The musical genre Progressive Rock is known for its focus on technical virtuosity and long, complex songs. Some of the songs consume an entire album side, or roughly 15 to 20 minutes for those less familiar with music delivered on vinyl. It is an acquired taste - one many people never develop - but I have always enjoyed it.
Yes is perhaps the best-known Prog Rock band, and the eponymous “Close to the Edge,” from their 1972 release, neatly sums up the first quarter of 2026 in multiple ways. The title captures current market sentiment, and the structure of the song, alternating between stretches of discordant chaos and highly melodic passages, closely mirrors the market action we experienced over the past three months.
For all the volatility in markets and the real world during the first quarter, the point-to-point change ended up looking surprisingly muted. The SMCO composite finished the quarter +1.7% gross and +1.6% net of fees, slightly trailing the Russell 2500 Index, which was up +2.0%. We outperformed the index for much of the quarter, but that relative strength faded in mid-March following the escalation in hostilities between the U.S. and Iran. The primary driver was pressure on our AI-related holdings, as investors reduced gross exposure and more broadly de-risked portfolios. Any remaining outperformance disappeared on the final day of the quarter, when meme stocks, heavily shorted names, and biotech rallied sharply, with many up more than 7%. Even so, that late move lifted the SMCO composite’s absolute performance as well, and we ultimately finished the quarter in positive territory.
During the quarter, we saw solid contributions from our Industrials, Technology, and Energy holdings, while Health Care, Financials, and Consumer Discretionary were a drag on performance. At the individual stock level, Ciena, MKS Instruments, and MACOM Technology Solutions were notable contributors, while Kyndryl, Planet Fitness, and RadNet detracted from results.
The dynamic conditions of the first quarter prompted a number of strategy adjustments. As always, we act incrementally, and while our first quarter turnover of 12% was higher than recent quarters, it was not excessive. At a high level, we tilted the strategy more defensively, reducing “risk-on” exposure in favor of companies less reliant on the macro environment to drive earnings growth. From a sector perspective, the most notable change was a reduction in Consumer Discretionary, particularly among businesses tied to the lower-income consumer, where inflationary pressures may persist even if the ceasefire holds. We offset that by increasing exposure to Consumer Staples, adding to both more defensive names and growth-oriented names.
Our positioning in Industrials and Technology was shaped by our effort to actively manage overall exposure to the AI theme. This, combined with stock-specific considerations, led to a reduction in Technology exposure. In contrast, our Industrials weighting increased, as we added more to core industrial businesses than we pruned from certain AI-related winners. We also increased exposure to Health Care, reflecting both the sector’s defensive characteristics and a number of compelling company-specific opportunities, particularly where strong fundamentals are being enhanced by differentiated applications of AI. More on this below.
Uncertainty stemming from the Iran conflict, along with mixed economic data, has weighed on markets. The prospect of higher inflation remains the primary concern, with a softening labor market not far behind. Even so, we continue to see pockets of opportunity.
Most notably, the AI buildout remains a clear bright spot, creating attractive investment opportunities across the small- and mid-cap landscape. While core data center spending continues, our focus is increasingly shifting to what we view as “Phase II,” the connective infrastructure and related capital investments needed to support the buildout. These opportunities span areas such as optical networking, transmission, power generation, and broader energy infrastructure. We have invested in both direct and indirect beneficiaries and continue to hunt for additional undiscovered opportunities.
Beyond AI, we are beginning to see early signs of life in the broader industrial economy. After an extended period of lackluster results, several indicators point to a potential turn. Some of this may be a knock-on effect from the AI buildout, as elevated capex drives incremental demand for suppliers to the primary beneficiaries, but we think there may be more at work. The prolonged stretch of weak performance may ultimately prove to have been a shallow, drawn-out correction. If that is the case, even modest improvements in demand could meaningfully lift the group. At the same time, the long-discussed re-shoring of U.S. manufacturing appears to be gaining traction, potentially providing a secular tailwind to what would otherwise be a cyclical recovery. Beyond the policy push for domestic production, a series of recent disruptions, including COVID-era supply chain challenges, an evolving tariff landscape, and now the Iran conflict, we believe have reinforced the need for greater supply chain resilience and less reliance on overseas manufacturing. Industrials are the most direct beneficiaries, but we also see positive implications for areas like Energy and Materials tied to the broader “Made in the USA” theme. Importantly, the extended period of underperformance has left many of these companies trading at attractive valuations, which further supports the investment case.
There is a third theme we are focused on: companies utilizing AI in genuinely differentiated ways. Most businesses will adopt AI to drive incremental gains in productivity and efficiency, and those that do not risk finding themselves at a competitive disadvantage. But we are looking beyond that baseline. Our focus is on companies leveraging AI to fundamentally reshape their business models or deliver products and services that were not previously possible. Examples include RadNet using AI to improve cancer detection and clinical outcomes in medical imaging, or HealthEquity applying AI to streamline claims processing, drive member engagement, and help optimize portfolio construction within health savings accounts. This theme is still in its early stages, but we believe these types of applications have the potential to drive meaningful share gains and even create entirely new markets.
Lastly, and specific to our market, we think that the outperformance of small- and mid-cap stocks relative to large caps during the first quarter is a noteworthy development. Periods of elevated market and geopolitical volatility would typically push investors toward the perceived safety of larger companies. Instead, it appears to us that even amid the noise, diversification remains of interest to investors. With stronger consensus earnings growth expectations than large caps, small- and mid-caps could attract incremental capital and build on recent outperformance.
Markets are “Close to the Edge,” having endured a barrage of policy shifts, macro volatility, and now a kinetic conflict in the Middle East. The path forward is far from certain, but as always, we have a plan and will adjust as conditions evolve. From here, we see two primary paths, and a few songs help frame the setup.
The first is “The Song Remains the Same,” the opening track from Houses of the Holy by Led Zeppelin. In this scenario, the Iran conflict is resolved without lasting economic damage, and the constructive environment of earlier this year persists. Some effects of the conflict may linger, and our shift away from certain consumer exposures would likely prove prudent, but the backdrop could still support moderate growth, a softer but stable labor market, and incremental policy support. Recent concerns about resurgent inflation probably mean interest rate cuts are off the table for now. But even absent rate cuts, we can envision a constructive path for equities, with domestic activity and the themes we have highlighted, particularly AI infrastructure and an improving industrial cycle, continuing to support small- and mid-cap opportunities.
The alternative is less favorable. If the conflict drags on and inflation truly accelerates, the risk of stagflation increases, creating a more challenging environment for equities. To borrow from Genesis’s Invisible Touch, this would resemble “Throwing It All Away,” with the war derailing what had been a promising setup. This outcome would likely require more meaningful strategy adjustments. Importantly, we believe the strategy is well positioned to navigate a range of outcomes, with a deliberate mix of defensive exposure and targeted investments in areas where we see longer-term structural growth.
Periods like this tend to create dislocations, and we are already seeing opportunities emerge across several of the themes we have highlighted. Time has not run out, and while markets remain "Close to the Edge," we believe the strategy is well-positioned for what lies ahead. As always, we remain focused, flexible, and committed to navigating whatever comes next.
Thanks for your continued interest and support.
(Editor’s Note: The body of this document contains about 1,500 words, and it takes the average reader 5 to 6 minutes to read. That is far shorter than "Close to the Edge" which clocks in at 18 minutes, 43 seconds. Yes, Prog Rock at its finest…)
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