The government shutdown remains at the forefront of headlines, with no clear end in sight. Prediction markets now expect this to become the second-longest shutdown in history. Over the last fifty years, there have been twenty shutdowns, ranging from two days to thirty-five days. Historically, they’ve had limited economic impact, and unless this one proves unusually long or triggers significant job losses, we expect the market response to remain muted.

Beneath the surface, the economic picture remains mixed. Inflation continues to hover near 3%, above the Fed’s long-term target. Meanwhile, the labor market is softening. The most recent ADP data (with official government releases delayed by the shutdown) showed a second consecutive month of job losses. This is forcing the Fed to pivot to lowering interest rates in an attempt to stimulate the economy and spur job growth.

At the same time, the S&P 500 sits at an all-time high. Seemingly, investors are overlooking these broader concerns. In reality, the market’s gains have been propelled by the continuation of the artificial intelligence (AI) capital expenditure boom that began shortly after ChatGPT’s release in late 2022. A recent report from J.P. Morgan shows that AI-related stocks have accounted for roughly 75% of total market returns, 80% of earnings growth, and 90% of capital spending since ChatGPT was introduced. This surge has made the S&P 500 increasingly concentrated, with just eight companies now representing 38% of the index. Incredibly, the same eight account for roughly 70% of the Nasdaq 100. Investors are crowding into the same few stocks, creating meaningful concentration risk.

Amid these dynamics, the S&P 500 now trades at roughly 23 times forward earnings — rarefied territory by historical standards.

In recent months, discussion has intensified around whether the current enthusiasm for AI has entered bubble territory. The argument certainly carries some merit. Nvidia CEO Jensen Huang has suggested that global data-center capital spending could reach $3–4 trillion per year by 2030, a staggering figure compared with about $650 billion today. OpenAI, the creator of ChatGPT, has recently announced several major partnerships and infrastructure projects with Oracle, Nvidia, and AMD. These deals have also raised concerns about circular funding flows. For example, Nvidia is investing in OpenAI, which will then use those funds to purchase Nvidia chips.

Our research team remains deeply engaged in tracking the many moving pieces surrounding this powerful trend. From our research, two key risks bear watching. The first is economic viability: for that level of investment to be sustainable, AI use cases must translate into tangible productivity and revenue gains. The second is energy: these data centers require enormous amounts of power, creating potential bottlenecks for utilities and infrastructure. If sufficient power generation cannot be achieved, these ambitious growth
projections may be in jeopardy.

As of now, our belief is that while AI-related revenue generation is minimal compared to the capital being deployed into these data centers, the investment spend will continue as no one wants to miss out on this potential generational shift in technology.

Against this backdrop, our team continues to emphasize diversification and valuation discipline. While we maintain a healthy exposure to this AI theme, our research team continues to look elsewhere for opportunities. It’s worth noting that if you exclude the top holdings in the S&P 500, valuations across the broader market look far more reasonable. In fact, multiple sectors have posted negative returns over the last twelve months despite the market’s strong rally. For instance, the healthcare sector is an area that remains under pressure while software and IT Services are areas where investor sentiment has turned overly pessimistic. We see this as an opportunity to find high-quality businesses trading at appealing valuations.

Within our core equity offering during the quarter, we made several additions to the portfolio. We added to our position in Crane (CR), an industrial technology company that is seeing strong growth from its aerospace division. Boeing is increasing its near-term production schedule, and a massive backlog of demand for both Boeing and Airbus aircraft remains. Crane stands to benefit from this long-term secular trend.

We also initiated a position in Arthur J. Gallagher (AJG), a best-in-class insurance broker consolidating the mid-market space. The company recently completed its largest acquisition to date, which is expected to drive earnings growth of more than 20% next year.

In the software space, we increased our position in Tyler Technologies (TYL), which provides mission-critical software to local governments. Its products support thousands of small municipalities nationwide. While sentiment around software has turned negative amid fears that AI could displace existing products, Tyler operates in a highly fragmented market with high switching costs and few credible new entrants. We have great confidence in management’s ability to continue expanding within this market.

Lastly, we initiated a position in ServiceTitan (TTAN), a fast-growing software company modernizing the trades industry. ServiceTitan helps plumbers, electricians, and HVAC technicians run their businesses more efficiently. There is a huge need to professionalize the trades. With its brand recognition and first-mover advantage, ServiceTitan is leading the charge. Rather than being displaced by AI, the company is already leveraging it to automate scheduling, billing, and customer service, driving significant productivity gains.

Within our corporate bond portfolios, we remain fully invested. However, as the year has progressed, yields have drifted lower and credit spreads have compressed, making attractive opportunities scarcer. With such tight spreads and a flat yield curve, it doesn’t pay to take duration or credit risk. Under these conditions, we are taking a patient and selective approach to reinvestment, emphasizing high-quality issuers and waiting patiently for more attractive entry points.

As we approach year-end, we remain cautious but opportunistic. We are pleased with our current portfolio positioning and maintain an unwavering focus on quality. Given elevated valuations and ongoing economic uncertainty, we will remain selective and continue to look for pockets of opportunity as they arise.

Warmest regards,
Rick Ryskalczyk, CFA
Managing Partner, Portfolio Manager

This newsletter is for informational purposes only and does not constitute investment advice, a recommendation, or an offer to buy or sell any securities. The views expressed reflect the current opinions of Sandhill Investment Management (“Sandhill”) as of the date of publication and are subject to change without notice. Information from third-party sources is believed to be reliable, but its accuracy and completeness are not guaranteed. Sandhill is a registered investment adviser with the U.S. Securities and Exchange Commission and is independently owned and operated. This commentary includes general market observations and investment-related insights that are not intended to represent any specific investment strategy or account performance. Any performance data referenced is historical and should not be relied upon as indicative of future results. Certain statements may contain forward-looking views or expectations that are subject to risks and uncertainties and may not come to pass. All investments carry risk, including the potential loss of principal. For additional information, please contact Sandhill Investment Management at 716-852-0279.