Midterms and gridlock
The midterm outcome does not matter much for markets. Any result points to gridlock, and markets like gridlock. There is a 71% chance Democrats take both the House and the Senate, and a 23% chance of a split where Republicans keep the Senate. Either way the result is gridlock.
Markets hate uncertainty. Wall Street cares about the bottom line more than events in Washington. Since 1950, six months after a midterm election the S&P 500 is usually up about 15%. The patient investor gets rewarded this election season.
Crude oil as the main risk
The biggest thing to price in is the risk of oil. The war in Iran turning kinetic could blow up that outlook, though that is not expected now. WTI fell this morning on good headlines from the Middle East.
Oil above $100 a barrel brings secondary and tertiary effects and has been the main weight pressing on broad equity markets. Over time relief should come, not through one great headline that erases every problem, but gradually. When oil falls, inflation forecasts ease quickly. That could bring rate relief from the Fed and lower pressure from the bond market. Those shifts would let a very concentrated market broaden out.
Friday's sell-off and concentration
Friday was the worst day for stocks since June, and the Nasdaq 100 briefly touched correction territory. This was a consequence of heavy concentration. Since the March 30th lows, 10 companies accounted for about 70% of the S&P 500's move up.
At that level of concentration, the market is pricing future AI opportunities worth trillions of dollars. Each small piece of new information makes the market rewrite that future. Across recent earnings seasons, if a company misses by an inch, it misses by a mile. That hit Alphabet (GOOGL) and other names last week.
With concentration this high, investors must form an opinion on the future. Do you believe AI demand is real? Without a view, big swings make conviction hard to hold.
Is AI demand real?
AI demand will come to fruition. Google Cloud grew over 100%, and Azure grew 48%. Alphabet's (GOOGL) problem was that its search business did not grow as fast as the street expected.
You have to trust the leadership of these companies, which have strong track records. Google (GOOGL) must shift from its traditional blue-link search revenue to making money on the AI side, and over time that should happen. Last week showed the other side of that in how the stock was valued. Alphabet (GOOGL) trades at 20 times forward earnings, about the lowest price-to-earnings ratio it has ever traded at.
Picking winners: cash flow and debt
Free cash flow and debt matter a lot when judging the health of AI-linked companies. The key question for hyperscalers is who can fund AI spending mainly from their own cash flow.
Microsoft (MSFT) stands out. It was under heavy pressure earlier this year with the stock at $390 a share and had every reason to chase the trade and overspend, and it missed a bit on Microsoft Copilot earlier in the year. Now it is praised for discipline. It will take on some debt, but the vast majority of its AI spending is funded from cash flow. That cash flow is a safety net for investors. Meta (META), Google (GOOGL), and Microsoft (MSFT) each manage their cash flow differently.
On management, Meta's (META) Zuckerberg has a mixed history after the metaverse push. Larry, Sergey, and Sundar at Alphabet (GOOGL) have a 20-year record of 30% return on invested capital. Satya Nadella is leading Microsoft (MSFT) well through a transformational period.
Apple (AAPL) reports later today, a possible chance to turn things around for tech names after a rough earnings season.
