A well-seasoned investor generally correlates historically high interest rates with poor stock performance. A higher interest rate typically signals higher borrowing costs and lower business profits. As the risk-free rate of return rises due to higher interest rates, the expected return on equities rises as it is a riskier asset, commanding greater returns and adding greater downward pressure on prices to account for this expectation.

Moreover, heavily indebted companies also face higher interest payments, which sometimes leads to an excessive burden, leading to bankruptcy or insolvency.

Thus, when the interest rate in the U.S. had been raised to 5.5%, the highest it had been in over 20 years, the assumption was that the returns on equities should remain muted at best and reflect a decline at worst. The S&P 500 initially posted poor performance in comparison with its 2021 highs.

Strange deviation

However, in a strange deviation from the general expectation, the S&P 500 had posted a return of 24.5% over the past 12 months (as of the time of writing this piece).

However, when taking a closer look at the outperformance of the S&P 500 over the past year, it is evident that most of the gains in the index come from a select few performers.

Specifically, the “magnificent seven” companies, which include Nvidia, Microsoft, Apple, Alphabet, Amazon, Meta, and Tesla, were some of the top performers in the index. Nvidia alone rallied by over 172% during the past year. Other star performers such as Meta (59%), Amazon (45%) and Alphabet (50.5%) also outperformed the index and inflated the S&P 500’s return over the past year.

On the other hand, the S&P 500 equal weight index, which is identical to the S&P 500 index other than that it continues to maintain equal weights of all its constituents regardless of market cap value, has only posted a return of 10.7% (Note: the magnificent 7’s outperformance continues to affect the equal weight index too).

The S&P 500 uses a free-float market capitalisation-weighted methodology, which, in simple terms, assigns a more significant index weightage to a company that has a larger market capitalisation. This mechanism favours companies that perform well.

When a company’s stock price rallies, its market capitalisation naturally sees an increase, which leads to its index constituent weightage increasing. This increase in the weightage leads to a more significant portion of the passive flow to index funds being directed towards the company’s stock, pushing it further and leading to a positive feedback loop.

For example, Nvidia, which has posted a 700% increase in its stock price since 2022, has seen its weightage in the S&P 500 index rise from 1.4% to 7% in 2024. The rest of the index has lagged behind the magnificent seven, with most sectors (especially those such as real estate, which heavily depend on interest rate cycles) posting poor returns over the past year.

Certain chip-making and technology companies’ outperformance stems from the positive attention Artificial Intelligence (AI) has gotten over the past two years. It is undeniably true that the advancements in generative AI over the past few years have been remarkable.

However, as investors, it is essential to ask a few critical questions before jumping into the AI stock rally. A recent report by the Goldman Sachs Research Newsletter raises vital questions about whether the advancements made in generative AI justify the valuations we see today.

It states that AI capacity is expensive to build/implement and run, which contrasts with other technology displacements, such as the dot com revolution, which was cheaper than the architecture it sought to displace. Moreover, AI does not currently benefit from network effects where the value of the technology increases with a more significant number of people using it, such as social media platforms.

Finally, the report states that it remains unclear what the actual use case of this technology will be. Therefore, it is essential to exercise caution when dealing with companies swept up in the AI hype cycle.

In summary, despite historically high interest rates typically leading to poor stock performance, the S&P 500 has defied this trend with a remarkable 24.5% return, driven primarily by the “magnificent seven” tech giants.

However, as reflected by the S&P 500 Equal Weight Index, the broader market shows a more modest 10.76% return, indicating that most sectors, especially those sensitive to interest rate changes, have lagged. This disparity underscores the influence of market-cap weighting in indices.

Caution is advised for investors caught up in the AI hype, as high costs and uncertain value propositions raise questions about current valuations. Instead, opportunities may lie in undervalued sectors of the market.

(Anand Srinivasan is a consultant, Sashwath Swaminathan is a research assistant at Aionion Investment Services)

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