Bull Market Health Check. Plus, Philip Morris CEO Jacek Olczak | Barron's Streetwise

Key Concepts

• AI-Driven Bull Market: The current stock market rally is significantly influenced by investments and growth in Artificial Intelligence.
• S&P 500 Performance: The S&P 500 has shown strong returns, particularly in 2023-2024, driven by mega-cap tech and AI-related companies.
• DeepSeek Selloff: A significant drop in Nvidia's stock in January 2024, triggered by concerns about China's AI advancements, highlighting the market's sensitivity to AI competition.
• Market Concentration: A small number of large technology companies are disproportionately driving the S&P 500's performance.
• Dot-Com Bubble Comparison: Similarities and key differences between the current market and the dot-com bubble of the late 1990s, focusing on company quality and fundamentals.
• Capital Expenditure (CapEx) in AI: Significant spending by companies on data centers and AI infrastructure is a key driver of the current market.
• Sector Rotation: Potential shifts in investment focus from AI-centric tech to other sectors that benefit from AI infrastructure development, such as industrials and utilities.
• Philip Morris International (PMI): A company transitioning from traditional combustible cigarettes to "smoke-free" products like heated tobacco (IQOS) and nicotine pouches.
• Reduced-Risk Products (RRPs): Products designed to offer a less harmful alternative to traditional cigarettes for existing smokers.
• Financial Incentives for PMI: The increasing profitability of smoke-free products for PMI, making them financially more attractive than cigarettes.
• Harm Reduction: The concept of reducing the negative health impacts of smoking by encouraging a switch to less harmful alternatives.

AI-Driven Market and S&P 500 Outlook

Scott Ren, Senior Global Market Strategist at Wells Fargo Investment Institute, discusses the current stock market, particularly the S&P 500, and its outlook. He anticipates that while the S&P 500 will continue to offer attractive returns over the next three to ten years, the exceptionally high growth rates seen in 2023-2024 (potentially over 20%) are unlikely to persist. Future returns are expected to be lower but still considered attractive.

The DeepSeek Selloff and Market Resilience

The conversation touches upon the DeepSeek selloff in January 2024, which saw Nvidia's stock drop by 17% on January 27th. This event was triggered by concerns that China's DeepSeek AI model had surpassed US advancements, potentially impacting US AI companies. Despite Nvidia's significant decline, the broader S&P 500 index only fell by approximately 1.5% on that day. This resilience is attributed to 70% of S&P 500 constituents actually rising, with investors rotating out of semiconductor stocks into value, quality, and safe-haven assets.

AI's Dominance in the S&P 500

Currently, AI stocks constitute over 40% of the S&P 500 index and are responsible for nearly all of the market's returns since the launch of ChatGPT in late 2022, as well as most of the earnings growth. The sustainability of this AI narrative, particularly the massive spending on data center build-outs, is a key concern for the market. Barclays estimates that a 20% reduction in data center CapEx could lead to a 10-13% decline in the S&P 500's price-to-earnings (P/E) ratio. The S&P 500 is currently trading at a P/E of around 23-24 times earnings, which is considered high.

Comparison to the Dot-Com Bubble

Ren addresses the comparison between the current market and the dot-com bubble of 2000. While both periods exhibit a concentration of returns in a small number of stocks, Ren highlights a key difference: the quality of companies. In 2000, many companies were built on future expectations with weak revenues and cash flows. Today's leading companies, while also carrying high valuations, possess real revenues, products, and cash flows. Furthermore, S&P 500 earnings have consistently exceeded consensus expectations, with double-digit beats in the first and second quarters, largely driven by mega-cap tech companies. The market's P/E ratio of approximately 25 times earnings is lower than the 32 times earnings seen in March 2000.

Trajectory of Earnings and AI CapEx Concerns

A primary concern is the sustainability of the massive spending on data centers. The fear is that customers might engage in double or triple ordering, leading to a spending frenzy followed by a slowdown or inventory issues. Ren acknowledges that while there were initial concerns about AI CapEx slowing down, leading to a market dip in late March/early April, these CapEx numbers have continued to be strong for tech and communication services companies. However, any significant whiff of AI CapEx spending decreasing could negatively impact the S&P 500.

Sector Opportunities Beyond AI Tech

Ren suggests that while the handful of companies directly involved in AI are pricey, other sectors can benefit from the AI infrastructure build-out. These include:

• Industrials: Companies involved in building data centers, supplying components, and performing construction.
• Utilities: Sectors that will see significant increases in electricity demand and benefit from utility grid upgrades.

These sectors are seen as playing into the AI growth story without being directly involved in the high-flying, expensive AI tech stocks. Ren expects growth to be tied to AI CapEx through at least the end of next year, with AI CapEx being the primary driver of growth within the S&P 500, while other segments remain relatively flat. Wells Fargo's target for the S&P 500 for the next year is 7500, driven by the continued strong performance of these large growth companies.

Overweight Sectors and Financials

Wells Fargo is overweighting the following sectors:

• Technology
• Industrials
• Utilities
• Financials

Financials are favored due to a steepening yield curve, which benefits their lending margins, anticipated deregulation, increased merger and acquisition activity, and a stronger economy leading to higher demand for loans. These sectors are expected to outperform through the end of 2026.

Hedging Strategies and International Markets

Ren advises against hedging the S&P 500 by buying a value index, stating that value is unlikely to outperform in the current growth-oriented environment. He views a 10% correction as a buying opportunity rather than a reason to hedge. He also advises against hedging with small caps, as he does not foresee an earnings contraction or recession, which typically benefits small caps early in a cycle. Instead, he emphasizes the importance of quality, cash flow, and strong balance sheets.

Regarding international markets, Wells Fargo is neutral on developed markets and underweight emerging markets. They believe the US will lead global growth, and while Europe might see some benefit from increased military spending, the long-term outlook for emerging markets is not supported by current fundamentals, despite some stimulus from China. These regions are reliant on external demand, which is expected to be limited in a modest US growth environment.

Long-Term Outlook and Investor Behavior

Ren believes that while performance may have been pulled forward over the last three years, the S&P 500 will offer attractive long-term returns over the next three to ten years, albeit at a lower rate than recently observed. He stresses the importance of patience and having a plan for market pullbacks, which occur approximately every 10.5 months. He identifies a common investor mistake: sitting on cash and failing to invest during market downturns when fear and nervousness are high, which he considers the best time to buy stocks for long-term investors.

Philip Morris International: Transition to Smoke-Free Products

The discussion shifts to Philip Morris International (PMI), a company undergoing a significant transformation from traditional cigarette sales to "smoke-free" products. Yatsek Ulchek, CEO of PMI, explains that the growth in their business is increasingly coming from non-combustible products like IQOS (heated tobacco) and nicotine pouches. These are considered reduced-risk products (RRPs) for existing smokers.

Financial Incentives and Profitability of Smoke-Free Products

A key point is that these smoke-free products are becoming financially more attractive than traditional cigarettes for PMI. While 41% of PMI's revenue comes from smoke-free products, these products account for 42-43% of profits. This indicates that they are more profitable on a per-unit basis and are driving overall company profit growth. Wall Street estimates project double-digit earnings per share growth for PMI over the next few years, with analysts like Jefferies expecting significant margin improvement driven by the growth of next-generation products like Zyn (nicotine pouches) and IQOS.

The "Harm Reduction" Argument and Divestment of Cigarettes

Ulchek addresses the criticism that PMI continues to sell cigarettes despite understanding their risks. He argues that by retaining the cigarette business, PMI can better allocate resources and finance the transformation to smoke-free products. He believes that deliberately cannibalizing cigarette sales with their own RRPs is better for smokers, the public, and investors. He states that the strong cash generation from cigarettes finances the investments needed for their smoke-free initiatives.

Investor Perception and Valuation

Historically, tobacco stocks were seen as cheap due to negative public perception and litigation risks, offering high dividend yields. However, PMI's valuation has increased, with the stock trading at approximately 22 times projected earnings for the current year, indicating a shift in investor perception. Ulchek believes PMI is now appealing to growth investors, who recognize the technological advancements and future growth opportunities in their product portfolio. The stock is no longer solely catering to income investors.

Conclusion and Investor Takeaways

The conversation concludes with advice for investors to be patient, have a plan for market pullbacks, and to invest when others are fearful. For PMI, the financial incentives for transitioning to smoke-free products are becoming increasingly clear, making it a potentially attractive investment for growth-oriented investors. The company's strategy of using cash flow from traditional cigarettes to fund the development and expansion of less harmful alternatives is a core part of its transformation.