When a momentum-driven, theme-based bull market begins to falter, even the most die-hard trend chasers eventually turn to what they perceive as value.
And as the trend reversal builds downside momentum, the first order of business is often a flight to safety, with investors raising cash or rotating into traditionally defensive sectors such as consumer staples, utilities and healthcare.
But once that defensive rotation becomes crowded—and even the so-called safe havens begin to look expensive—investors increasingly shift their focus from safety to valuation. That’s when value investing tends to move to the forefront, as the search for genuinely underpriced stocks begins in earnest.
In a sign that the AI bullish trend reversal could be paving the way for a shift toward both a defensive and a value-oriented posture, Tuesday’s (July 28) issue of the Financial Times carried this warning: “Hedge funds face demands to stump up collateral as AI stocks tumble.”
The gist of the story is that the recent correction in AI stocks isn’t just causing paper losses—it’s triggering what many analysts fear is a classic deleveraging cycle among hedge funds. After the rapid build-out in AI exposure among such funds in the first half of this year, this summer’s sell-off of big AI-related names (particularly semiconductor, memory, networking and infrastructure companies), margin calls have lately increased for the hedge funds most heavily exposed to such stocks.
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As a result of the margin calls, many funds have been forced to sell stocks to raise cash, in turn increasing downside momentum in these equities. Moreover, there’s a possibility that if margin demands persist, funds may also be forced to liquidate assets beyond just AI—including energy stocks, Treasuries or credit positions—to meet collateral requirements.
Scary though this development may sound (and FT’s tone was more concerned than it was reassuring), it’s important to note that the average hedge fund remains up 10% for the year to date despite the recent unwinding of certain aspects of the AI trade, so it can hardly be considered an existential crisis.
Market liquidity, moreover, remains strong enough, based on my assessment, to prevent the AI unwind from creating a massive spillover effect across the entire market. (In other words, a bear market is likely to be averted.)
On this score, most of the indicators I use to measure market liquidity point to a current state of health in terms of money and credit availability. For instance, the iShares High Yield Corporate Bond Index (HYG), which is one of the more widely used indicators for credit sentiment, is still showing a fairly healthy backdrop for corporate bonds, in turn supporting broad market liquidity.
Additionally, the Financial Times recently noted that despite continued worries over the private credit market, investment banks and advisory boutiques continue to hire senior bankers with private-credit expertise, alongside AI and energy specialists, showing that they view private credit from a bullish perspective rather than a business to exit.
Another point worth making is that it’s widely believed—and not without good reason—that liquidity is partly a function of investor confidence. A relatively low-participation environment, like the one we’re seeing this summer, means stocks are more vulnerable to pullbacks due to the recent lack of strong buying activity.
Against this backdrop, the ability of the market to quickly rebound from a decline depends on investors’ willingness to step in and “buy the dip” in such cases. I’d say there’s enough recent evidence to support the view that investor confidence in the overall bull market remains fairly strong despite the recent weakness in semiconductor stocks and other areas of the tech sector.
But while the AI trade still shows signs of petering out (at least in the near term), I’ve noticed that a growing number of participants are already starting the search for value-oriented names. Indeed, a rotation of sorts appears to be underway as the enthusiasm for high-multiple AI names rapidly dissipates. And though it’s not yet a full-on flight to value, the steps in this direction are conspicuous enough, along with a broadening of leadership in certain value-oriented areas.
If you’re looking for deeper value to replace exposure to the richly valued tech sector (or at least large parts of it), might I suggest starting with the traditionally defensive healthcare sector? There are to be found in it a fairly large number of attractive deep-value, and even turnaround-oriented, companies in this space.
Indeed, many biopharma names and managed-care firms have outperformed several leading high-growth tech stocks during the recent pullback. Overall, the sector combines reasonable valuations with fairly defensive earnings characteristics.
Consumer discretionary is also showing a surprising resilience this summer as the rotation from growth to value advances, with more than a few companies in this space executing restructuring plans right now (of special interest for turnaround-focused investors like us).
And while not especially cheap, many consumer staples stocks (another key defensive sector) have attracted investors willing to pay up for stable earnings and dependable cash flows.
Finally, there’s still value to be found in some precious metals mining companies—especially after the recent correction in this segment of the market. Bolstering the outlook for the miners is the ongoing central-bank purchases, which continue at a robust pace this year.
We have exposure to each of the aforementioned market spaces in the Cabot Turnaround Letter, with some of the relevant stocks in our portfolio showing double- or even triple-digit gains.
What’s more, our recent focus in the newsletter is to find deep value in under-the-radar areas of the market that are being ignored by most investors, while also avoiding overexposure to the more popular segments. So, if you’re interested in finding value, consider letting Cabot Turnaround Letter serve as your guide.
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