Is the Market Wrong About Software Stocks? | With Jeremy Schwartz
Audio Brief
Show transcript
This episode analyzes the conflicting signals in the current market, specifically the tension between strong jobs reports and a sell-off in software stocks driven by fears of AI displacement.
There are three key takeaways for investors looking to navigate the current AI hype cycle. First, beaten-down software stocks may offer a compelling contrarian opportunity. Second, the structural bull case for Japanese equities remains intact despite currency volatility. Third, gold is becoming a vital geopolitical hedge that requires a more modern approach to asset allocation.
Let’s examine the software sector first. The market is currently punishing cloud computing and SaaS companies like Salesforce or Adobe on the assumption that generative AI will make them obsolete. However, Jeremy Schwartz argues this view is excessively pessimistic. Incumbents possess the distribution networks and resources to integrate AI into their existing stacks rather than being replaced by it. Instead of a job killer, AI acts as a massive productivity enhancer, allowing companies to expand output and margins without increasing headcount. This dynamic could lead to a scenario where profit margins accelerate rather than revert to the mean, making the recent correction in cloud stocks potentially excessive.
Next, looking at international markets, Japan continues to offer significant value. While US equity premiums have compressed, Japanese equities remain cheap relative to local bond yields. The investment thesis is supported by corporate governance reforms and specific thematic plays, such as defense stocks benefiting from re-armament trends and AI derivative plays. Schwartz highlights that the earnings growth story in Japan is robust, suggesting investors should look past the currency fluctuations to focus on the strong underlying corporate fundamentals.
Finally, the conversation turns to commodities. Gold has seen a surge in prices despite high real interest rates, signaling a structural shift driven by central bank buying, particularly from China, as a hedge against geopolitical risks and sanctions. The challenge for investors is often the opportunity cost of selling stocks to buy gold. A solution lies in capital efficient asset allocation. By utilizing futures to stack asset classes, investors can overlay gold exposure onto a core equity portfolio. This strategy allows for diversification and protection against inflation or geopolitical shocks without sacrificing participation in stock market gains.
This discussion underscores that while AI is reshaping labor and margins, opportunities exist in mispriced incumbents, undervalued international markets, and strategic commodity exposure.
Episode Overview
- Orient the Reader: In this conversation, Maggie Lake speaks with Jeremy Schwartz, Global Chief Investment Officer at WisdomTree, to dissect the conflicting signals in the current market: a strong jobs report versus a sell-off in software stocks driven by AI displacement fears.
- Narrative Arc: The discussion moves from the immediate impact of AI on labor and corporate margins to specific investment opportunities in beaten-down cloud computing stocks, the structural bull case for gold amid geopolitical shifts, and the enduring value proposition of Japanese equities.
- Relevance: This episode is highly relevant for investors trying to navigate the "AI hype" cycle, those looking for diversification outside of the "Magnificent Seven" through international markets or commodities, and anyone concerned about how generative AI will impact long-term corporate profitability.
Key Concepts
- AI as a Margin Expander, Not Just a Job Killer: While the market currently fears AI will make software companies obsolete or destroy jobs, the counter-perspective is that AI is a massive productivity enhancer. This "do more with less" dynamic allows companies to expand output and margins without increasing headcount, potentially leading to a scenario where profit margins accelerate rather than mean-revert.
- The "Holy Grail" of Productivity: High productivity growth driven by AI is inherently deflationary. If realized, this creates a macroeconomic "Holy Grail" where GDP grows faster than debt, allowing the economy to outgrow its fiscal deficits without triggering the inflationary spirals usually associated with debt monetization.
- Incumbent Advantage in Software: The market is punishing software stocks (like Salesforce or Adobe) on the assumption that AI will replace them. However, incumbents often have the distribution networks and resources to integrate AI into their existing stacks, making the current sell-off in cloud computing potentially excessive.
- Capital Efficient Asset Allocation: Traditional portfolio models often under-allocate to commodities like gold due to the opportunity cost of selling stocks. A more modern approach uses "capital efficiency"—utilizing futures to stack asset classes (e.g., holding 90% equities and 90% gold futures with the remaining cash as collateral) to gain diversification without sacrificing equity exposure.
- Geopolitics Driving Gold: The recent surge in gold prices, despite high real interest rates, signals a structural shift. Central banks, particularly China's, are diversifying away from US Treasuries due to geopolitical risks (sanctions fears), creating a non-interest-rate-sensitive buyer for gold.
Quotes
- At 2:28 - "We do think it could be a year where we don't have that much jobs growth, but the economy still does well because of this productivity story... you're able to actually grow output, grow margins as a business, and just not hire as many people." - Explaining the "no hire, no fire" economic environment where efficiency drives growth rather than labor expansion.
- At 3:19 - "People worry that the market's expensive and margins are at... cyclical highs [and] they mean revert. But what if they just keep accelerating? What if margins actually... because of this new technology... might keep accelerating higher?" - Challenging the bearish view on valuations by suggesting AI permanently alters corporate profitability structures.
- At 12:47 - "I think a lot of these software stocks, the narrative is that they're being displaced. And some of them will not [be], and some of the infrastructure on them will stick around... Are we going to really spend our engineers' time to go reinvent Salesforce? Or are we just going to build apps on top of what we have?" - Highlighting the stickiness of enterprise software even in an AI-disrupted world.
- At 28:56 - "Our equity premium [in the US], stocks versus bonds, is 2.5. In [Japan], it's 7... comparing the valuations versus their bond yields. You should still be buying stocks locally in Japan. They're cheap, earnings are growing, they've got AI derivative plays all over." - Illustrating the massive valuation gap and attractiveness of Japanese equities compared to the US market.
- At 30:38 - "If you just took a passive allocation to the liquid markets—stocks, bonds, gold—what would the passive allocation be? It'd be 52% equities, 32% bonds, and 12% gold. 12 is just the size of the market." - Contextualizing how under-allocated the average investor is to gold compared to its actual global market cap.
Takeaways
- Revisit Beaten-Down Software: Look at the cloud computing and SaaS sectors that have been sold off on AI fears. Focus on incumbents with strong distribution that are likely to integrate AI tools rather than be replaced by them, as valuations here may have corrected too far.
- Target Japan for Value and Defense: Continue to allocate to Japan, focusing specifically on defense stocks (re-arming theme) and "Buffett-style" conglomerates with low valuations. The widening yield gap has not broken the thesis, and corporate governance reforms remain a strong tailwind.
- Stack Gold on Top of Equities: Instead of selling stocks to buy gold (the traditional trade-off), consider capital-efficient strategies or ETFs that use leverage/futures to overlay gold exposure onto a core equity portfolio. This allows you to hedge against geopolitical risk and inflation without missing out on stock market gains.
