Lance Glinn:

Welcome in to another episode of the Inside the ICE House Podcast, our Markets in Focus series, and joining us as always to talk market trends and market movements is Phil Rosen. Phil, thanks as always for joining me. Happy to have you here.

Phil Rosen:

Thank you for having me.

Lance Glinn:

So NYSX component Alphabet reported negative free cash flow in Q2 for the first time in its history, which frankly is a remarkable stat first and foremost. But with these results, do you think investors should view this as a red flag or is this simply the cost of competing in the AI arms race?

Phil Rosen:

I think that investors took the negative five billion free cash flow as a surface level red flag, but if you look beneath the surface a little bit, they did make over $100 billion in the quarter, which is an insane amount of money. And that shouldn't surprise anyone because they've been generating ridiculous amounts of cash for years and years and years at this point. And what Google is really doing is they are building a full stack, in-house AI ecosystem. They have the distribution, they have all the apps and tools. Gemini is getting better and better. I use Gemini a lot. I think it's great, but they're also developing their own TPUs to compete with Nvidia and also try to discount their future from having to rely on other semiconductor names and external chips. So to me, I've been in Google for a long time personally. I like it long-term as a investment.

The near term negative free cash flow, yes, it makes a great headline. I wrote about it myself. I think it's something to pay attention to. I don't think it's necessarily a sell signal unless they were suddenly making way less cash because they were losing money on their other parts of the business. But right now they're deploying as much capital as possible into this infrastructure build-out. So I think we could see more quarters of negative free cash flow. But at the same time, all their business lines, they're going up 50 to 80% year over year as far as revenue growth. Those are insane numbers for a company as mature as Google or Alphabet. And even if you saw a company growing revenue at 20% a year, you'd say, "Wow, this is amazing fundamentals and the story looks great." But at 80% a year for Google's cloud business, for example, that is just preposterous, the fact that they can do that and they're essentially competing on every single layer of the AI ecosystem. I think Google is an amazing company and an amazing investment, even with negative free cash flow.

Lance Glinn:

Got it. So the negative free cash flow is certainly a headline, but it's those numbers beneath the surface that I would say probably tell a greater story than just that negative free cash flow. You'd agree?

Phil Rosen:

Yes, of course. I mean, anything in the red is going to draw a lot of attention. But if you just look at Google's track record, if you look at their extremely long history of being literally the best moneymaker in corporate America ever, I don't think one quarter out of however many years of existence should suddenly make people sell all their stock and try to find another company that can compete with Google. Because right now, most of what I'm reading and also the investors I'm speaking with, the Mag 7 names to bet on would be Google and Nvidia.

And to me, I actually like Google a lot better than Nvidia. I think they're more diversified. They have a bunch of great business lines that Nvidia is not even touching. Nvidia is a great monopoly for what they're doing with GPUs and chips. But at the same time, Google has got YouTube, they have Waymo, they have Search, they have all these other components that they've been doing forever, and they're essentially a monopoly on a bunch of different verticals. I think that's very compelling from an investment standpoint. And I also own a little bit of Nvidia, but I'm definitely not as long-term bullish on them as I am for Alphabet.

Lance Glinn:

So when you just look across the AI landscape, semis are obviously capturing a huge share of the economic benefit while big tech is spending aggressively on infrastructure. Chip makers are obviously seeing cashflow and profit surge. Why have the chip companies become such clear winners in this space?

Phil Rosen:

Well, I think if you think about it in the picks and shovels analogy, everyone keeps saying that, but the semiconductor chip maker names, those are essentially the picks and shovels right now. So they're going to see immediate cash coming in that they can use, invest, deploy, whatever it might be. But then the hyperscalers, those are the companies doing the digging, let's say, long-term. So we're not going to know if they're making a good bet until they dig and find gold. So that's going to be a much longer-term investment horizon. Assuming that AI fulfills the promises that all the bulls believe it will, these hyperscalers should do very well long-term because if they find gold, great news. But right now it's a K-shaped AI ecosystem here. The hyperscalers' cashflow has been going all the way down and semiconductors going all the way up. So that is maybe the story of this entire chapter of the AI boom because that K-shaped economy or K-shaped AI economy, either that's going to reverse at some point or it's not.

I think it'll probably reverse or at least it'll contract to the point where they're both more even rather than so radically on other sides of the spectrum. But to me, I think people will also look to hyperscalers, not just for the AI boom and trying to capitalize on the AI trade, but when the macro environment gets a little more uncertain, people will probably rotate back into the Mag 7, something like Amazon, Meta, Google, Nvidia. These are names that you could essentially expect them to be around forever when I think people are less certain about that for some of these chip names that have gone parabolic in the last few months. So to me, it's not even necessarily picking and choosing right now. I think you could probably buy all of them and do just fine. The free cashflow variable, that's going to be the near-term headline for everyone. I think long-term though, as long as AI delivers on what we expect it to deliver, hyperscalers will be just fine.

Lance Glinn:

So you mentioned the K-shaped, you mentioned with semis going up, hyperscalers going down. The potential of it one day reversing, maybe even evening out, is there a world or do you foresee the opportunity or the ability for both sides, the hyperscalers and the semis, to be a winner in this together? Or is it one or the other in your opinion?

Phil Rosen:

That's a great question. Near term, I'm sure semis will outperform just because that's where we are in the current cycle. I think long term, it's very hard for me to bet against the hyperscalers. I know their free cashflows are going down, but they're also the only companies in the history of the world that could fund infrastructure build-out like this. So if they're not going to do it, no one else is able to participate, which I don't see how that's bearish for the hyperscalers. I've seen a lot of arguments about how their free cashflow can't last forever as far as spending a trillion bucks a year to fund this thing. I think there's more nuance here, because if you have companies like Amazon, Meta and Alphabet deploying hundreds of billions of dollars, they're also making hundreds of billion dollars and they've been doing that for years and years and years. So they have these fortress balance sheets that, even if they're spending in investment increases, it's not like they will make less money over time because all their businesses are still growing like crazy.

And these are extremely mature companies that all essentially have monopolies on what they do. So I don't see how, even if their spending goes up, sure, maybe their margins squeeze a little bit, but it's not like, for example, Alphabet, they just had their earnings. Their margins are in completely good shape. I wouldn't say they're one negative quarter free cash flow, it's not like the company was in the red. It was just their free cash flow, but they were still making over $100 billion in three months. So to me, I don't think there's that much of a bear case right now over some of these hyperscalers. They've underperformed in the market, but I think that they are more resilient businesses long-term.

Lance Glinn:

So obviously we're in July, we hit the second half of the year. Analysts expect the rest of the market to gradually close the earnings growth gap with big tech over the coming quarters. Do you think we're at the beginning of a broader market rotation or do the Mag 7 still have enough momentum to remain the dominant force in corporate earnings moving forward?

Phil Rosen:

I think their earnings are expected to stay stronger than the rest of the market until the fourth quarter. Then I think the S&P 493 is forecasted to actually have a stronger earnings growth than the Mag 7. But this is after how many years of just destruction from the Mag 7? They've been beating and raising for quarter after quarter for years and years and years, and then the 493 is only just now starting to hit this inflection point where they can not only keep up, but where the Mag 7 are also coming down on earnings growth. I think that trend, it might be underestimating the Mag 7. What I think the average FactSet consensus was that Mag 7 would under grow the 493 in Q4. Maybe. Again, I'm not as in the weeds as all these analysts certainly, but it would be hard for me to bet against something like an Alphabet or Nvidia or Amazon or Meta.

I don't see how, even if their earnings growth slows down, that's only because they've been growing so sharply for so many years, but it's not like they're making less money just because their growth rate slows down. So if they're making $100 billion a quarter now, and then they're suddenly growing at 18% a year instead of 28% a year, that's an amazing business still, and I'd be investing that every other day. So I think the broadening and earnings strength generally, it's a good sign for the duration of the bull market. And the 493, or you could say the equal weight S&P 500 this year, they've outperformed the Mag 7 on a stock price basis this year, which is a great sign. Usually not what you see as a bull market is ending, this rotation trade people keep talking about. That's a broadening out that usually signifies a healthy and resilient bull market.

Because if we were getting more narrow over time and the gains were being concentrated more and more on a stock performance basis and an earnings basis, then you could start to say, "Okay, we're looking a little toppy here historically." But right now we're seeing earnings broaden out and stock performance broaden out. So that's a pretty good sign. Whether we see the strength of the Mag 7 earnings pick up or beat expectations down the line, I'm not sure if they're going to do that. Usually FactSet is pretty on the point here. But again, that's not a reason to not invest in these companies.

Lance Glinn:

So to stay on looking ahead, is there a sector or sectors that you're eyeing for the remainder of this year?

Phil Rosen:

A lot of the smartest investors I've been speaking with over the last month, all of their favorite sectors is financials. So they've been telling me this on my show, Full Signal, and whenever I ask them, "What's your favorite sector right now?" They say financials. So then I started looking into it more and more. And to me, the bull case seems so obvious that it's almost troubling why more people haven't picked up on this. Financials are about flat on the year right now, and the S&P is up 9, 10%. So they're underpouring the index dramatically. I think they're in the ninth out of 11th sector as far as performance this year, which is not great. But the second half of the year, we could see a pretty strong catch-up trade for financials because I think earnings have been unbelievable. All these big banks have been reporting record profits. Their M&A numbers are up. There's a current IPO boom happening, which benefits all the financial stocks and banks. Trading and investment is going up.

We're also seeing interest rates stay higher for longer, and people are saying, "Oh, well, if we get a rate cut," which I think we're going to get, "that could be less bullish for financials if interest rates go down." But 0.25 basis points one direction or the other, that's not going to change the fact we're higher for longer. So elevated interest rates, which benefits the financials long-term. And generally, if you see a sector like this having such strong earnings and fundamentals, and the stock prices have been underperforming, that's primed for a catch-up, I think. So we could see some compression as far as the earnings are up here, but the stock price is down here, so stock prices could start to inflect just to meet where earnings are already at right now, which I think is a pretty bullish sign.

Lance Glinn:

Well, Phil, I always appreciate our conversations. Always enjoy having you here. Thanks so much for joining us inside the ICE House.

Phil Rosen:

Thank you, Lance.

Speaker 3:

That's our conversation for this week. Remember to rate, review and subscribe wherever you listen and follow us on X at ICE House Podcast. From the New York Stock Exchange, we'll talk to you again next week inside the ICE House. Information contained in this podcast was obtained in part from publicly available sources and not independently verified. Neither ICE nor its affiliates make any representations or warranties express or implied as to the accuracy or completeness of the information, and do not sponsor, approve or endorse any of the content herein, all of which is presented solely for informational and educational purposes. Nothing herein constitutes an offer to sell, a solicitation of an offer to buy any security, or a recommendation of any security or trading practice. Some portions of the preceding conversation may have been edited for the purpose of length or clarity.