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We begin this hour with stocks adding to gains to kick off the first full week of the first quarter, the third quarter. Mike Wilson at Morgan Stanley writing, 'Falling energy prices, peaking tariff inflation, and contained services keep the Fed on hold rather than hiking this year. Lower real rates should support equities and further fuel the broadening trade.' I'm pleased to say that Mike joins us around the table for the next hour. He joins us for more. Mike, good morning.
Good to see you. Good morning.
Let's just start with the stability we're seeing in the rates market and how important that is to set the stage for what you're anticipating in the next few months.
Yeah, I think you were saying it earlier. I was listening to the show. There's somebody expecting a hike, somebody expecting a cut, and we're on hold. This is what we got to get used to: with the new chair, probably not giving as much guidance, he's going to allow the market to figure it out on its own and have these differing views. We're in that adjustment period now. I think that's one reason the market's been a little choppy or even correcting in the last month or so — we're getting used to this new regime, which is going to be higher volatility, potentially in the bond market. But over time, the market's going to settle down. More estimates or wider dispersion of estimates actually leads to lower volatility in pricing over time. But we're in that adjustment period. So we think rates are lower ultimately, particularly at the back end. And we've talked about this many times: new Treasury Secretary, new Fed chair, this new Fed-Treasury accord to really anchor the back end. That's what they're focused on. They've got to get the back end down or at least anchored because you have so much debt to finance.
Do you think in the meantime we're confusing a reduction in guidance with an increase in hawkishness? Just in the meantime.
Yeah, I think that's right. And the market's pricing that now. So the good news is that we've already had that adjustment. That adjustment started four months ago, right? This is why precious metals have traded really poorly. The day that Warsh was announced as a nominee, the gold market peaked, and that was a sign the dollar has been stronger. So once again, the market has really gotten ahead of this.
So rates have reset. We've come down from around 4.3% to 4.1. There's a belief this morning, at least, we've removed the urgency to hike as soon as July. So we can put that story to bed. Crude declined, massive reset crude from triple digits down to the 60s on WTI. Does that open the door within the equity market? And let's talk about the stock market exclusively. Does that open the door to the broadening trade again?
Yeah, that's our call, basically. That was happening at the beginning of the year, then we had Venezuela and then Iran. By the way, the market priced Iran before the invasion even happened or the attacks happened because it was pretty well signaled. So that's when the broadening trade stopped. The broadening trade literally stopped the day that the attacks happened and we had the big spike in oil and then the pricing of the Fed to hike rates. Since mid-May, when we reiterated the broadening call, we had a different view than most. We thought oil prices would come down, and that has allowed Fed pricing to stabilize and the broadening trade to reignite.
Small caps have performed nicely, just had a massive quarter, up by more than 20% on the Russell. We've seen the broadening trade speak to the performance we've seen in the equal weight on the S&P 500 as well. Let's talk about the Mag 7, which increasingly was called the Lag 7. You've got a note out this morning talking about maybe the money going back into the hyperscalers. Just walk us through how you're thinking about what's happening in tech and that divergence between big spending companies and the beneficiaries of all that spending and the divergence that's really widened in the last few months.
Yeah, there's a symbiotic relationship between the spenders and the beneficiaries, and typically they trade in lockstep. A couple things we've been writing about for the last several months. Number one, CapEx to sales — that particular factor has been straight up since the big beautiful bill was passed. The government is incentivizing businesses to spend money today rather than later. So that CapEx to sales factor has been driving a lot of stocks higher. That looks like it's peaking now. And by the way, the hyperscaler stocks started to trade poorly about a month and a half ago into this idea. But that's not sustainable. You can't have the spender stocks trading poorly and the beneficiary stocks continuing to go straight up. Now what we saw last week, Meta announced that perhaps they're going to sell some excess capacity, maybe turn into a provider of capacity. That is a reason for these things to take a break. Also, peak rate of change on revision breadth — the memory stocks, revisions have been spectacular, but they can only go so high. So all of that's happening at the same time. I expect the hyperscalers now to stabilize. That's what's been going on the last couple of weeks. And the semiconductor stocks are going to correct. That's a good development. It doesn't mean the CapEx cycle is over, but that ebbing and flowing between the two is a natural governing factor because you can't have this divergence continue. It's unstable.
Your words, take a break. That's interesting. Some people have called it a narrative shift for the overall trade. And maybe a shift in spending, too. Why is it one and not the other?
Well, we don't know for sure, but we've had three of these already, John. Since ChatGPT was announced in November of '22, we've had three of these mini cycles within the broader structural CapEx cycle. The market starts to question, 'Oh, the return on capital isn't good enough to support this kind of CapEx.' What happens then? The stocks trade poorly. Then the CEOs of those companies come out and say, 'Well, maybe we won't spend as aggressively.' And then it goes the other way. That's the dance back and forth. There is going to be a time, we don't know when, where the CapEx cycle will exhaust itself. And we will have malinvestment. We don't think that spending cycle is over because they just started raising capital in the credit market. So they're going to spend the capital. But we can have these mini cycles within the structural bull market of capital.
As you know though, forget the spending that's not yet happened. It's the intentions that matter. A deceleration in CapEx intentions from here. How do you think this market's going to internalize the prospect of that in the coming months?
Well, it's doing it right now. We talk about it as a peak rate of change or trough rate of change, second derivative growth. That's exactly what's going on. There are two things we're focused on. Earnings revision breadth for the semiconductor stocks themselves are like 75%. That's about as high as it goes. We've documented that. So that's going to roll over. That doesn't mean it goes negative, but the deceleration on that can cause those stocks to correct. And then the hyperscalers will benefit if the market perceives these companies as being somewhat CapEx disciplined, that they're not going to do willy-nilly spending where free cash flow goes to zero or negative. Free cash flow expectations for some of those companies are going towards zero. That's why they've underperformed. So it's back and forth. Now in the last week and a half, the hyperscalers, some of them have started to trade better. That's a good sign that we're going to have this little correction. This could last four, six, eight weeks, something like that. And then we'll probably have the next up cycle for the semis.
Are names that were in bear markets. I'm talking about Meta and Microsoft. Meta had a better week last week. Chips, you keep using this word 'correct.' When I hear that, I'm just thinking, what do you mean by that? How much is the downside? How big is the downside for some of these chip names?
