Wells Fargo Strategist Ohsung Kwon on Year-End Equity Setup and AI Capex Risks

Positive Year-End Equity Outlook

• 💡 The setup for equities into year-end is considered pretty positive, with a recommendation to buy the dip.
• 📈 The recent earnings season was strong, with companies beating EPS expectations by 8%, marking the broadest beat in four years, as 75% of companies surpassed EPS estimates.

Bull Cases for Market Rally

• 🗓️ Seasonality typically favors a more positive market from November to December, especially for lagging stocks, suggesting a potential catch-up trade.
• 💰 A potential tariff refund from the Supreme Court ruling could reduce future tax obligations or directly impact company bottom lines, leading to improved margins as companies maintain price increases while costs decrease.
• 💸 A larger tax return, estimated at $800 more per person, is expected due to a significant legislative bill.
• 🏛️ The government reopening is anticipated to remove an overhang for equities, with historical precedent suggesting this is positive for the equity market.

Bear Case: AI Capex and Hyperscalers

• ⚠️ Concerns exist regarding hyperscalers and the ongoing AI capital expenditure cycle, which is believed to be in its early stages (fourth inning).
• 📉 This AI capex might be more about maintenance to stay competitive rather than growth, potentially leading to reduced free cash flow and historically low free cash flow margins.
• 📉 Hyperscalers, being the largest companies in the S&P 500, could negatively impact the index if their free cash flow conversion drops significantly.

Multiplier Effect of AI Capex

• 🧩 The multiplier effect of AI capex is considered smaller compared to traditional capital expenditures, meaning it creates fewer jobs than expected based on historical regression.
• 📉 A significant portion of recent layoffs were related to AI, indicating that while AI capex benefits corporations and stock markets, its broader economic impact on job creation is limited.
• 📊 The AI economy is characterized by EPS up, layoffs up, benefiting large companies with access to capital but not necessarily the broader workforce.