How the US Midterms May Reshape the Stock Market

Market Context & Post-Election Sentiment

• Active investors have adopted defensive positioning, with beta-adjusted net exposure in prime books at historically low levels during the second half of the year.
• The S&P 500 excluding AI is identified as the preferred strategy for the next six months, offering exposure to quality compounders with high balance sheet strength at lower valuation multiples (high teens) compared to AI-heavy sectors.

Data Center Sector Dynamics

• The AI data center trade has underperformed expectations, driven by concerns over ROI, open-source competition, and capital market constraints.
• Stock corrections have been severe relative to early-year highs:
  • Data center stocks: down 36%.
  • Memory stocks: down 42%.
  • Optical networking stocks: down 46%.
  • Neocloud stocks: down 57%.
• Valuation multiples have compressed to roughly half of their June levels, aligning with "Liberation Day" lows, eliminating valuation as a headwind.
• The extreme valuation compression has lowered the threshold for positive surprises, with positive catalysts anticipated moving forward.

The "New Defensive" Sector: Healthcare

• Healthcare is emerging as the next leg of the AI trade and a credible defensive sector due to its historical uncorrelation to traditional AI markets.
• Growth drivers include adoption of AI at the tools and diagnostics levels, transitioning the sector from headwinds to tailwinds.
• Healthcare is uniquely positioned to deliver accelerating growth next year through both cyclical and secular forces.
• AI exposure extends broadly across the economy, including the application layer such as cybersecurity.

Critique of Traditional Defensives

• Traditional defensive sectors like consumer staples are deemed unattractive in a slowing growth environment due to expensive valuations.
• Current yield metrics for staples are unfavorable relative to fixed income:
  • Earnings yield is half that of high-yield bonds.
  • Dividend yield is half that of the 10-year Treasury yield.
• Investors are advised to prioritize "quality," free cash flow yield, and earnings yield over traditional defensive labels.

Forward-Looking Statements & Key Catalysts

• Key near-term variables to monitor include employment data, inflation trends, resolved geopolitical events, and the remainder of the earnings season.
• Longer-term focus areas include equity and debt capital markets.
• The FOMC decision scheduled for December 9th is identified as a critical upcoming event.
• Outlook for year-end includes a "relaxed" Santa Rally.