AI can do Investment Management!

Can AI conduct investment management?

I tested five free versions of AIs.

1. Claude Sonnet 3.5
2. ChatGPT
3. Gemini
4. Perplexity
5. Mistral

I could not complete the investment management task with Perplexity and Mistral. Thus, I was left with just three: Claude, ChatGPT, and Gemini.

The investment management task

Come up with an investment management recommendation for a pension fund by analyzing 12 different macroeconomic variables.

I captured data from a website with a matrix of 12 time series graphs, including 6 variables related to the S&P 500 (P/E, earnings yield, dividend yield, etc.), and another 6 economic variables (GDP, Inflation, interest rates, etc.).

Here is the visual data I fed to the AIs to conduct their investment analysis and recommendation:

Source: multpl.com

You can see the matrix of time series graphs at the following link:

https://www.multpl.com/

Below was my detailed prompt to the AIs:

As a stock market analyst, please complete the following [task] and display the output in the following [format] and [tone]:

‘’’task

Assess whether the S&P 500 is fairly valued, overvalued, or undervalued. Make this assessment by reviewing all the 6 variables related to the S&P 500 and analyzing the impact of all the 6 economic and interest rate variables on the S&P 500. Discuss the current economic environment in relationship to the S&P 500 valuation. And, conclude with a recommendation on whether to increase the exposure to the S&P 500, leave it unchanged, or decrease it. You are addressing a pension fund manager. The current exposure of the pension fund is 60% stocks and 40% bond.

‘’’format

Write a report of no more than 1,000 words. Use bullet points to emphasize the main themes of your report.

‘’’tone

Use a formal tone and convey your analysis in the most sophisticated way possible. The pension manager you are addressing has a Ph.D. in economics and decades of experience in investment managing.

Below see Claude’s report generated in a few seconds.

S&P 500 Valuation Analysis and Investment Recommendation [generated by Claude]

Executive Summary

This report provides a comprehensive analysis of the S&P 500’s current valuation, considering key market metrics and macroeconomic indicators. The analysis suggests that the S&P 500 is moderately overvalued in the current economic environment. Given this assessment, we recommend a slight decrease in equity exposure for the pension fund.

Key Findings

• Valuation Metrics: The S&P 500 PE Ratio and Shiller PE Ratio indicate elevated valuations.
• Economic Indicators: Strong GDP growth and moderate inflation support current valuations to some extent.
• Interest Rate Environment: Rising rates pose a potential headwind for equities.

Detailed Analysis

S&P 500 Valuation Metrics

1. S&P 500 PE Ratio (28.45)

• Significantly above the historical average of ~15–16.
• Indicates potential overvaluation, but must be contextualized with current economic conditions.

2. Shiller PE Ratio (35.65)
- Well above its historical mean of ~17.
- Suggests overvaluation from a cyclically-adjusted perspective.

3. S&P 500 Earnings (196.70)

• Strong earnings support higher valuations to some extent.
• However, the sustainability of this earnings level is questionable in a potentially slowing economy.

4. S&P 500 Dividend Yield (1.29%)

• Low yield compared to historical standards.
• Indicates potential overvaluation or reflects a shift towards growth-oriented market composition.

5. Inflation Adjusted S&P 500 (5,474.63)
— Near all-time highs even when adjusted for inflation.
— Suggests potential overvaluation relative to historical real returns.

6. S&P 500 Earnings Yield (3.51%)
— Low compared to historical averages.
— Indicates potential overvaluation, especially when compared to rising risk-free rates.

Economic and Interest Rate Variables

1. 10 Year Treasury Rate (4.32%)
— Significantly higher than recent years.
— Reduces the relative attractiveness of equities.

2. US Inflation Rate (3.36%)
— Moderating but still above the Federal Reserve’s 2% target.
— May lead to continued monetary tightening, potentially pressuring equity valuations.

3. US GDP Growth Rate (5.38%)
— Strong growth supports higher valuations.
— However, this rate may not be sustainable in the long term.

4. US Real GDP Growth Rate (2.88%)
— Solid real growth, supporting current economic activity.
— Provides some justification for higher-than-average valuations.

5. 20 Year Treasury Rate (4.55%)
— Higher long-term rates increase the opportunity cost of equity investments.
— May lead to valuation compression if sustained or increased further.

6. S&P 500 Historical Prices (5,474.63)
— Near all-time highs.
— Reflects strong market performance but raises questions about future return potential.

Economic Environment and S&P 500 Valuation

The current economic environment presents a complex backdrop for S&P 500 valuation:

- Strong Economic Growth: The robust GDP growth rate of 5.38% and solid real GDP growth of 2.88% provide fundamental support for elevated equity valuations. This growth environment has contributed to strong corporate earnings, as evidenced by the S&P 500 earnings figure of 196.70.

- Inflation Concerns: While moderating, inflation remains above the Federal Reserve’s 2% target at 3.36%. This persistent inflationary pressure may necessitate continued monetary tightening, potentially creating headwinds for equity valuations.

- Rising Interest Rate Environment: The 10-year Treasury rate at 4.32% and the 20-year rate at 4.55% represent a significant shift from the low-rate environment of recent years. Higher risk-free rates increase the discount rate for future cash flows, potentially putting downward pressure on equity valuations.

- Valuation Metrics: Both the S&P 500 PE Ratio (28.45) and the Shiller PE Ratio (35.65) are substantially above their historical averages, indicating potential overvaluation. The low dividend yield (1.29%) and earnings yield (3.51%) further support this assessment.

- Market Momentum: The S&P 500’s historical price trend and inflation-adjusted level show strong momentum, reflecting investor optimism. However, this also raises concerns about the sustainability of future returns.

In this context, the S&P 500 appears to be moderately overvalued. While strong economic growth and corporate earnings provide some justification for above-average valuations, the elevated PE ratios, low yields, and rising interest rates suggest that much of the positive economic outlook may already be priced in.

Recommendation

Given the analysis of the S&P 500’s valuation in the current economic environment, we recommend a slight decrease in equity exposure for the pension fund. Specifically:

- Reduce the equity allocation from 60% to 55%.
- Increase the bond allocation from 40% to 45%.

Rationale:

1. The moderate overvaluation of the S&P 500 suggests potentially lower future returns.
2. Rising interest rates increase the attractiveness of fixed income investments.
3. A slight reduction in equity exposure helps to mitigate potential downside risk while maintaining significant participation in any continued market upside.
4. The increased bond allocation can provide additional stability and income in an environment of higher yields.

This adjustment aims to balance the need for long-term growth with prudent risk management, considering the current market valuation and economic conditions. Regular reassessment of this allocation is recommended as economic conditions and market valuations evolve.

Claude and ChatGPT are comparable. Gemini is a lot weaker

When I passed the same prompt request by ChatGPT and Gemini, ChatGPT’s analysis was very comparable to Claude’s. Gemini was much weaker on several counts:

1. It felt like a summary. It addressed only 7 of the 12 macroeconomic variables.
2. It suggested that the P/E ratio may be reasonable because it was lower than the Shiller P/E ratio. This is false. The correct assessment is that both P/E ratios are much above historical averages and suggest the market may be overvalued on such counts.
3. It addressed the Price-to-earnings growth ratio (PEG) only to mention that it was not submitted in the data.

In my mind, items 2 & 3 above qualify as hallucinations.

Gemini feels like it was written by lawyers

Claude and ChatGPT appeared to have a more thorough understanding of macroeconomics, investment theory, discounted cash flows, etc. than Gemini.

By contrast, Gemini’s tone was more like “the lawyers made us write it that way.” Gemini was the only one with a Disclaimer statement indicating that “this report is for informational purposes only and should not be considered for investment advice. Please consult with a financial professional…” There is nothing wrong with this statement, it just conveys a tilt. Gemini is more legalese oriented. Claude and ChatGPT are more focused on the macroeconomic factors affecting market valuation.

Another Gemini’s nuisance is that I could not copy and paste sections of its response within this article. I had to type it manually. This may be another case of “the lawyers made us do it that way.”

To avoid too much repetition, I will disclose below only ChatGPT and Gemini’s respective recommendations instead of their entire analytical report.

Recommendation [generated by ChatGPT]

Given the current high valuations indicated by the PE ratios and low dividend yield, coupled with a competitive bond environment due to rising interest rates, it is prudent to adopt a cautious stance towards the S&P 500. However, strong economic growth and robust earnings provide a counterbalance, suggesting that a drastic reduction in exposure may not be necessary.

Recommendation: Leave the exposure to the S&P 500 unchanged at 60% stocks and 40% bonds, but closely monitor market developments, especially interest rate movements and inflation trends. Adjust allocations dynamically as new economic data and market conditions evolve.

This balanced approach ensures that the pension fund remains well-positioned to capture potential upside while being mindful of the risks associated with current high valuations. ​

Recommendation [generated by Gemini]

Given the current fair valuation of the S&P 500 and the mixed economic environment,I recommend maintaining the current asset allocation of 60% stocks and 40% bonds. This allocation provides exposure to the potential for capital appreciation in the stock market while also mitigating risk with a bond allocation that provides income and stability.

Key Considerations

• This report is based on the data available as of June 27, 2024. Market conditions can change rapidly, and this assessment may need to be revised in the future.
• The fair value of the S&P 500 is a matter of judgment, and there is no single definitive measure.
• The investment decision should also consider the specific risk tolerance and investment objectives of the pension fund.

Comparing the recommendations

They are convergent.

• Claude recommends lowering equity risk so the equity to bond allocation is to be reduced from 60%/40% to 55%/45%.
• ChatGPT and Gemini recommend staying at 60%/40%.

However, both ChatGPT and Gemini are very cautious, as they suggest that equity exposure should be monitored closely as both the economic and market environments can be volatile. And, market valuation can change rapidly calling for potential adjustment in allocation.

Conclusion

Focusing on just Claude and ChatGPT, they completed this task remarkably well. They demonstrated a surprising understanding of macroeconomics and markets behavior. They conveyed nuance in their analytical judgment.

And, they did all of the above by just reading a matrix of time series graphs that is quite challenging to read by humans.

Gemini comes in a very distant third.

If you want to explore Claude Sonnet 3.5 Artifacts capabilities in data analysis, please refer to this related article (that uses the same data set):

https://medium.com/@gaetanlion/claude-sonnet-3-5-artifacts-does-data-analysis-38ce1eef1c33