When Good News Stops Working

Meta reported strong earnings and raised its capital spending plans, yet the stock fell sharply and its key suppliers failed to rise. In previous quarters, the market would have welcomed this news. Last week, it raised a question investor had set aside for months: what happens if AI spending slows?

The first concern is funding. The largest technology companies have spent all of their free cash flow on AI infrastructure and are now borrowing heavily. Meta’s free cash flow has turned negative, and the company noted that raising money is getting harder as Anthropic and others compete for capital. The cost of insuring AI company debt against default is rising. These companies borrow long term to sell computing capacity on short contracts with uncertain future pricing. Because AI investment drives a large share of U.S. growth, any slowdown would raise recession risk.

However, much of the selling appears to have been driven by hedge funds rather than weaker fundamentals. Hedge funds entered the second half with record gains and record borrowing, and moved quickly to protect those gains when AI stocks weakened. Goldman Sachs’ basket of the most crowded hedge fund holdings had its weakest 75 day period against the S&P 500 this century, outside the 2008 financial crisis. The closest comparison is August 2007, when quantitative funds unwound positions built over 18 months in just 75 days. Last Thursday, 324 S&P 500 stocks rose even as the index fell 1.36%. For the week, the S&P 500 declined only 0.5%.

The broader picture is harder to ignore. Brent crude closed above $115, its highest level since 2022, largely on fears of escalation between Israel and Iran. French 10 year bond yields have risen above U.S. Treasury yields amid cost of living protests ahead of next year’s elections. The Federal Reserve faces rising inflation and slowing growth, and is expected to hold rates next week.

For now, the economy remains steady. Jobless claims are stable and corporate profits are growing about 20%. Credit markets are more cautious. Yields on the lowest rated corporate bonds now exceed their 2022 peaks, and falling long term Treasury yields point to slower growth ahead. Defensive sectors and energy are leading.

This week, Microsoft, Alphabet and Amazon report earnings, with options markets pricing a 6% to 8% move in Amazon.

Our view: the forced selling appears largely complete. Whether this was a temporary positioning adjustment or the start of a broader AI slowdown will depend on upcoming earnings and credit conditions.