Canadian stocks continued their upward move in February, rising over 7%, driven by ongoing strength in basic materials (up 21% on the month), energy and banks.  The U.S. stock market, on the other hand, continued to struggle as the AI-fuelled technology rally ran into some serious headwinds.  The S&P500 had its worst month since ‘Liberation Day’ last April, falling over 1% while the ‘tech heavy’ Nasdaq Index fell over 3%.  The market continues to experience a shift from the high technology ‘growth’ sectors to the value-oriented cyclical groups such as banks, resources and industrials.  The relatively higher weight of those sectors in the Canadian market has been enough to sustain the better relative performance over the past year despite the ongoing economic risks from U.S. tariffs and the threats about the renewal of the USMCA.  The bigger question now becomes ‘where do we go from here?’  Even more so after the weekend bombings in Iran by the U.S. and Israel.  This is a stock market that has seen 3 ½ years of almost uninterrupted gains outside of the brief period around the tariff threats on ‘Liberation Day.’  But are we starting to see more holes in the AI growth story that has been the tailwind for the market averages as well as the capex boom that has helped to sustain economic growth beyond expectations.   We believe the risks of a more serious pullback in stocks has increased sharply since the beginning of the year and have positioned our portfolios to reflect these rising risks. 

One old trading adage we continue to cling to is that when stocks stop rallying on good news, then it is time to start worrying.  The corollary of that being that when stocks stop falling on bad news, then it is probably time to buy.  There was no bigger demonstration of the former than what happened following the release of earnings and outlook from tech industry giant, Nvidia, the largest capitalization stock in the world.  They once again beat expectations, with revenue for its fiscal fourth quarter hit $68.13 billion, ahead of analyst estimates of $66.21 billion.  Total revenue climbed 73% from the figure Nvidia reported a year ago and guidance also came in ahead of expectations and hey also guided to sales of $78 billion next quarter.  To put this in perspective, when this AI boom started three years ago, Nvidia was doing about $9 billion in quarterly revenues, so the growth has been beyond outstanding.  Yet despite the ‘beat and raise’ and the fact that the stock is only trading around 24 times forward earnings versus an average of over 40 times over the past five years, the stock still fell over 10% during the two trading days following the release.  Clearly the bar is set exceptionally high for companies such as Nvidia.  But, more importantly, the technology trade is clearly starting to unwind after a stellar 3 ½ year period of excessive returns. The debate has shifted away from near-term results and toward the sustainability of AI capex spending, amid concerns around its quantum, monetisation and potential cashflow degradation.  What is weighing heavy on investors’ minds is how Nvidia can maintain its phenomenal growth rate now that its core customers, the hyperscalers, have mostly depleted their free cash flows by their massive spending on AI-related capex.

The stock market turmoil unleashed by the artificial-intelligence industry reflects two fears that are increasingly at odds.  One is that AI is poised to disrupt entire segments of the economy so dramatically that investors are dumping the stocks of any company seen at the slightest risk of being displaced by the technology.  The other is a deep scepticism that the hundreds of billions of dollars that tech giants like Amazon, Meta, Microsoft and Alphabet are pouring into AI every year will deliver big payoffs anytime soon.  The duelling anxieties have been brewing for months, but they’ve shifted to the centre of the stock market over the past few months.  The result has been a series of punishing selloffs that have hammered dozens of companies across industries from real estate services and wealth management to insurance brokers and logistics firms and, in the process, wiped more than $1 trillion from the market values of the big tech companies investing the most in AI.  The shift marks a major break from the sentiment of the last few years, when speculation that AI would set off a transformative productivity boom kept pushing stock prices higher.  While big tech stocks kept rising — sending Meta surging nearly 450% from the end of 2022 until the start of this year, and Alphabet up more than 250% — the growing belief that it was a bubble about to burst did little to derail the rally.  That began to change late last month as earnings reports from some of the biggest tech companies started to spook investors, who are growing impatient that the spending has yet to produce a commensurate windfall in revenues.  Microsoft, Amazon, Meta, and Alphabet alone are expected to spend more than $600 billion on capital expenditures in 2026.  That spending is effectively using up all of their free cash flows and load the companies with depreciating assets, radically altering many of the characteristics that have helped fuel those firms’ rise over the past decade.  That is why the stocks that showed the biggest increase in capex investment last quarter, without a commensurate increase in revenue, were the ones that sold off most aggressively on those earnings reports.  That included Microsoft, Amazon and Meta.

 This negative free cash flow has begun to erode one of the big advantages the tech industry’s most-valuable companies had over high-flying AI upstarts like OpenAI and Anthropic.  As of the end of the latest quarter, the four leaders still had a total of over $420 billion in cash and equivalents, but this balance was expected to fall further over the next few quarters.  Businesses today are testing and building new AI agents to handle all sorts of tasks, including developing applications with just a few text prompts. All that advancement requires hefty amounts of compute, which the cloud providers say is creating insatiable demand for their technology.  This spending is so massive that it is impacting overall economic growth numbers in the U.S.  Estimates are that capital spending on technology were responsible for over 40% of the growth in GDP in the U.S. in the past three quarters.  Ditto on the contribution from tech stocks to overall corporate profits is even more acute.  Nvidia is the single largest contributor to both earnings and revenue growth among S&P500 firms.  Strip out the impact of this one company alone and the blended earnings growth would fall to 12.0% from 17.7%.  Clearly the continuation of these massive spending levels is not only important to the stock market but to overall economic growth as well.  That makes the bet on the success of AI an even bigger gamble for the entire stock market. 

Beyond the capex story and the hyperscalers, the software stocks have been a particular source of anxiety as the biggest, well-known names are down anywhere from 30-50% over the last six months.  The largest software sector ETF, ticker IGV, has plunged 30% since its peak last October.  What precipitated this has been widespread concerns that AI could make software-as-a-service, or SaaS, business models obsolete, which sparked a sell-off and warnings of an impending “SaaSpocalypse.”  Worries that new AI models from Anthropic and OpenAI will replace core ERP software systems hit industry leaders such in cyber security, logistics, transportation and data management.  In the past week, IBM stock dropped 13% in its worst daily performance since 2000 after Anthropic published a blog post saying its Claude Code AI tool for developers can assist with modernizing code written in the Cobol programming language. 

In our view, the rumours of the death of SaaS are premature.  Investors, as they often do with any new narrative in the market, have quickly priced almost the entirety of the risks from the slower expected growth trajectories into most of the larger providers (Salesforce, Adobe, Workday, ServiceNow).  We believe the scepticism is overdone and the impact on growth will not be as quick or substantial as projected.  “Systems of Record” like Salesforce, SAP, or Workday will survive because they hold the “Ground Truth” data that enterprises rely on for legal, compliance, and historical reasons. Many SaaS systems have ‘data moats’ such as decades of proprietary data and complex business logic (e.g., tax codes in payroll software) that are difficult for an AI to “hallucinate” accurately without a structured foundation.  While there is a real threat to the long-term margin outlook for parts of the sector, it is harder to make the case for an existential threat across many companies that provide essential services within today’s business and scientific infrastructure.  Despite these ongoing worries and the poor performance of software stocks over the past six months, we do not expect that software will be usurped by AI and will instead be a major beneficiary of its development.  Consumer AI platform developers — like Google parent firm Alphabet, ChatGPT maker OpenAI and startup Anthropic — have little to no experience creating “enterprise class” software and would be architecting from scratch in unfamiliar highly complex areas. Meanwhile, it was not practical, realistic, or economically sound for companies to use AI to develop their own in-house software systems.  Within a full-blown enterprise application, we think AI is destined to be subordinate to the overall software platform. 

We believe that the reason why the reaction to these threats in the stock market have been so severe is because technology was a ‘crowded trade’ that is now in the process of unwinding.  Public investment in the stock market reached record highs last year and most of this new money had gone into the tech sector.  That had also driven the weighting of the biggest tech names in big indices such as the S&P500 to records while the growth in ‘passive investing’ had driven even more money into those indices.  The result has been an average exposure to the technology sector in both active and passive funds that was far higher than it had ever been and held by investors who were either driven solely by momentum or quantitative trading programs and were therefore less committed to being long-term holders.  This has led to higher average levels of volatility in the stock market.  In this type of environment, stocks tend to overshoot on the downside just as they did on the upside.  We could be seeing this occur now.  Valuations in what we believe are strong, long term core growth companies (i.e. Salesforce, Workday, Adobe, Constellation Software, CGI Group, Service Now) have fallen to levels not seen since the depths of the financial crisis.  We see more opportunities in the GARP (Growth at a Reasonable Price) stocks than we do in the pure Growth Indices (where leadership is struggling) or the Value Indices (which have been rebounding but are dependent on strong economic growth).   

Unpacking the market reaction to Shopify earnings.  Another anomalous reaction to earnings was found in the market’s response to the Shopify earnings earlier this month.  Following the 14% pre-market surge in the stock following the release of exceptionally strong 4th quarter earnings which included year-over-year revenue growth of over 30%, the stock gave up all those gains and finished more than 10% lower on the day.  The worries about software stocks continues to be more important than actual results and may also signal that investors are still too aggressively positioned in the technology sector.  The pullback provides a buying opportunity for a category leader we think is poised to benefit from AI, with Agentic Commerce tailwinds and via the leveraging of AI internally to drive growth cost efficiently. We also believe management said all the right things on its public call and on the sell side callback. While generic SaaS firms offering simple interfaces or features may be at risk of being replicated by AI, SHOP views itself as the opposite: a mission-critical “System of Record” that now powers 14% of U.S. E-commerce, and helps its merchants manage the wide range of commerce complexities beyond just the “front-end”, including “back-end” infrastructure (payments, fraud detect, authorization, inventory management, identity, etc.).  The company is now generating substantial free cash flow and the valuation, while not cheap by any measure, has fallen to the low end of its 10-year range.  We added to the position on the recent selloff and still think it has tremendous long-term growth potential. 

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