One week / one topic: Pain thresholds

What happened?

For much of the last two years, equity markets appeared to largely follow a simple rule: if AI-related stocks went up, so did the broader market.

Semiconductors, memory producers and other infrastructure beneficiaries became the undisputed leaders of the bull market.

Investors rewarded virtually anything linked to the AI buildout, while concerns around valuation, concentration and positioning were largely ignored.

Yay!

Looking at YTD returns, there is indeed an unmissable pattern in terms of what kind of stocks were the market leaders:

However, as we know, more recently cracks have started to emerge.

Several high-profile technology companies have delivered strong earnings and continued to increase investment, yet share price reactions have become noticeably less enthusiastic.

At the same time, there is compelling evidence that hedge funds have been reducing exposure to technology stocks, semiconductor-related positioning has been scaled back and momentum strategies have experienced a meaningful unwind.

Alphabet provided the clearest example this week.

Despite delivering 82% cloud growth, the shares fell 6.9% after management increased 2026 capex guidance to $195-205bn and reported negative quarterly free cash flow of $5.9bn.

Investors are increasingly willing to ask a question that has largely been ignored throughout the AI boom: when will all this spending actually generate an attractive return?

Also, the increased capex guidance confirms that this is a no-holds-barred arms race.

If Alphabet feels compelled to spend more, how can competitors afford to stand still?

Throw in continued escalation in Iran, surging bond yields, the return of tariffs (as expected) and things start looking shaky.

Despite all this, global equities still sit only 2% below recent all-time highs thanks to a very sizable rotation.

Over the last month – beyond the expected outperformance of Energy stocks in line with surging oil prices – Financials, Health Care and Utilities have posted strong performance.

Are we then witnessing just the beginning of a market leadership transition, or perhaps something more ominous?

Our observations

• Fundamentals: Markets chatter is still very focused on the AI investment cycle and now also on the potential fallout from continued conflict in Iran and high oil prices.

  On the latter point, increased inflation volatility across components is also not helping and indeed would justify higher risk premia.

• Price action: While there have been days that felt like momentum unwinds and rushed liquidations, I don’t think we have seen any proper panic.

  Upcoming Tech earnings no doubt have the potential to engender large intraday moves, especially Microsoft on Wednesday.

• Investor beliefs: Can the AI theme continue to dominate in the face of an increasingly challenging backdrop? Or if not, can other sectors pick up the leadership baton?

  Hope springs eternal, but the potential for a single headline to materially change perceptions is certainly there.

So what?

We can all only take so much pain.

Nobody knows where the current threshold lies for investors to start changing their tune, but for now it is not at all obvious that there is materially less conviction about the AI trade.

Unsurprisingly, the VIX index is also nonplussed so far.

It is hard for investors to escape the Skinnerian conditioning of the last 18 years since the Great Financial Crisis, where equity drawdowns have been very short-lived and policymakers have consistently come to the rescue with ever larger and more creative ways to resuscitate markets (first) and the economy (second).

Not only have investors learned to associate drawdowns with policy support; they were also repeatedly rewarded for buying the dip.

You could argue that, this time around, the Iran crisis can’t be really resolved by fiat – i.e. oil is either flowing, or it is not – but I wouldn’t underestimate human ingenuity in this area either.

For the time being, then, we try to balance the abovementioned expectations that ‘they will eventually fix this, too’ with humans’ well-known tendencies to panic at (usually) the wrong time.

Time to tighten risk positioning and remain disciplined then, without any rash reactions – but without complacency either.

Again, nobody said this was going to be easy…

Mood music: Pink Floyd – Comfortably Numb

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