DAILY STRATEGY: Earnings reports from GOOG, META, MSFT and AMZN have reduced some ROIC risk fears. The ROIC risk reduction is related to the strong compute demand comments (confirmed by H100 rental prices. See below). The firm AI capex estimates support the AI buildout beneficiaries. Bottom line – fundamentals are supporting AI buildout names. However, that was also true last week. The new information is some levered holders of AI Capex Beneficiaries being washed out and South Korean authorities signaling direct investments into SK AI stocks.
Out shorter term Momentum factor suggestions have been wrong. We suggested increasing exposure 3 weeks ago only to give up on that idea Monday. The Momentum factor seems to have clearer short-term support. We are not saying chase today, just marking to market. We like the AI Build Beneficiaries and Momentum longer term. But volatility in the AI Capex Beneficiaries and Price Momentum factor needs to come down for investors to get more comfortable in Alpha generation. We think that will happen over time as the normal economic expansion continues.
See the charts below…
WEEKLY AI Update: We are constructive on Service companies that use AI. Open source models are gaining popularity and are less of a threat to the application layer than frontier labs training on their data (see HERE). Then using that data to put many service companies out of business. This last point is most important to software companies, but they are not the only companies impacted by AI disruption fears (See Insurance cos and Payment cos performance in 1Q26).
The AI Service basket is not just Software. It’s a mix of Media, Software, IT, Insurance, Health Care Services, and Logistics providers. A downloadable excel of the constituents can be found HERE.
The Facts Seem to Support Better Performance Going Forward – High AI usage services are beating EPS estimates at nearly the same rate as last quarter (85.5% vs. 84.9%). This quarter, though, beats are more concentrated in the 0–10% range, and all beat sizes have generated positive average relative performance. Last quarter, by contrast, only beats of 10% or more were rewarded. Further, margin sentiment for the AI service basket has accelerated. That is consistent with margin expansion across the index. AI service companies, with and without Software names included have unusually high margins.
Going forward we would expect AI Goods (which includes semis and the broader AI buildout names) and the AI services basket to both outperform if AI is improving profitability for all companies. The current trends of increasing margins across market caps and strong compute demand support that view (HERE). Both Momentum and Software names outperformed yesterday. Both AI Service and AI Goods EPS revisions are BOTH stronger than normal.
We have both Services and Goods available as tradeable swaps through Morgan Stanley: MS22AISV Index and MS22AIGD Index on Bloomberg, respectively.
FYI – AI Service names are less sensitive to higher rates. Post the FOMC meeting, our view is 10yr yield volatility is going up. Tightening or easing of financial conditions is more likely to come through the long end of the yield curve vs the Fed funds rate. Current economic trends suggest more upside vs downside risk to 10yr vol (see Peter Willaims HERE and the Video we did with Peter HERE on this subject).
Charts and details…
The H100 rental index (ticker SDH100RT) is a daily benchmark tracking the average hourly spot price and contract costs of renting an NVIDIA H100 GPU. It standardizes prices across neo-clouds, hyperscalers, and private platforms.
Breaking down 1mo volatility into deciles for historical non-recessionary periods, the top quintile group has the worst Price Mo daily return, especially during sharp plunges. Current 1mo volatility remains at historical 97th percentile, which needs to drop below the 90th percentile, roughly the level around 0.012 to imply a more stabilized Price Mo outlook.
In addition, the concentration of Price Mo names also suggests risk, though less strongly tied to return changes as volatility. Currently, the weight of high Price Mo names within the S&P 50 has dropped to its 76th percentile.
When S&P 500 Momentum weight becomes very large, there is a clear risk for its forward return, especially for forward 3 month and 6 months periods. As concentration sharply dropped, the risk has fallen from its extreme level.
Service companies that are using AI have a similar EPS beat rate compared to last quarter (85.5% vs 84.9%), but fewer large beats. Beats are more concentrated in the 0-10% cohort. All beats have resulted in positive average relative performance. Last quarter only beats of 10% or greater were positively rewarded on average.
AI Services are beating earnings at a higher clip than AI Goods. The chart below is the spread between the Service and Goods beat rates in each cohort. This quarter is much better for Services than last was.
AI Service and AI Goods revisions are BOTH stronger than normal.
The margin story seems to favor AI Services for now too. Implementing AI is an advantage, and investors are getting more concerned about the buildout. FYI, ultimately, both baskets can work together if AI proves to be a profitability enhancer.
