Two Sell-Offs Show Sector Rotation Is Afoot
The Weekend Edition is pulled from the daily Stansberry Digest.
The "rotation" out of tech continues...
Most of the Magnificent Seven have now reported their latest round of quarterly earnings. Given that these stocks make up roughly 30% of the S&P 500 Index, the results influence short-term market direction.
That sure happened after Alphabet (GOOGL) reported its second-quarter results on July 22...
On the surface, the company appears to be firing on all cylinders. Revenue jumped 24% year over year, led by Google Cloud's 82% surge in revenue.
Net income nearly quadrupled... with operating income growing roughly 30% and Alphabet's equity investments (which include Anthropic and SpaceX) growing by $98 billion.
As for Alphabet's AI business, its Gemini app now has 950 million monthly active users ("MAUs"). That makes it one of the most-used apps in the world, and only trails ChatGPT in the AI space (which just crossed more than 1 billion MAUs in May).
That's all well and good. But what investors are really focusing on is the AI capital-expenditure ("capex") forecast.
As Select Value Opportunities editor Mike Barrett explained in an article recently published on the website of our parent company MarketWise, capex was the "market-moving number" in Alphabet's earnings report.
And the stock, at least, moved. Alphabet dropped roughly 7% to its lowest level in about three months.
But as we'll explain, this was more than just one bad day. Instead, it signals a broader trend in the tech sector...
The AI Hyperscalers Can't Afford Their Spending
The reason why is simple: Alphabet entered a cash-flow deficit...
While revenue was up more than 20% year over year in the second quarter, Alphabet spent about $45 billion in capex, doubling from the same quarter last year. Meanwhile, operating cash flow was $39 billion in the quarter. That huge capex number means Alphabet is now in a free-cash-flow deficit.
As the Financial Times shared on social media platform X, it marks the first time that Alphabet has run at a cash-flow deficit...
For the full year, Alphabet is now forecasting between $195 billion and $205 billion in capex – up from its previous forecast of $180 billion to $190 billion.
On the company's earnings call, Chief Financial Officer Anat Ashkenazi said that the increase was the result of Alphabet pulling forward investment to build capacity to meet "growing demand."
But the money has to come from somewhere...
These companies can no longer cover their spending plans with the cash flow from their operations. By pursuing and building AI infrastructure, they've become much more capital-intensive businesses than they were before. So they either have to raise new debt or issue new shares – or, in the case of Alphabet, do both.
Alphabet raised $50 billion in debt over the past 12 months, and it was looking to raise $80 billion from issuing new shares.
Since these investments aren't coming from their own cash flow, hyperscalers are on shorter leashes to show the payoff from the massive capex boom.
Mr. Market was not impressed with the higher spending forecast. As we mentioned, Alphabet shares were down roughly 7% after the earnings release. Even with a rebound this week, the stock is still down around 12% from its most recent high in May.
Shares of Elon Musk's Tesla (TSLA) did even worse...
The company reported negative free cash flow for the second quarter, while its capex surged more than 140% year over year to around $5.8 billion. Tesla's stock lost more than 14% on the news.
During an earnings call with analysts, Musk put a spin on a "massive capex year" and investments in semiconductor production and development of its humanoid robot. Musk said...
I'm confident that all the things that we're investing in will yield incredible returns. Really, maybe the best capex returns that we've ever seen.
We shall see.
It looks like a troubling picture...
The Federal Reserve kept interest rates steady at its meeting this week – its second under new Fed Chair Kevin Warsh. But future Fed meetings could still be pivotal for the market. What we wrote in the July 20 Digest bears repeating...
[I]f the market has reason to believe inflation will be "sticky" for longer, expectations for interest-rate hikes will persist and maybe even grow from the roughly 50/50 odds the futures market has priced in for a hike at the Fed's September meeting.
All things being equal, a lower interest-rate environment is often a tailwind for growth stocks. But should high(er) inflation persist, and Warsh talks up a big game about fighting higher prices, money could rotate into more "boring" plays like energy, materials, certain commodities, or healthcare.
We're seeing this rotation today. At the same time, a company like Alphabet shocking people by reporting its first-ever quarter of negative cash flow could be a "canary in the AI coal mine."
But this doesn't look like a panicked market environment, either. Sure, some Big Tech stocks – which have been due for a pullback – are seeing just that. But that doesn't mean everything is headed down.
In fact, some saw share prices rise this week. Microsoft (MSFT) rose roughly 16% on Thursday after the company outlined plans for more capex while maintaining positive free cash flow in 2027.
Similarly, Amazon (AMZN) shares soared 15% on Friday as it showed its cloud business is booming more than ever before.
Fellow tech firm Meta Platforms (META), on the other hand, reported its FCF dropped more than 90% year-over-year last quarter, and its stock dropped roughly 8% after its earnings report.
Rotation is afoot...
Even after Alphabet and Tesla's stock dropped the day after earnings, for example, energy stocks were higher, but so were industrials, healthcare, and utilities. More than 200 stocks in the S&P 500 closed higher, and the equal-weight S&P 500 was only down 0.4%.
This week, the market-cap weighted indexes bounced around, with the tech-heavy Nasdaq up roughly 3% on Thursday... The market also rewarded some Big Tech firms, but not others.
When we write that the U.S. benchmark index is influenced by just a handful of giant companies "for better or worse," this recent action is what we mean. If you're worried that AI is getting overheated, there are other places to put your money.
In a blistering bull market, when everything is going up, anyone can look like a genius. But in volatile times when money is rotating around the market, true diversification and strategy matter.
That means owning shares of high-quality companies and buying them at good prices... having exposure to "boring" sectors like healthcare and "hard assets" like real estate and gold... and avoiding the bad "eggs" – like overvalued stocks trending in a bearish direction.
That's as worthy a strategy as any to limit big drawdowns and keep compounding your wealth, especially now.
All the best,
Corey McLaughlin with Nick Koziol
Editor's note: A handful of Wall Street's most powerful players are about to cash out of several household-name stocks. That's part of a major new prediction from the founder of our corporate affiliate Altimetry, Joel Litman – a 30-year Wall Street veteran who called the 2008, 2020, and 2022 financial crashes. And right now, he's revealing the one sector Wall Street is about to rotate into – but you need to act by August 12.