You're Getting the Regime Wrong | Adam Parker on Growth, Rates, and What Comes Next

Key Concepts

Equity Investing Drivers: Changes in perception of growth and changes in perception of weights.
Market Multiples: Expectation of higher future multiples due to increased gross margins in the market's constitution.
Quantitative Signals: Low P/E strategies demonstrably do not work.
Hyperscaler Capex: Risk of diminishing returns on massive capital spending by hyperscalers.
AI Impact: Potential for productivity gains, margin expansion, and shifts in employment.
Government Deficits: A persistent concern, though timing and impact are debated.
Market Structure: The S&P 500 is increasingly an "AI index" with correlated stock movements.
Valuation: Not a primary driver for stock picking, especially at extremes (low P/E or high EV/Sales).
Blow-up Avoidance: Focus on factors like free cash flow conversion, accruals, and momentum.
ETF Analysis: Critical assessment of ETFs for true factor exposure and avoiding "closet" plays.
Asset Allocation: Diversification is for the wealthy; focus on taxes, fees, and long-term investing.
American Exceptionalism: Structural advantages in innovation, technology, and healthcare.
Investor Psychology: Overestimation of abilities, importance of long-term perspective, and the role of insecurity.

Comprehensive Summary

This discussion delves into the intricacies of equity investing, market dynamics, and strategic approaches, featuring insights from Adam, founder and CEO of Trivari Research and Tri Vector Research. The conversation highlights a multi-faceted analytical framework combining fundamental, quantitative, and macro perspectives.

The Core Drivers of Equity Investing

Adam posits that the primary drivers of equity investing are changes to perception about growth and changes to perception about weights. Over the past 25 years, he has observed that the market is likely to trade at much higher multiples in the future than in the past. This is attributed to the constitution of the market itself, which now features companies with significantly higher gross margins. He explicitly states that a strategy of buying stocks with a low Price-to-Earnings (P/E) ratio and selling those with a high P/E ratio demonstrably does not work as a quantitative signal.

Long-Term Market Outlook and AI's Role

Adam outlines a long-term bullish case for US stocks, projecting the S&P 500 could reach 10,000 by 2030. This projection is based on an assumed 9% annual earnings growth, potentially boosted to 10% due to AI-driven productivity gains from 2027-2029. He anticipates paying low 20s multiples for these earnings. The primary pushback he receives concerns the multiple, with some arguing that current multiples are too high compared to historical averages. However, Adam believes the skew towards higher gross margins is structural, driven by companies leveraging AI to predict customer behavior, optimize operations, and reduce labor costs without necessarily increasing headcount. This structural shift in gross margins is a key reason for his expectation of higher future market multiples.

Key Risks and Concerns

Despite a generally bullish outlook, Adam identifies three significant bare cases:

Hyperscaler Capex Diminishing Returns: Massive capital spending by hyperscalers may eventually lead to diminishing returns. A more immediate near-term risk is that these companies increase their capital spending further due to perceived strong returns, potentially leading to less free cash flow or even negative free cash flow for companies like Microsoft. This is particularly concerning as the S&P 500 is increasingly becoming an "AI index," with many top stocks correlated due to their AI exposure.
Government Deficits: While acknowledging the "wartime deficit" levels, Adam notes that the timing and impact of government deficits on businesses are debated. He has historically de-emphasized this as a proactive investment signal because positioning for it has not consistently worked over the past 15 years.
AI's Ultimate Employment Impact: The long-term consequence of AI-driven productivity gains could be rising white-collar unemployment, impacting consumption. However, he notes that large companies, which constitute a significant portion of the S&P 500 market cap, employ a relatively small percentage of the workforce, creating a potential disconnect between top equity performance and the broader economy.

A significant near-term risk is overly bullish sentiment, where investors who were previously bearish are now turning bullish, which can be a contrarian indicator.

Comparison to the Dot-Com Bubble

Adam draws parallels and distinctions between the current environment and the late 1990s/early 2000s dot-com bubble. He states that human behavior (fear and greed cycles) remains the same. The common cause of market tops is a combination of hubris and debt. While Wall Street hubris is high, he doesn't believe we are at the same excesses as the dot-com era, particularly given the compelling cases for productivity gains. The speculative behavior in profitless stocks is a similarity, but he believes the funding dynamics are different now, with many companies funding operations organically due to high cash flow generation.

The Economy and Market Synchronization

Adam describes the US economy as being in decent shape but slightly eroding. He notes that the period and amplitude of economic cycles have changed structurally due to factors like COVID-19. Previously synchronized global monetary policies and synchronized industry cycles have become less correlated. He uses the example of barbecue grills and swimming pools to illustrate how demand can surge and then collapse rapidly, creating short, high-amplitude cycles. Conversely, other industries experienced longer, lower-amplitude cycles due to supply chain issues.

Furthermore, the US equity market has less perishable inventory than in the past. Many companies no longer primarily manufacture goods with easily perishable inventory. Instead, they produce components designed into long-term products (e.g., Texas Instruments' converters in dump trucks). If demand slows, these companies can store excess inventory without immediate price collapse, leading to less margin downside in downturns. This structural shift contributes to a more resilient equity market compared to the broader economy.

Inflation and the Federal Reserve

Adam views inflation as a situation where the US has been below 2% for a decade, and now running "a little bit above 2%" for a period might be acceptable. He has been surprised by the limited impact of tariffs on US equities, suggesting that the market generally believes tariffs will not lead to sustained inflation.

Regarding the Federal Reserve, Adam believes the market's perception is that the Fed will be skewed more dovish. He personally thinks the Fed will focus more on unemployment data due to the difficulty in getting ahead of inflation. He recalls his time at Morgan Stanley where the firm was consistently wrong on interest rate outlooks, highlighting the difficulty of predicting Fed policy. He views positioning for an inevitable backup in long-term rates as a "widowmaker trade" that has failed for 15 years. He anticipates a dovish Fed through most of the current presidency, which, along with AI, forms the pillars of the bull case. He notes that the Fed's balance sheet expansion is a strong bullish signal, as it has historically correlated with S&P 500 gains.

Government Deficits and Debt

Adam's perspective on government deficits is pragmatic. He acknowledges the concern but emphasizes that positioning the portfolio proactively for deficits has not been helpful. He recalls instances where concerns about specific country debt crises (like Cyprus) were overshadowed by larger market forces. He believes that until the situation demonstrably impacts subsequent stock performance, it should be de-emphasized for short-term equity investing. He notes that historically, despite fears of bond supply overwhelming demand, quantitative easing and investor fear have driven down long-term yields.

Small Cap vs. Large Cap and Valuation

Adam argues that valuation is not a helpful tool for picking individual stocks, particularly at the extremes. He states that buying stocks with low P/E ratios results in owning inferior assets that are cheap for a reason (e.g., impaired businesses, capital intensive, competitive). Similarly, the highest and most expensive stocks (EV to forecasted sales) also tend to underperform. His argument is that valuation is not useful between the second and ninth deciles.

He categorizes stocks into four buckets:

Revenue Line Beneficiaries from AI: Companies like Nvidia and Arista.
Productivity Beneficiaries from AI: Businesses with high revenue, many employees, and low margins, where AI can predict behavior and drive out costs (e.g., drug distributors, consulting firms). This is a longer-term play, potentially materializing around 2027.
Impregnable to AI: Essential services like toilet paper, water, waste management, and Wi-Fi, where revenue achievability in 2030 is expected to be similar.
Potentially Disrupted by AI: Companies facing significant disruption.

He believes that stocks getting more expensive are likely beneficiaries or impregnable, while those getting cheaper are potentially disrupted. Using valuation in a mean-reverting fashion would mean buying disrupted stocks and selling beneficiaries, which he considers a "dumb" strategy for now.

Regarding the dominance of large-cap companies, Adam believes technology has favored them due to the high costs of running a business. Median gross margins for small-cap companies are significantly lower than for large-cap companies, indicating less pricing power, weaker technological moats, and higher regulatory burdens. He sees AI as potentially bimodal: large companies will continue to win by acquiring technology, but smaller companies might catch up to mid-sized ones, and entirely new, unheard-of companies could emerge as significant players. Mid-sized companies might get squeezed.

Quant Factors and Blow-up Avoidance

Adam focuses on blow-up avoidance rather than solely on alpha generation. Key factors he watches include:

Free Cash Flow Conversion: Companies in the bottom decile with declining free cash flow conversion underperform. Top decile performance is not guaranteed, but bottom decile is a clear risk.
Accruals: High increases in capital intensity, inventory, and intangibles are negative signals.
Bad Momentum: Stocks that have already underperformed are more likely to continue doing so.

He lists momentum, capital spending to sales, inventory to sales, intangibles, free cash flow conversion (level and change), and extreme valuation (bottom decile) as factors to watch for potential blow-ups.

ETF Analysis

Trivari Research uses a custom risk management system to assess ETFs. They are critical of ETFs that do not provide the expected factor exposure. For example, they found a momentum ETF (MTUM) that barely beat the S&P 500 despite momentum being an effective factor. They also criticize "closet AI plays" within sector-specific ETFs, arguing that investors should get the precise exposure they seek. They believe ETFs can often be improved with custom baskets. They have been critical of ETFs like ARKK, some quality factor ETFs, XLF, and XLP for not delivering their stated exposures.

Asset Allocation and Long-Term Strategy

Adam's view on asset allocation is nuanced, stating that diversification is a concept for the wealthy. For most individuals, he advises a more conservative approach, focusing on low-fee, long-only products as a "northstar" and staying fully invested for the long term. He stresses the importance of considering taxes and fees, and starting retirement accounts early.

For wealthy individuals, he suggests taking more risk. He believes the right call has been to own non-US value and US growth. He advocates for a significant allocation to low-fee large-cap US equities and low-fee large-cap non-US value. He sees a place for dollar hedges like gold or Bitcoin (5-10% of a portfolio) and believes real estate should be a chunky allocation. He is not a fan of individual private equity or private credit products due to illiquidity and high fees, preferring to invest in businesses directly.

American Exceptionalism and Innovation

Adam's view on "American exceptionalism" has evolved. While he previously argued that Europe was great for vacation but not for stocks due to lower innovation and a smaller tech sector, he now believes the US is better for both. This is driven by technology, healthcare, and innovation. He notes that European companies tend to have less margin expansion capability and a smaller proportion of tech in their indices. He contrasts the innovation in the US, citing the creation of companies and technologies since his birth, with older, more industrial-focused companies in Europe.

Closing Thoughts for Investors

Adam's key lessons for the average investor are:

Don't overestimate your abilities: Avoid trying to make short-term market calls, as this can destroy value.
Stay invested long-term: Allocate a portion of your money to low-fee, long-only products and don't touch it.
Think long-term and stay fully invested.

His most contrarian view is that the healthcare sector will be the best-performing sector in the next 5 years, with a 30-40% chance of significant outperformance. He believes healthcare is a primary beneficiary of AI on the productivity side due to its current unproductivity. He is motivated by generating performance versus the index and believes this is where he can add value as a human. He also believes that insecurity and a worry about being a fraud are healthy signs for equity investors, indicating a realistic assessment of the market's complexities.