The UNTHINKABLE is about to Happen to Stocks

SUMMARY

Felix Nikolas Prehn, economist and former investment banker, analyzes the recent $3.46 trillion drop in major AI stocks and explores the implications of U.S. midterm election cycles on market performance. He provides historical context, outlines risks, and offers a strategic plan for investors facing heightened volatility and political uncertainty.

MAIN POINTS

• Major AI stocks have lost significant value, but index funds mask the extent of the decline, creating a false sense of security for many investors. [1:02]
• The correction in AI stocks is attributed to overvaluation, high capital expenditures, and rising interest rates, leading to a sharp repricing of tech leaders. [8:01]
• Historical analysis of U.S. midterm elections shows that the S&P 500 has consistently risen in the year following the vote, regardless of which party wins. [13:03]
• The 1974 and 2011 case studies demonstrate that political gridlock can initially trigger sharp market declines, especially when combined with external shocks like inflation or debt ceiling crises. [17:01]
• A four-step plan is recommended: audit holdings for risk, avoid trading based on election results, use targeted alerts, and monitor sector rotations and insider activity for better decision-making. [21:01]
• Sector rotation is accelerating as institutional investors exit crowded trades, emphasizing the need for individual investors to adapt and prepare for ongoing volatility. [23:00]

DETAILED ANALYSIS

Over the past month, the largest artificial intelligence stocks have experienced a dramatic sell-off, erasing approximately $3.46 trillion in market value. Notable declines include Intel falling by 43% and double-digit losses for Google, Meta, and Nvidia. Despite these substantial drops, broad market indices like the S&P 500 have only slipped by about 3.5%, masking the severity of the downturn for many investors, especially those with diversified portfolios.

This discrepancy is due to the index weighting methodology, where losses in a handful of major tech companies are averaged out by gains or stability in other sectors. The Nasdaq 100, heavily concentrated in technology, has entered correction territory with a 10% decline, while the Dow Jones has occasionally moved in the opposite direction, reflecting sector rotation rather than an overall market exit.

Investor sentiment has reached a state of extreme fear, as indicated by the CNN Fear and Greed Index reading of 23. This heightened anxiety often leads to panic selling, disproportionately affecting long-term investors who may be heavily exposed to past winners now underperforming. The recent correction in AI and tech stocks is attributed to three primary factors: valuations that far outpaced underlying profits, massive capital expenditures on infrastructure such as data centers and chips, and a challenging macroeconomic backdrop characterized by high U.S.

Treasury yields and volatile oil prices. As safe government bonds become more attractive, capital shifts away from riskier, overvalued tech equities. The sector's sharp decline is further illustrated by the chip fund SMH, which has dropped nearly 20% from its peak.

The timing of this market turbulence coincides with the U.S. midterm elections, a period historically associated with significant market patterns. Analysis of the past 19 midterm cycles since the 1950s reveals that the S&P 500 has been higher one year after every election, with an average gain of 16.6%. This trend holds regardless of the party in power, but the specific configuration of a Republican president and a Democratic Congress—seen only seven times since 1954—has also produced positive returns, averaging 15.5% in the subsequent year.

The rationale is that divided government leads to legislative gridlock, reducing the likelihood of major policy changes and providing businesses with greater regulatory and fiscal predictability. Markets have historically rewarded this stability, with annualized returns of 9.9% under divided government compared to 8% under unified control.

However, historical precedent also warns of exceptions. The 1974 midterm cycle, marked by high inflation, weak growth, and an oil shock, saw stocks fall 32% in the year leading up to the vote and another 10.3% in the month after, before eventually recovering. Similarly, in 2011, a debt ceiling standoff resulted in the U.S. losing its AAA credit rating and a swift 17% market drop.

These episodes highlight the risks of external shocks and political brinkmanship, which can override otherwise favorable statistical patterns. The upcoming government funding deadline on December 11 is identified as a potential catalyst for renewed volatility.

In response to these risks, a disciplined approach is advocated. Investors are urged to audit their holdings using risk filters, such as the 'Danger Zone' feature in the Winston app, to identify vulnerable equities. Trading based on political outcomes is discouraged, as financial security should remain independent of partisan preferences.

Instead, reliance on targeted alerts, sector rotation monitoring, and insider activity tracking is recommended to inform decision-making. The ongoing rotation out of crowded trades like technology and into other sectors underscores the importance of adaptability. The overarching message is to avoid panic, maintain a structured plan, and prepare for both the best and worst-case scenarios as markets navigate a period of heightened uncertainty.

LINKS

• Registration for The Great Pivot live training event.
• Winston Metals & Stock App free trial and Founders Tier offer.
• Free research report on the tech crash from The Prehn Institute.
• Biography of Felix Nikolas Prehn.
• Official website of Felix Nikolas Prehn.
• Essays and writings by Felix Nikolas Prehn.
• Research profile of Felix Nikolas Prehn on ORCID.
• Felix Nikolas Prehn's profile on X (formerly Twitter).

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