In the year 2023, a wave of enthusiasm regarding artificial intelligence (AI) has catalyzed a remarkable surge in the stock marketInvestor fervor has led to a bullish atmosphere, suggesting a promising outlook for companies harnessing the capabilities of AIHowever, amidst this excitement, it is crucial for investors to maintain a disciplined approach, ensuring long-term perspectives overshadow the fleeting attractions of immediate gains.

Throughout the second quarter of this year, stock markets globally experienced an uptrend, largely driven by a select group of companies perceived as front-runners in the ongoing AI revolutionBeneath this surface, though, lies a necessity to uncover companies with robust profitability profilesThese resilient firms could potentially safeguard investment portfolios against adversities that loom in the coming economic landscape.

Recent technological enthusiasm has obscured concerns regarding interest rates, inflation, and the possibility of economic downturnsThe stock market managed to shake off these risks as evidenced by the MSCI ACWI Index, which recorded a gain of 6.6% in the second quarter alone, contributing to a commendable first-half increase of 14%. Yet, returns varied significantly across regions, with Europe, emerging markets, and China laggingNotably, the Japanese stock market showed gains, buoyed by corporate governance reforms and a weakening yenIn the U.S., the technology sector surged, ignited by optimism surrounding breakthroughs in AI technology, resulting in significant upticks in indices like the S&P 500 and NasdaqThe momentum in American stocks positively influenced global growth stocks, fueling an exceptional performance in the quarter.

From a sectoral standpoint, technology stocks and consumer discretionary shares led the charge in the global markets

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Meanwhile, materials and utilities faced declines, and the energy sector struggled due to falling oil prices.

A Select Few Stocks Dominated Q2 Gains

In the first half of 2023, just ten U.S. stocks accounted for a staggering 79% of the rise in the S&P 500 and 54% of the gains in the MSCI global indexProminent names like NVIDIA, Microsoft, Apple, and Alphabet Inc. emerged as unambiguous beneficiaries of the productivity transformation spurred by generative AIAmong these, NVIDIA displayed the most robust overall returns, being the leading manufacturer of GPUs deemed essential for the AI revolution.

But why did the performance of these stocks starkly eclipse that of others in the market? A principal reason lies in investors grappling with the Federal Reserve's (Fed) appetite for slowing economic growth, amplifying concerns about earnings sustainabilityWinners within the AI space have garnered especial favor as they are deemed to possess structural growth engines capable of weathering macroeconomic difficulties with comparative ease.

Indeed, those holding shares in these companies have substantially benefited from this trendConversely, portfolios lacking exposure to such stocks have seen lackluster performance relative to the marketThis concentration, however, poses a risk; should valuations reach unsustainable heights and market sentiment shift, those heavily invested in this small set could face significant lossesAlthough the potential of AI presents genuine hope, we assert that every related company deserves evaluation through its broader fundamentals and values, aligning their positioning with portfolio investment philosophies and risk management frameworks

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Even growth-focused portfolios should benefit from exposure to diverse stocks across less correlated industries.

Selecting Companies with Long-Term Earnings Outperformance

In contemplating bottom-up earnings prospects alongside top-down economic anxieties, aside from the darlings of AI, other sectors in the market may present opportunities exceeding common expectations.

As we reach mid-year, investors' perspectives on corporate prospects continue to be tainted by recession fears, a sentiment that is understandableIn mid-June, an unexpected hawkish revelation from the Fed maintained rates while implying two potential hikes within the yearGiven the robust labor market, stabilized banking sector, and resilient economic growth, Fed Chair Jay Powell concluded that current restrictive conditions remain insufficient to revert inflation rates to target levels.

In Europe, inflation has proven stubbornly challenging, with interest rates continuing their ascentConsequently, key manufacturing indicators remain weakSimultaneously, China's economic recovery process has been lethargic, with a faltering real estate market no longer stimulating growth.

Within this context, investors face a critical question: to what extent do earnings forecasts align with economic expectations? A year prior, amid pervasive anticipation of economic weakness, earnings prospects appeared overly optimistic

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However, over the last twelve months, earnings forecasts for many sectors in 2023 have dramatically declined, particularly in the U.S.

Of course, earnings expectations can be subject to further revisionStill, indications suggest that profits for U.S. corporates may be near a nadirOutside of the U.S., while the extent of earnings revisions has been modest, conditions vary significantly across sectorsFinancials, for instance, could benefit in a rising interest rate milieu, while commodities remain highly sensitive to economic vicissitudes.

Today's market presents abundant opportunities to invest in stocks less affected by macroeconomic cyclesFor instance, in the U.S., only 35% of the weight of the S&P 500 Index is allocated to cyclical sectors such as financials, industrials, and energy—down from 58% in 1998. In contrast, the sector composition in European markets has remained relatively stableHowever, in emerging markets, there appears to be a shift toward technology.

The stock market remains susceptible to economic cycles and geopolitical risksConsequently, we believe that a long-term perspective could be beneficialOur research indicates that current global long-term earnings forecasts—spanning three to five years ahead—are considerably below long-term averagesThis suggests that stocks from companies outperforming current expectations may have significant upside potentialIn essence, should long-term earnings consistently exceed current expectations, we find today’s valuations potentially attractive.

At first glance, after a year of gains, the U.S. market's valuations appear relatively high

By the close of Q2, the S&P 500's price-to-earnings ratio (2024E) had surged to 17.7, up from 14.9 at the year's beginningHowever, excluding the top-performing ten companies presents a more reasonable P/E ratio of 15.3, with expected earnings growth for 2024 at 9.9%. Historically, the valuation premium for the top ten U.S. stocks is also notably elevatedWe maintain that discerning investors can locate stocks with attractive valuations and robust growth prospects by casting a wider net within global stock markets.

Indeed, should inflation rates subside and central banks maintain elevated interest rates over extended periods, real interest rates could turn positive, potentially exerting pressure on stock valuationsWe believe that attractive stock valuations coupled with strong long-term earnings prospects will provide an optimal balance of risk and reward throughout this complex transition.

Early Stars of the Disruptive Revolution May Not Be Long-Term Winners

The hype surrounding AI has propelled U.S. stock market valuations, reflecting the fundamental challenges investors now face.

Excitement regarding AI has permeated many sectorsFollowing the launch of ChatGPT in November 2022, the application garnered approximately 100 million users within just two monthsAccording to our stock data science team's research, 317 companies in the MSCI global index mentioned AI, ChatGPT, or related terms during Q1 earnings callsOur team analyzed over 2,000 earnings call transcripts worldwide

Although AI is predominantly referenced by tech companies, it has also become a trending topic across diverse fields, from consumer discretionary to industrial sectors.

Clearly, businesses are beginning to seriously contemplate how to leverage AI—asset management included—for efficiency gainsHowever, discerning which companies and products will lead the competition within AI will take timeThe early stars of this disruptive revolution may not necessarily emerge as long-term winners.

The internet bubble serves as a cautionary taleDuring the early days of the internet, companies like AOL and Netscape dominated the emerging landscape, only to quickly fade from prominenceInvestors anxious about missing out on the tech gold rush saw a barrage of internet startups emergeWhen the bubble burst, many unwittingly caught in the irrational exuberance incurred significant losses.

However, over time, the internet undeniably brought about revolutionary changesIt reshaped our world, spawning new industries and large corporate leadersAI too may inject vitality into both tech and other sectors, with many companies poised to discuss how they plan to utilize or deliver AI-driven productsIn the initial wave, tech enablers—the so-called miners and shovel manufacturers—will likely thriveYet, these companies often struggle to achieve profits from this technologyIn certain scenarios, if AI-driven products are commercialized, individual company profit gains might be erodedWhile some AI technology proponents may warrant lofty valuations, we caution investors to remain vigilant when forecasting the widespread commercial implications of AI.

Active investors should always remain focused on a company's core business

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