We can’t ignore AI.
We mean that literally… You cannot ignore AI because it is everywhere. AI firms have grown to dominate the market… AI-related articles flood our news feeds… And if you don’t mention AI in your earnings call, are you even a company?
All joking aside, AI hyperscalers and their suppliers have become a major factor in today’s equity market movement. It won’t surprise anyone to hear that Technology has grown to account for nearly 35% of the S&P 500 market cap. Perhaps even more significant is that semiconductor companies now represent nearly 50% of the technology sector (compared to 27% in the 1999-2000 boom).
However, it may surprise you to hear that we feel there’s greater risk than opportunity in over-weighting AI-focused firms, in particular the semiconductor group.
Here’s why.
Hyperscalers have committed huge amounts of capex toward data center construction (which includes the semiconductors required to run them). That makes sense in an emerging technology segment, and to date these expenditures have widely been committed within the backdrop of a cash-rich, healthy balance sheet.
That’s not the case today.
Hyperscalers are now projected to spend more than 100% of their cash flow in capex, which means their free cash flow will turn negative. We’re also seeing these firms begin to borrow money. This means that, on average, their balance sheet quality is beginning to deteriorate.
The market sports a 21.6 forward PE ratio today. While PEs are historically high, they are lower than the recent high of 23 times forward earnings recorded in 2025. This can be misleading.
It’s easy to look at lower PE ratios and assume market valuations have become more attractive. However, we have to consider the significant upgrade to projected earnings over the last several months, a period which historically sees declining forecasts.
Below are the changes in projected earnings for selected sectors and the S&P 500.
The persistent increase in earnings projections are built on assumed sales growth but also increasingly on operating margin growth. This is notable in the semiconductor realm with operating margins expected to increase from 25% to 45% over the next 2 years. This drives the S&P 500 margin from 15% to 21% and even the S&P 493 index (minus the Mag 7) margin from 13% to 19%. These are very aggressive assumptions.
AI may change everything (and may help operating margins to some degree). We’re seeing improvements all the time. But the change tends not to happen as fast as the prognosticators think. We’ve seen this trend play out with each AI model release — promises of exponential improvement which turns into incremental improvements with more bugs than were expected. Again, the progress is happening, but is it happening at the rate needed to generate margin and earnings growth requirements set by huge capital expenditures?
Today, the S&P 500 is historically overvalued. Overvaluation does not imply immediate stock price weakness but does mean greater sensitivity to negative news. The story that advisors and investors should be tracking is earnings growth. Earnings projections are becoming increasingly optimistic, which means the expectations will be increasingly difficult to meet.
Could companies rise to the occasion and meet projections? Yes. However, the goals are lofty and with widespread overvaluation that means there is quite a bit of risk in the market which should be managed – especially in the semiconductor space.
For a fundamental manager (that’s us), this all points toward a diversified portfolio with a high emphasis on balance sheet quality and ample allocations toward traditionally defensive sectors, such as Health Care, Staples, and Utilities. We hold a moderate technology exposure (around 20%). However, we don’t feel that it is appropriate for most long-term oriented investors to chase the semiconductor trend as technology garners a higher percentage of the S&P 500’s market cap.
Why?
Because beating the index in the short run isn’t the goal (though we have outpaced the S&P 500 due to missing much of the drawdown in Q1). The goal is to deliver the highest return within an acceptable level of risk. In other words, consistently deliver returns in line with an investor’s goals without adding a crazy amount of risk to the portfolio, which could jeopardize their long-term goals or cause an emotional decision to exit the investment plan.
We firmly believe fundamentals can be a great tool in that endeavor. We’ve been following the fundamental process since the late 90s (members of our investment team since the 70s). We’ll continue to do so, even as we work through a highly-valued market.
PS – this may go without saying, but this article was not written by AI.
Interested in exploring the benefits fundamental investing could deliver to your portfolios? Click here to explore AAMA’s full model lineup or reach out to us directly at engage@aamamail.com. We’d love to speak with you.
The information and opinions in this report have been prepared by the investment staff of Advanced Asset Management Advisors (AAMA). This report is based upon information available to the public. The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but AAMA makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this report constitute AAMA’s judgment and are subject to change without notice. This report is provided for informational purposes only. It is not to be construed as a recommendation to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction in which such an offer or solicitation would violate applicable laws or regulations.
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