AI impacts "future cash flow," causing the "traditional factors" of Wall Street quantitative strategies to become ineffective

The development of artificial intelligence is disrupting Wall Street professional fund managers’ investment toolbox. AI technology is reshaping the future economic landscape, challenging the quantitative strategies that once supported trillions of dollars in asset allocation. Traditional stock-picking assumptions—what is safe, what is cheap, what is worth chasing—are being completely rewritten.

This upheaval began with a thought experiment published by the well-known research firm Citrini on the Substack platform. The report envisioned a dystopian near-future scenario where AI rapidly eliminates white-collar jobs, and the economy cannot bear the blow. This warning quickly caused market turbulence, with IBM’s stock price experiencing its largest drop in 25 years, following heavy losses in software stocks that fell to new lows. Renowned scholar Nassim Taleb also issued a bankruptcy warning.

This event not only affected specific tech stocks but also shook the entire market valuation system. As AI reshuffles the winners and losers across industries, investor confidence in long-term cash flows is waning, leading them to seek stocks with immediate fundamentals and low valuations or companies supporting AI infrastructure.

Nick Niziolek, Co-Chief Investment Officer at Calamos Investments, pointed out that AI is changing the behavior patterns of many traditional stock factors used by investors to build portfolios, “causing the composition and characteristics of factor baskets to shift in real time.”

“Quality” factor under pressure, high-profit companies abandoned

In Wall Street’s quantitative models, the “quality” factor typically represents companies with high profit margins and stable earnings, once considered a “safe haven” for investors. However, under the current AI impact, this factor is being penalized by the market. For example, Microsoft and AppLovins, providers of complex customer management platforms and business solutions, had high profit margins built on automating complex work.

In the past, these high-profit companies’ high valuations were justified by their wide competitive moats. But now, these moats are precisely what AI aims to breach. As a result, these stocks are being shunned by investors. Meanwhile, the long-neglected “value” factor has suddenly come back into focus. In the Russell 1000 index, high-quality stocks in February underperformed value stocks by over 5 percentage points, marking the worst performance since 2021 and reversing the trend of high-quality stocks leading over the past three years.

Alexander Altmann, Head of Global Equity Tactical Strategies at Barclays, said that hedge funds had previously bought large amounts of high-quality stocks, and rebalancing their positions may have exacerbated the recent decline of this factor. “Disruptive technologies meeting crowded long positions have created chaos for many quantitative strategies.”

“Momentum” factor decoupled, fundamentals no longer the main driver

Not only the “quality” factor, but the “momentum” factor (i.e., chasing winners) in portfolios is also showing rare internal contradictions. Over the past decade, the most reliable trend in the stock market has been that stocks on the rise tend to accelerate, often driven by analyst upward revisions based on earnings expectations.

However, analysis from Man Group shows that the stocks with the biggest recent gains have little correlation with fundamental improvements reflected in analyst earnings upgrades. As long as they are related to AI, stocks can gain upward momentum. Ziang Fang, Senior Portfolio Manager at Man Group, said:

“You might think this is a momentum portfolio, but at this moment, it’s an AI portfolio. It’s worth considering where this exposure comes from, whether intentional or unintentional, and what this exposure means from a risk perspective.”

Reevaluating safe assets, cash flow and infrastructure become new favorites

For decades, investors have been willing to pay premiums for future profits and wait years for companies to fulfill their promises, such as software developers, pharmaceutical companies, and social media firms. But as AI rapidly disrupts multiple industries, the market is no longer willing to bet on cash flows that may not exist in five years.

Now, certainty has become a scarce resource. The development of AI technology requires substantial infrastructure support, and companies providing this infrastructure—such as utilities, chip manufacturers, and grid and pipeline producers—are becoming new hot trades. Goldman Sachs strategists refer to these stocks as “heavy assets, low obsolescence” or HALO stocks. Travis Prentice, Chief Investment Officer at Informed Momentum Company, believes that AI is returning focus to physically capital-intensive and more cyclical industries, which often have higher weights in value strategies.

Additionally, investors are rediscovering stocks like AngloGold Ashanti, Coca-Cola, and Acadia Healthcare, which have strong current fundamentals and low prices. The demand for quick access to under-the-radar cash is unprecedented.

Bloomberg data shows that ETFs tracking high-dividend and share repurchase companies attracted $7 billion in new funds this month, ranking second among so-called “smart beta” ETFs after value-based funds. 22V Research reports that the basket of stocks focused on high cash returns has risen about 7% this quarter.

Dennis DeBusschere, co-founder of 22V, said:

“AI is a specific force driving changes in factor relationships. We should expect the typical breakdown of factor relationships to continue over the next year.”

But it’s also undeniable that if AI’s disruptive potential proves narrower than expected or if an economic slowdown restores the pursuit of quality, traditional quantitative strategies could quickly rebound.

Risk Disclaimer

Market risks are present; investments should be cautious. This article does not constitute personal investment advice and does not consider individual users’ specific investment goals, financial situations, or needs. Users should consider whether any opinions, views, or conclusions herein are suitable for their particular circumstances. Invest at your own risk.