AI Concentration & the Case for Rebalancing

[00:00:00] Lizanne Saunders: I'm Lizanne Saunders, and I'm Colin Martin, and this is On Investing, an original podcast from Charles Schwab. Every week, we analyze what's happening in the markets and discuss how it might affect your investments. [00:00:23] Colin Martin: Well, hi, Lizanne. Good to see you again, back for another podcast. [00:00:26] Lizanne Saunders: Yeah, thank you. Good to see you too, Colin. [00:00:29] Colin Martin: Let's kick it off with something about AI, artificial intelligence. I mean, we talk about it a lot, but I think it's all over the headlines. I know a lot of our listeners are hearing about it. A lot of our clients are hearing about it. So you've talked about this a lot also. And in past episodes, you've talked about all this CapEx spending and how much these huge companies are investing in data centers and things like that. I'm seeing it in the bond market as well. So how is all of that affecting the weight of indexes? How is that translating into, say, market cap, things like that? And then, you know, specifically for investors, what does that mean when you're holding stocks where maybe the weights have kind of shifted? What does that look like? And what should investors consider in terms of rebalancing? [00:01:18] Lizanne Saunders: Yeah, I mean, that's a great question. I think the discipline of rebalancing doesn't get as much attention as it probably deserves. It's maybe because it's a little bit boring to talk about, whether it's on a podcast or if you and I are on a, you know, financial network. But it is such a valuable discipline. And I'll give the why and some of the mechanics of that in a minute. But let's just put some numbers on the concentration piece of it. If you take the five largest stocks in the S&P 500 by market cap, so it's the three A's, Apple, Amazon, and Alphabet, and then Microsoft and NVIDIA. That's getting pretty close to about 30% of the S&P from a cap-weighted perspective. Now, because many of those stocks have had some relative underperformance, that percentage has actually come down a little bit. So it was more than 30% at their kind of collective highs. If you take it down a level from that, the top 20 AI-related names are now pushing up toward 50% of the index. And then, of course, you can go to sort of a broader aggregate of AI-related names, bringing in everything data center-related, which carries you into sectors like industrials and into the energy sector. And you can slice and dice it a lot of ways. But when you look more broadly, you're talking about significantly hefty weights as well. And the CapEx numbers are jaw-dropping, and they change every single day. Just the top two spenders are looking at about $700 billion this year. But those numbers continue to get raised. I think this is an important couple of weeks now that we sit here in the market, because we're just about to get into the teeth of earnings season with a whole slew of the tech communications services, MAG7, AI-themed stocks, depending, again, how do you categorize them. And what I'm going to be paying attention to is the share of that spend as it relates to cash flows. Because collectively now there are subsets of the AI space where they're now spending more than their cash flows, which is why the story morphs into your world, Colin, into the corporate debt market with how that money is being raised. And what I think is really in focus right now, beyond just the concentration, is when will the payoff of all these investments be actually proven in a real quantifiable way? In the meantime, though, part of the concerns around the future spend, is there that return on investment is the reason why we've seen a lot of rotation and churn under the surface. We recently saw bear market level decline in the semiconductor stocks, which obviously had been the darlings of the AI story for a while. Prior to that, we saw just carnage in the software stocks. So I think that environment is likely to persist where the half-life of these narrative changes, these regime changes in terms of what's the shiny new object in AI and what's maybe the dull new object in AI is likely to persist. And here's where rebalancing comes in, in such an important way. Instead of trying to get ahead of these really short-term sector rotations, industry rotation, cohorts of individual stocks rotations, take advantage maybe of what I often call portfolio-based rebalancing. So a lot of rebalancing strategies that are systematic in nature, they tend to be done based on the calendar. It might be quarterly rebalancing or it might be year-end rebalancing, but when you have a lot of churn and rotation under the surface, you have really high dispersion, you have very low correlations, let your portfolio and the volatility associated with that tell you maybe when it's time to take profits in some of the winning areas, add to areas that may have had underperformance. So stay in gear by reacting, and I don't like that word when we're talking about investing, because reacting often means you're chasing winners and you're, you know, you're selling losers. This forces us to do a version of buy low, sell high, which is add low, trim high. And I think that's a great way to take advantage of this rotation without trying to guess what the next spin is going to be. But rebalancing is an exercise and a discipline across full portfolios. It's not just in the equity domain. So I want to toss back to you on the same subject, Colin, and ask about what rebalancing means and what it looks like maybe in the current environment that might be unique relative to the past. Last week, you talked a bit about short term versus long term interest rates and how the markets are forward looking. So what factors, what spread should bond investors look for in terms of adjusting portfolios, either based on what's been happening in the market or to their own risk tolerances? It's a great question. [00:06:23] Colin Martin: We talked about that last week, that there's short term, long term interest rates, bond yields. They're not always moving in the same direction. And to build on what you were talking about, there is a way to rebalance in the bond market. It doesn't mean you always need to be rebalancing. I think bond investments and fixed income investments are very different from stock and equity investments. And for a lot of investors, in a lot of instances, they're meant to be long term where you kind of buy and hold to maturity. They can be great for planning purposes. They're great strategic allocation, strategic investment, but there are still opportunities to tactically rebalance depending on what the economy is looking like, depending on what our outlook for the direction of interest rates looks like. Because when you're investing in bonds, I think the most simple way to figure out what sort of bonds should I be in is to focus on what I call the two key risks. There's a number of additional risks, but the two key risks with bond investing are interest rate risk and credit risk. Interest rate risk is the risk that a bond's price, its value will fall if interest rates rise. Because a key characteristic for bonds, it's important to understand that their prices and yields move in opposite directions. In a rising interest rate environment, that's bad for current existing bondholders because it pulls the value down. And the key measure of that interest rate sensitivity, key measure of interest rate risk is duration. And it's highly related to a bond's maturity. So the longer a maturity, the higher the duration, the more sensitive it is to those changing interest rates. So what the textbook would tell you is if interest rates are expected to rise, you probably want to focus more on short term investments. So you might not see as large of price declines. And if you have short term investments and interest rates rise, that means they're maturing more quickly so that you can reinvest in those higher yields. That's very important. And in today's environment, there's probably this idea that interest rates might be rising because the Federal Reserve may or may not hike rates later this year. It's possible. I mean, we think it's very fluid, but we think a lot of investors are probably worried about that. Well, why invest now if the Fed's going to hike rates and interest rates, I'll use my air quotes here, are all going to rise? It doesn't mean they're all going to rise. And in fact, from a rebalancing standpoint, if you're an investor in very short term investments, you can just go out a year or two and pick up maybe a quarter of a percentage point, maybe a half a percentage point, more than what's available very short term. So the way we phrase it is why wait for the Fed to hike? Because we're not sure they even will. You can earn higher yields now. So that's one way to consider rebalancing if you're holding too much in cash or very short term investments. You mentioned the word spread before, Lizanne, and that's important, too. The second risk is credit risk. That's not when will I get my money back? It's will I get my money back? And so when you borrow or lend to non-governments, non-U.S. governments, so anything other than a treasury. So if it's a corporate bond, even a municipal bond, although that varies because of tax consequences, we generally get rewarded with higher yields, and that's called the spread. It's the relative yield advantage. Right now spreads are very low, so that means we as investors aren't earning much additional yield by considering non-treasuries, whether it's an investment-grade corporate bond, a high-yield corporate bond. But we still think it's okay to take a little risk today, mainly because the economic outlook is still relatively favorable. The economy continues to grow. Corporate earnings continue to grow. Corporate fundamentals generally seem okay. There are some cracks under the surface. But if you focus on some of the higher-rated investments, whether it's investment-grade, which is ratings of triple-A down to triple-B, or even in the high-yield universe, which goes from double-B, or below, if you focus on the higher rungs of the high-yield universe, we think those fundamentals are generally okay. So from a credit risk standpoint, even though you're not earning too much additional yield, we're okay taking a little risk there. So again, if you're in cash or very short-term investments and you're waiting, and we know a lot of investors do that, we think there's opportunities, one, just to kind of move out a little bit longer in maturity because the yield curve is positively sloped, but also to maybe take a little credit risk because you are being rewarded with low but still positive spreads. Now, Lizanne, I wanted to go back to you for a question just on the whole idea of rebalancing, because this all ties in together. And I think a lot of investors, they're not sure how to do it, right? You hear about these things and it's almost like paralysis. Okay, what do I actually do? And when I was listening to your discussion about the rising tech weights and semiconductor structures, AI build out, when I hear about all these things, when I see the strong performance in the stock market, a lot of times the B word is thrown around, a bubble, and that might be a risk for investors. But rebalancing, I think, is the key. You know, if you're worried about things like that, it sounds like there's ways to be a little bit defensive as opposed to having a binary decision of own stocks or not. [00:11:24] Lizanne Saunders: Exactly. And that's a great point. And there's, you know, there's certainly hedging strategies that investors can use within their portfolio, either to ease concentration risk or do some downside protection or some protection against extreme volatility. And that's what we always say. That's what the investor needs to sit down and talk to their investment advisor, their financial consultant about. There's no cookie cutter answer. I've got the magic bullet from a hedging perspective. Rebalancing is a component of the disciplines that can be used. But there's also ways to get exposure to some of these interesting areas that are AI and AI adjacent without developing the same concentration risk in your portfolio as exists in these capitalization weighted indexes. One would be investing in equal weight, not just cap weighted. Cap weighted. So the S&P 500 equal weight index is outperforming the traditional cap weighted index on a year to date basis. There's also opportunities in smaller capital stocks. The Russell 2000 is handily outperforming the S&P 500, both the cap weight version and the equal weight version. And what I often talk about when it comes to diversification into other areas of the market versus just the cap weighted S&P is that in small caps, I think what you do want to be really mindful of is staying up in quality. Last year was a year where the non-profitable stocks within the Russell 2000, which is 40% of that index are non-profitable. That component of the Russell 2000 last year, calendar year 2025, were up 20%. The profitable components were up 10%. So double the performance by the non-profitable components. That is flip-flopped this year. We had a little bout earlier in the year where the non-profitable stocks were picking back up again. That was that phase this year where the meme stocks were all the rage again, but now we're in a backdrop where the profitable stocks are outperforming the non-profitable stocks. And another, maybe call it hack, if you want to call it that. It's not a recommendation specific to an index, but just more of an FYI because a lot of investors use indexes as just a source for ideas. It's a base of ideas that maybe you can screen at that index level. The Russell 2000, part of the reason why 40% of the stocks are not profitable, Russell doesn't use a profitability filter for that index. There's another small cap index not used as much as a benchmark. It's the S&P 600. They use a profitability filter and the S&P 600 is even outperforming the Russell 2000, which is outperforming the S&P 500. So that's just a little bit of a hack. If you're using an index as a source for just a group of stocks that you want to maybe do screening on or look into further, you get that profitability angle in an index like the S&P 600. You know, Colin, I'm not going to toss it back to you, but not on Russell 2000 versus S&P 600, but we are off next week, but next week is also a Fed meeting. So we couldn't have one of these episodes where we don't talk a little bit more about the Fed. You touched on it. But what are your lead in thoughts to the July Federal Open Market Committee meeting? And I don't know what the commonality is or how frequent it happens, but the meeting, the announcement of the two day meeting comes on July 29th. The personal consumption expenditures price index, which is the Fed's preferred inflation measure, doesn't get released until the next day. So in part, given that dynamic, what are your thoughts as it relates to this month's Fed meeting? [00:15:17] Colin Martin: Sure, if we could respond with an emoji, I think I'd do that shrugging emoji. That's not entirely true. So we don't expect a change to Fed policy next week. And as you mentioned, Lizanne, we're going to be off next week. So I think it's good to preview it here. But also we will still be publishing a commentary after the meeting next week. So you'll be able to read that a few hours after the meeting. But I don't think there'll be a change in Fed policy next week. But I'd also say we don't know. Because with Kevin Warsh as the new Fed chair, he hasn't really been very open and transparent about how he views or what his plans are and how he views the current stance of monetary policy. And there's one thing that we used to look at and the markets would point to. If we look at the Fed funds futures market, which is a market where investors all across the globe, across the world are basically making bets on where they see the Fed funds rate being over the next week, month or quarters. And we can get implied probabilities of a move at a given meeting. And there used to be this kind of unofficial rule of thumb that unless a move, whether it was a hike or a cut, was priced in by the markets, the Fed didn't really like to surprise. And they would kind of do what the markets were expecting. Or they would at least try to guide the markets to expect what they wanted to do. I don't know if that's the case anymore. So we don't expect the Fed to hike because we did get some good inflation readings earlier this month. You mentioned after the meeting, we'll get the personal consumption expenditures index. But I think we have an idea of what that might look like because a lot of the consumer price index and producer price index metrics flow into that. So I think the benign numbers we got earlier this month allow the Fed to be a little bit patient. So we're not expecting a change there. It'll be interesting to see how long the press conference is because we know that Kevin Warsh is not a fan of those. And knowing that at next week's meeting, we don't get updated projections. We don't get a new dot plot. We don't get a new look on what the committee views, the economic outlook, the labor market outlook, the inflation outlook. So Warsh isn't really going to have much to say because his task forces that he announced are still very much in the early stages. And he is not a fan of forward guidance. So he doesn't want to provide too many insights. So I'm expecting no change. That's what our team's expecting. I think we might see a shorter than expected press conference because I just don't think that Warsh is going to have much to say. Now, beyond that, our outlook has remained steady for the last few months where we do expect the Fed to remain on hold through the end of the year. But we acknowledge that the outlook is very fluid if we see a resumption of those high inflation readings. And we're starting to see oil prices rise again. So that can flow through to the inflation metrics. I do think the Fed is ready to hike rates if necessary. So even though we think they'll be in wait and see mode, they can be patient. That can change if inflation picks up a little bit. So what are your thoughts on the Fed meeting Lizanne? But more importantly, let's say the Fed does end up hiking rates later this year. What sort of impact might that have on the stock market? Because that could raise borrowing costs. [00:18:29] Lizanne Saunders: Some of it is a function of that forward guidance or maybe lack thereof or any other telegraphing that can be done. Maybe to your point, if you start to see the Fed funds futures market price in the necessity of hikes, I think it could be a bit of a volatility trigger. But the market has been able, as we've seen, to adjust to what was an easing bias and expectations thereof to now more of a hiking bias. It's just a question of what the feeder is into that changed view. If we're talking about any kind of coming serious renewed pick back up in inflation, both at the headline and core level, and unfortunately at the headline level, it seems to be in the cards given the re-escalation in the war and the move back up. In the case of Brent oil, going from about $72 to it hit $95 earlier today as we're taping that. So I think it's as much the why behind any shifts that the Fed might have to make as opposed to just those shifts. In terms of what I'm watching in the press conference, there's going to be a lot of questions asked regardless of Kevin Warsh's desire to keep the press conferences short and not say much. That doesn't mean the reporters are going to abide by that. They're going to ask a lot of questions, probably a lot of questions on the task forces. And I expect some combination of really short answers or maybe non answers. And we'll have to see whether reporters continue to do that or whether there's any kind of announcement about whether there will continue to be press conferences after every meeting. But there's also just so much data coming out in the next week or so. So we've got the initial read on second quarter gross domestic product GDP. Those now casts that are out there actually saw a bit of a deceleration in growth. And one thing I wanted to mention, I think this is an environment where you really want to look at the details of GDP reports because there's a misperception out there that all this AI spending and that it's such a big economic driver, which is absolutely valid. But a lot of the AI spending is on imports on imported products. So if a lot of spending is happening in imports, and it's not offset by a similar strength in exports, that accrues to the disadvantage of GDP because of how the math works within that index. So I just wanted everybody to be aware of that because you could see a GDP number come in fairly light. But if a big part of that is that net imports versus exports, that is not suggestive of a serious dislocation within the economy, just but just the nature of this capex spending on AI, and how much of it is imports. And then a few other things that I'm keeping an eye on, obviously that the Fed meeting, but we get personal income and spending, we already mentioned that we're going to get the PCE, we get the University of Michigan data, which is consumer sentiment, and inflation expectations. We also get the conference board's version of that, which is consumer confidence. So that's what's on my radar. How about you? Anything else on your radar beside what we've already touched on? [00:21:39] Colin Martin: No, I think you made all the key points. What I'll highlight with GDP, we get that second quarter advance estimate. I'm just in full agreement that the details matter. And we get this headline number, and markets tend to react rightly or wrongly about what it tells us. But you need to look under the surface. So investment, fixed investment clearly matters. I'm always paying attention to the consumer spending. And you mentioned that we also get that with the PCE report, we get personal income, we get personal spending, we get real personal spending. So it's important to see, is the consumer still consuming? Because we know that the consumer is the driver of the economy. Over the past quarter or two, fixed investment has been doing a lot of the heavy lifting, but we want to make sure that the consumer remains strong. That's going to be a key thing I'm paying attention to because in the first quarter, consumption was a little bit weak relative to where it's been in the past. It's expected to pick up a little bit, but that's really going to be key. Also, the first reading tends to get revised a lot, so you never know what it'll look like after another month or two. But I think it'll be good to see how the consumer is holding up. And then of course, like you said, the Fed meeting will be very important and the actual inflation numbers. I will say we get that PCE report if there is an upside surprise, because surprises can happen even though we have a general idea of what it should look like because of the CPI and the PPI. If there is an upside surprise, that would potentially shift us more closer to a rate hike down the road view. Hey, Colin, I want to just jump in with one more thing before [00:23:08] Lizanne Saunders: we wrap up because I'm glad you emphasize the word real when talking about consumer spending. That's really important in an environment where inflation, notwithstanding the recent more benign CPI and PPI readings is still a big issue. And so one of the most widely watched monthly consumer spending metrics is retail sales. Retail sales is reported in nominal terms, not in inflation adjusted terms, where a broader metric like GDP is reported in real terms. And a real world example of the differential here is if in one month you spent, you know, $50 to fill up your car at the gas station. And the next month you spent $80 to fill up your car at the gas station, solely because the price of gas has gone up. That's not a sign of stronger consumer spending. The nominal dollars were more. But in real terms, it was because you had that move up in inflation. So that's just a day to day real world because you know, gas prices are so visceral to everybody. It's often how the real world thinks about inflation, just always in a backdrop where you got elevated inflation to make sure when you're looking at any kind of economic data, you understand whether it's being reported in nominal terms or real terms. So that's it for us this week. Thanks as always for listening. As a reminder, you can keep up with us in real time on social media. I'm at Lizanne Saunders on X and LinkedIn. Continue to be wary of imposters. And actually those are the only platforms, social media platforms on on so be wary of imposters elsewhere as well. [00:24:55] Colin Martin: And I'm at Colin Martin CS on X and LinkedIn. That's Colin with two L's and the CS is for Charles Schwab. And as always, you can find all of our written reports, which include tons of charts, graphs, tables, timely insights. You can find those at schwab.com slash learn. [00:25:13] Lizanne Saunders: And if you've enjoyed the show, please consider leaving us a review on Apple podcasts, a rating on Spotify or feedback wherever you listen. And please tell a friend or more about the show. We will be back with a new episode in a couple of weeks. For important disclosures, see the show notes or visit schwab.com slash on investing, where you can also find the transcript.