and dispersion at the top of the index I think is one reason to to believe that's probably going to continue. You can have companies come into the top of the index that are not there today, companies may drop out, but the dynamism of the S P five hundred, we think Should continue to lead to some modest upside from here. Thanks for having me. And thank you for listening to this episode of Goldman Sachs Exchange.

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