Beyond AI: Following the Flow of Capital

Adam Turnquist [0:13] Welcome to LPL Market Signals. I'm Adam Turnquist, chief cross asset strategist here at LPL, and I am joined by Tom Shipp, who is head of equity research at the firm. Tom, welcome to the podcast this week.

Tom Shipp [0:26] Adam, happy to be here. Should be fun.

Adam Turnquist [0:28] Yeah, great to have you here. I really wanted to bring you in to get your perspective on the market beyond the AI trade, which often doesn't get talked about a lot, and really how the move in interest rates, the growth story, and credit are impacting your view on the fundamental setup for stocks. But before we jump into all that, let's, I guess, set the playing field a little bit for listeners. Just look at last week's price action. I think it's reflective of what we've seen play out over the last few weeks.

The S&P 500 down about half a percent, the VIX down 3%, still holding below 20, so pretty muted volatility environment, at least at the index level, but it gets a lot more interesting below the index. That's where we have a lot of moving parts. I think that's reflective in the equal weight index for the S&P 500 outperforming the S&P last week by, I think, around 1.5% or more.

Adam Turnquist [1:22] And it really seems like, as we go into earnings season here, the AI trade is on trial once again, investors rotating into other areas of the market. That's a theme we've seen play out time and time again during this bull market. It hasn't ended the bull market. But Tom, I'm curious your thoughts when you look across the equity market today, what really stands out beneath the headline indexes that we're all focused on?

Tom Shipp [1:45] And it's funny you say, "Hey, maybe we won't talk AI, but if we're just talking the inverse of the AI trade, it's we're still kind of talking AI, but — [laughs]

Adam Turnquist [1:54] It's hard to avoid. I know.

Tom Shipp [1:55] It is. It is. But I'd say one of the biggest things we've seen, if we can kind of peel back anything that's just pure positioning led, is really the market's starting to discriminate fundamentals, a little bit, at least. You know, there are plenty of good businesses outside of the AI thematic that were often treated, you know, as irrelevant or, you know, relics of the past. And but when you really dug into those companies, the fundamentals had not broken.

And now you're just starting to see, well, if there may be cracks in, you know, credit we'll talk about or, you know, worries about the free cash flow conversion of the hyperscaler level or all the CapEx spend. It definitely, the past, you know, several weeks have felt like investors have started to look at, you know, some of these names that maybe had been ignored for a while.

Tom Shipp [2:49] And, you know, it's where we, you know, as, you know, portfolio managers of diversified stock funds, like, yeah, we have our AI stocks and our AI related stuff, but we have, we look at names across, you know, the whole economy. And so it's always nice to see the market kind of confirming things that you've been looking at.

But yeah, there's definitely been a lot of underneath the hood, and all year I think we've been saying that is, oh, well, the index looks calm, but underneath the hood, a lot's going on. Well, this last past few weeks has really shown that in spades. So yeah, I think that's the higher quality names, cash generative businesses that aren't necessarily, you know, relying on, you know, debt or equity financing to continue the growth, right?

Tom Shipp [3:45] Just businesses that are turning along and doing their thing is really some of the stuff that I think investors have started to come back around to.

Adam Turnquist [3:53] Right. So maybe getting back to the basics, and I know that's music to your ears as someone deep in the weeds of fundamental bottom-up analysis. I guess the question from the market, at least, that I'm looking at the market from my perspective is really what's attracting the capital now, and I think more importantly, is that improvement or rotation going to last? Is there some durability to this, we'll call it the non-AI trade?

Tom Shipp [4:23] Yeah. So, I mean, just for, from the first question, like, what's attracting capital now, you know, here at LPL, we look at a lot of different sources, whether it's, you know, sell-side commentary, whether it's, you know, alternative data or third party data providers on looking at where sentiment's going or where flows are going. And it's been a pretty defensive kind of bid to, from a sector perspective, which we've seen utilities, we've seen energy, we've seen healthcare kind of attracting a bit of a bid.

And then from the style or, you know, factor standpoint, interestingly enough, you know, month to date, some of the data we're looking at has seen growth and, you know, attracting the most capital. And where I think that can be confusing is how is it defined or, what have you, but it also makes sense, right?

Tom Shipp [5:16] If there's companies that have long histories of steady growth, they would, you know, be considered growth companies. And maybe that's where folks are starting to look because, hey, we want something that's going to kind of grow despite any other cyclical headwinds.

And I think that much of the AI trade is kind of both secular and cyclical because of the financing needs and the infrastructure build out and the bottlenecks and all these very cyclical type things that are involved with it. You know, if you find a, whether it's a software business or, you know, an insurer or something that's got just kind of pretty steady Eddie recurring revenue with a, you know, a nice, maybe not, you know, shooting the lights out growth number, but a good enough growth number, like, that would be considered a growth stock by many of these indexes, and I could see where that would be attracting capital.

Tom Shipp [6:09] Now, to your point on, is the improvement in these businesses good enough to last? I mean, we're just getting through earnings season. We haven't seen much to say that they're getting better or really getting worse.

And some of these kind of non-AI, most all the, you know, data providers and Wall Street banks put out baskets of, you know, S&P ex AI or, you know, even just look at the equal weight and haven't really seen anything to kind of confirm or deny like, oh, the economy's slowing down or, oh, more capital's moving outside of AI in terms of fundamental strength. But yeah, I think that's what we're really looking out for during this earnings season is to, both from the AI names and the ex-AI names, or non-AI names, if you will, what the fundamental backdrop is looking like.

Tom Shipp [7:03] So I think it's, you know, will it last? It will depend on the fundamentals. It'll be earnings led. What kind of growth, what kind of guidance are we seeing out of some of those companies? So, you know, jury's still out on it.

Adam Turnquist [7:17] Right, and it seems like the market maybe pricing in a scarcity premium on the growth factor in terms of what we witnessed really last week, or I guess the last two weeks, almost a narrative change, I think, in the market as investors seemingly became a little more concerned about downside risk to growth versus upside risk to inflation.

It was pretty clear in the macro data. You look at interest rates falling for three straight weeks and pretty big moves across the curve just last week, while oil and energy markets are higher, I think, for the last three or four weeks, WTI and Brent trading at, I think, multi-month highs on Friday as rates fall. So it certainly seems to be a new correlation developing between yields and interest rates. We're getting into, I guess, the heart of earnings season here.

Adam Turnquist [8:09] Have you heard a lot on the corporate commentary side validating some of those growth concerns that are getting priced into the market, or at least are earnings expectations changing at all?

Tom Shipp [8:21] Yeah, not explicitly. There hasn't been any alarm bells on growth. So, you know, as you mentioned, it was interesting when, you know, there was a hotter than expected CPI print, and then, you know, the initial reaction was yield spiked, and then they kind of fell down through the rest of the day and the following day on this, you know, more of a stagflationary fear.

Corporates haven't really confirmed or denied that thus far, at least in where I've been reading. And one of the things that I would kind of point out as far as just kind of picking up one industry, I would kind of steer away from quoting any individual names, but one of the names that we follow within the oil services sector, and so these are the companies that are, you know, helping your oil companies pull, you know, oil and gas out of the ground.

Tom Shipp [9:23] And so even within an industry that is very much relying on one thing, right, the oil price and what's going to drive activity there, we saw just nuance. And I think that's the reason I bring that up is there's nuance across every company's earnings call that I've, you know, dug into or listened in on is, so some areas are doing fine, others aren't, right?

And so it's kind of the puts and takes of any business. But within, like, this oil field service company, it's, you know, companies that are exposed to energy security or offshore development or, you know, production, existing production recovery enhancement are seeing, you know, strong fundamentals, whereas, you know, you might have lower activity and more shorter cycle or North American areas, North American land.

Like, so, okay, so for a big diversified oil service company, these are puts and takes, and it all just kind of washes out to a pretty normal attractive growth rate, but not any one thing that's saying, "Oh, okay, things are slowing down."

And the reason I like to pick on an energy company like that is because, okay, yeah, prices are higher, so the more immediate term is higher earnings for the oil companies themselves, but an oil service company is generally where you want to listen to for the macro calls on energy as far as activity levels.

Tom Shipp [10:50] And if we were worried about a broader economic slowdown, that would start to seep through on energy requirements, energy needs, energy demand, and there wasn't anything that we heard from this company there. So just one example, and maybe not an example everybody's tuning into is why I brought it up, but not yet on that front as far as any broad based growth scare.

Adam Turnquist [11:18] All right good stuff. And I think it's interesting you're talking about the energy industry and some of the commentary we've heard. You've certainly brought it to my attention, some of the highlights from earnings calls. Let's go back to March, April, May timeframe when we heard from the energy companies talking about this supply shortage not going away anytime soon. The consensus was, look, this will be normalizing by the summer, early spring. They've been pretty spot on in identifying a major macro call with oil markets in this prolonged supply shock.

And I, it doesn't sound like, at least the anecdotes that I've read through that has necessarily changed. But let's go down the hypothetical road of growth slowing. Let's assume that we start hearing more about that at the company level. What characteristics become more valuable to you as a stock picker when you think about that slowing growth environment?

Adam Turnquist [12:17] What are you really looking for as a portfolio manager?

Tom Shipp [12:22] I mean, that's really when, you know, the quality factor tends to shine, right? And when we say quality factor, it can mean a lot of things to different people. So, I'll clarify. I would think about earnings visibility, earnings predictability, right? So, recurring revenue type businesses that can self-fund, right? So they've got this recurring revenue that is driving profitable growth that they can then reinvest in the business, kind of independent of any particular cyclical trends within a specific industry.

So what can that mean? I mean, I think the classic example is, you know, your software type companies, you know, excluding any disruption, AI disruption risk, but just generally, right, if you're thinking about software companies that have predictable revenue streams, predictable recurring revenue that is profitable and they have pricing power, they're able to take price, you know, every year or so, and just provide that kind of level of predictability, right?

Tom Shipp [13:27] This is why folks maybe like utilities and certain slowdown type regimes because, well, no matter what, right, folks need to have power in their homes and they're going to be able to pay their bill. You know, why staples sometimes catch a bid in this world. But I would characterize it from where I'm sitting as less of a sector call and going and looking at defensive sectors, but maybe more quality type names within any sector.

And so we'll look at balance sheet, we'll look at leverage, we'll look at, you know, again, that self-cash generating, self-funding type businesses. They can have debt on the balance sheet, that's fine as long as it's easily serviceable. But if we're talking about, hey, needing to rely on external factors to grow, i.e.

Tom Shipp [14:23] A lot of, you know, maybe the more speculative parts of the AI trade, that's generally not where we would be looking.

And then finally, it kind of always comes back to the valuation and the price you pay. And so in these kind of environments, if you're making moves or maybe, you know, positioning before you think something's going to happen, we typically don't want to swap one expensive name for another one that may have just as much downside risk. So it would be, you know, maybe looking for something that's maybe a steady Eddie type business like we talked about that's maybe been unloved or maybe they've just kind of gone through some of their own slowdowns, but it seems to have bottomed and from their fundamental perspective.

So you could see a lower valuation just giving you more margin of safety on any potential downside, because as we know, in a growth slowdown, if everything starts trading off, everything's going to go down, right?

Tom Shipp [15:24] You just want to hopefully own ones that are going to go down less.

Adam Turnquist [15:28] All right, let's switch gears a little bit, talk about fixed income markets, really the credit markets, because there's a lot going on there. It seems like there's no shortage of headlines. Talking about spreads widening out, especially in the triple Cs or junk part of the credit market, or even in the AI-related investment grade corporate issuance. How do you think about credit as an equity signal from your vantage point?

Tom Shipp [15:56] Yeah, no, it's interesting, and at different times in my career, I've had to focus on credit and what the credit markets are doing and, you know, what kind of covenants the company may have. And hopefully we're not getting into any point like that. But, you know, I think it kind of comes back to some of the same issues, right?

You look at the credit markets for the signals the market is sending, and right now, at least in certain corners, like, within some of these, you know, quote unquote, Neo Cloud companies, and these are companies that are building data center compute capacity and that's their kind of sole reason for being, is to provide, build and provide compute on leases to AI companies.

And what the credit markets have been, you know, the signals they've been sending is, "Hey, this is getting riskier than we're ready, you know, willing to fund at maybe double B, triple B type levels, and getting, you know, spreads are kind of blowing out a little bit down at that level." And so, what it reveals to me is just that the markets, you know, whether the market is still willing to finance long duration, you know, call it, maybe not even speculative, but just, like, a long duration payoff, like, "Hey, this is...

Tom Shipp [17:20] We believe this is going to happen, but we need a bunch of debt now to make the profit come later. And that, if that willingness fades, right, if that's the signal you're getting due to spiking yields, that can just kind of show that quality factor of internally generated cash flow is becoming more important.

And I just think about it as if a business can self-fund its own growth and capital returns, whether it be dividends or shareholder yield or anything like that, I'm willing, especially if there's inklings of a growth scare coming, I'm just more willing to pay up for that consistency. And so, I typically look at the credit markets as almost a sentiment factor for, you know, how much risk investors are willing to take, and you can take that signal however you will, whether it's, "Hey, the markets are whistling past the graveyard, and this is an opportunity for me to exit," or, "Hey, the markets are fine with risk, there's nothing to be worried about," you know, continue to maybe, you know, step a little out on the risk horizon.

Tom Shipp [18:29] But I definitely, that's generally how I'm thinking about credit markets for the most part. We're not getting too involved in highly leveraged names to where I would, you know, have to consider an earnings impact due to, you know, refinancing risk of rolling over their own debt at higher rates. It's just generally not where we're typically at. But it's something you consider when it comes to just the interest rates that corporates have to pay, but more so looking at credit as that signal for risk-taking and how much investors are willing to fund longer duration growth.

Adam Turnquist [19:13] All right, so it sounds like these, we'll call it at the risk of oversimplifying, self-funding businesses look a little more attractive right now in this current market environment than maybe the company's dependent on the capital markets in issuing debt. Fair assumption?

Tom Shipp [19:31] I mean, those look better to me all the time, but as far as markets, what the market's pricing is, that's definitely what the past couple weeks have shown.

Adam Turnquist [19:42]  All right, let's go back to the non-AI trade that's really been powering the market, at least holding the index up. When you look at some of the performance metrics, I'll throw some at you, for month to date, as of Friday, October 23rd, the S&P down about 0.4%, the equal weight S&P up over four, and Goldman Sachs has a bunch of different baskets, but I was looking at the broad US AI basket, down 13% month to date. Their AI at risk, I guess that's the definition of the anti-AI trade maybe, up over 20%.

There's certainly been a pain trade, especially for the hedge fund community, which have been pretty much offsides on both sides of their book on the longs and shorts, at least in aggregate. Do you think, one, is there further de-risking in that trade, or, and that's really going to power, I guess, two, the non-AI bid that we've seen really month to date?

Tom Shipp [20:45] Yeah, I mean, I guess, and without, you know, not sure what the, you know, hedge fund community's doing other than the positioning data that we both look at. And, you know, I guess part of it would be, well, are they going to degross or if they're having to, you know, unwind, right, and get out of their positions as their risk officers kind of tap them on the shoulder?

I saw something on, you know, shared in one of our chats that the number of PM exits at the, you know, pod shop and long short community has been pretty high, just meaning that people have gotten blown up and shown the door. So what I don't know is if they kind of lick their wounds and say, "Hey, well, let's pile right back into the same trade we were in," and it can kind of go back, or if that community tries, you know, see something different, right?

Tom Shipp [21:43] So don't know about that. I would say my guess is it, like I mentioned earlier, if this cohort of non-AI, whether you want to say the AI at risk or just the, you know, not, you know, the halo type trade, hard asset, low obsolescence type stocks, if you started to see some level throughout this earnings season of kind of estimate revisions going up, right, future guidance, maybe some companies start dripping out some 2027 initial guidance, and we start to see an earnings-led kind of reaction to, you know, of this cohort of kind of positive inflection on earnings, I think it could last, right?

So it could move from a pure positioning unwind to a, you know, maybe they're adopting AI, maybe they're doing any number of things that kind of help them grow earnings and do so whether or not whatever's going on with, you know, credit markets and the AI trade broadly, I think it could last, or it could just roll into a, hey, new capital doesn't just go to one thing, right?

Tom Shipp [22:55] New capital can go to multiple things. And so you could see the sell-off in the AI trade kind of subside and then things kind of move up together or you could see, you know, this reverse rotation and everything just kind of moves back to AI.

But, you know, earnings season will be key for that. And I think that the things that we'll look for are themes and, you know, things that we're kind of always speaking to our advisor community about is just what are some other diversifying strategies even within your US equity allocation? Like, how much of one theme are you really baked into and knowing how much of one theme you are invested in, and, you know, dividend growers or shareholder yield, right, as a, you know, self-promotion plug here.

Tom Shipp [23:50] Like, I think those are always good areas of the market to look at in the sense that these are, you know, businesses that can afford to either grow their dividends and increase those payouts to shareholders or, you know, they're, you know, share cannibals, as you call them, they're buying back a lot of their own stock because it's undervalued and, you know, reducing share counts, giving everybody, all existing shareholders, you know, greater ownership.

So those are some of the areas I would be looking at if looking to diversify. But yeah, I think just basically the move can really last if the earnings of those companies, this earnings season takes, you know, continues to grow, I think it could keep some bid underneath those names.

Adam Turnquist [24:36] All right, maybe on the flip side, we've got Amazon, Alphabet, Microsoft, I guess Caterpillar is an AI name now. [laughs] Nucor is tied to the AI trade, all with reports this week. In terms of what you're listening for, watching for in earnings that maybe could revive confidence in the space, anything specific?

Tom Shipp [25:01] Yeah, I think it's going to be the same as last earnings season, to be honest, just with even sharper pencils on scrutiny, if that makes sense. Like, so the earnings beats are kind of, that's table stakes. They're going to have to beat earnings and, you know, the whole beat and raise game, if you will, I think that's kind of a requirement, but that's not alone going to do it.

I think that they're going to need to do kind of three things to pull investor confidence all the way back in, and that's, you know, your visible demand, right? So, okay, yeah, you're spending money, but how much committed capital do you have to back this spending? Two, I would say monetization. Okay, well, now you've got this demand. How are you monetizing it?

Tom Shipp [25:52] How is that coming through? And whether it's, you know, subscriptions to your own AI services, whether it's, you know, continued margin expansion and growth in their cloud businesses, whatever it may be. But, like, not just saying, "Hey, yeah, the demand is insatiable, but okay, well, how are we making money on it?" It's because return on investment, ROI is what everybody is looking for and, you know, we can debate whether what they're showing at this juncture could even really resolve that, given all the spend that's supposed to come, but still, every step helps, every quarter helps.

And then finally, three, I would say, one of the big things that caused some earnings prints to, you know, cause their stocks to sell off was the level of negative free cash flow that they were either entering or projecting.

Tom Shipp [26:42] And that's just, you know, your cash flow from operations minus your CapEx, right? If you're spending more than even your own cash from operations can support, that means you have to go find external capital or, you know, eat up cash on your balance sheet.

And so everyone's already kind of accepted, okay, yeah, negative free cash flow is fine for a bit, but, you know, because we believe it is going to fund all this profitable growth in the future, but could we start to see, you know, something that would help is saying, "Hey, we expect to be back into free cash flow positivity by X date," right? And if that's better than where the street currently is, you have those positive free cash flow revisions. I think that matters even more than the EPS revisions, is that free cash flow revision.

Tom Shipp [27:30] So those three things, you have visible demand, monetization proof, and positive free cash flow, estimate revisions, I think that could be powerful enough to bring capital back in.

Adam Turnquist [27:43] Right. And I think the path to profitability becomes more of an uphill battle when rates are moving higher, credit spreads are widening, the economics change, and probably some of the rerating that we've seen in the space, certainly pricing in as a concern for the market. Tom, we're almost out of time here for the podcast, but I'll give you a minute here, just kind of final closing thoughts to leave our audience with.

Tom Shipp [28:12] Yeah, and I mean, there's so much to chew on in this space. I'd say, you know, if we're closing out on maybe two topics here, just the three things in that upcoming AI earnings that we've got this week, right, like I said, focus on the CapEx and how much that is signaling future demand, how much of it is backed, how are they proving the monetization and what the free cash flow, path, you know, path forward looks like? Like when does that get back to positive?

So leave you with those three things to look for in AI earnings season, and then just kind of more for a broader closing thought, if we're... The past year, right, has been, you know, if you're long AI, you're probably doing okay, despite some volatility, that's been a kind of a one-way trade, a one-way market, and you just, the market rewarded companies exposed to AI spending full stop.

Tom Shipp [29:15] We may be entering a phase where, you know, the market may reward companies that can prove, you know, can prove returns on capital, whether they're AI or not, right? Whether they're an AI company, whether they're AI adopter, whether they're something completely outside of AI where, you know, as hard as it may be to find.

And so from my perspective, it's a healthier market where your folks are looking more at fundamentals and doing more of that underlying work, but it's also harder, right, if you're having to kind of suss out, "Hey, who's adopting AI in a way that's driving profitable growth and efficiency, versus who's not, right? That's just not as, you know, plain and cut and dry as, 'Oh, well, Caterpillar's going to sell a lot of power generators to, you know, provide power to data centers, so they're going to do well,' right?"

Tom Shipp [30:07] So it's just going to be a little bit more difficult, but I think for folks in my seat, that's, you know, really where you have some edge and you want to be able to reflect that for clients. So that's my longer thought. My hope is that we do kind of get into this more fundamentally driven market that will be maybe more difficult, but hopefully more rewarding.

Adam Turnquist [30:29] All right. We will leave it there. And Tom, to your point earlier on the call, when we try to talk about non-AI, [laughs] it's hard to not talk about AI. It certainly touched on both. Great having you here. Thank you so much. Tune in next week for another episode of LPL Market Signals. Thanks, everyone.