It’s indeed been a hot summer, with temperatures soaring to record levels in many regions. Stocks too are having their season in the sun, with all major indices hitting record highs.
That two-year rally has been fueled mainly by investors’ exuberance for almost all things AI and tech. Specifically, the S&P 500 index surged to a high of 5,669 on July 16 thanks to a cluster of mega-cap, high-growth stocks dubbed the Magnificent 7 that include names such as Nvidia, Meta and Alphabet.
As summer inexorably rolls into fall, some market strategists say they are expecting these mega-cap tech stocks to eventually give way to other sectors and the remaining 493 stocks as the main drivers that propel the rally well into 2025. Industrials, financials and utilities are the top bets to set the pace beyond the current market cycle, say some strategists and wealth managers.
In other words, these sectors are built to last, say bulls, who cite these companies’ strong fundamentals, promising growth prospects, attractive valuations and sensitivity to easing monetary policy. Rate-sensitive real estate, frequently dismissed as the most-hated sector, also gets nods from some advisors and strategists as a potential dark-horse market leader, as it’s likely to perform well when the Fed starts cutting rates as expected this month.
“The forgotten 493 will move into greater prominence as the Fed nears the beginning of its rate-cutting cycle,” says Todd R. Walsh, the CEO and chief technical analyst of Alpha Cubed Investments, an independent investment advisory firm in Irvine, Calif. “These are regular economy stocks that have been sitting around waiting to see if this recession we’ve been talking about for two and a half years would happen.”
The market has put the risk of a recession in the rearview mirror, and Walsh adds that “the capex going into building AI is going to continue to form the backbone of a bull market that might last four to seven years.”
Some analysts and wealth managers, such as Jack Ablin, CIO and founding partner of Cresset Asset Management, also say small caps could outperform their larger cousins in the coming months. Small stocks tend to benefit from an easing monetary policy, and the value category is beginning to nudge growth off center stage as investors gravitate to laggards with sound fundamentals, including strong balance sheets and cash-generating power.
“A bull case for the markets is [if] the Fed lowers interest rates, engineers a soft landing so we avoid a recession and then we start on a new economic recovery path and small caps lead the way higher,” says Ablin, whose Chicago-based RIA manages more than $50 billion in assets.
Market strategists disagree on exactly when the broadening of the market, or sector rotation, began—some think as early as March of this year or late 2023—but it’s necessary, most say, to keep the rally going, especially as worries about geopolitical concerns replace fears of a recession as the main risks to equities. A broader portfolio would meanwhile buffer investors against the expected volatility of an election-year market.
“If the market was to go higher today led by mega-caps, again, it would be a bubble of epic proportions because that means that Nvidia has to go higher than 40 times sales, which is where it’s already at,” says David Lundgren, chief market strategist and portfolio manager at Little Harbor Advisors, an advisory firm in Marblehead, Mass.
Lundgren, who views the market mostly through a technical lens, thinks the beginning of a “correction” or rotation began in March. More recently, many large-cap tech stocks have suffered declines, as investors have started to question whether the payback from massive capex spending on artificial intelligence is going to take longer than enthusiasts had hoped.
“For the last couple of months there has been a leadership rotation, mostly within cyclical sectors,” Lundgren adds. “That’s healthy. It kind of resets the leadership clock and it perpetuates the bull market.”
Stocks Soaring To Multiple Highs
The current rally that began October 2022 shows little signs of slowing down. The market-capitalization weighted S&P has risen around 26% over the past year. The seven mega-techs, living up to their name, tripled the broader market by returning more than 75%. The Dow Jones Industrial Average, which tracks 30 blue-chip stocks, and the tech-heavy Nasdaq Composite have also hit highs this year.
Wall Street analysts’ 2024 predictions for the index range from 4,200 to 5,500. One of the top bulls is economist Ed Yardeni, who, in a recent market note, said his base case puts the S&P 500 at 5,800 by the end of the year and 6,300 in 2025. “A robust jobs market, rising real wages, increased productivity and record corporate profits and cash flow suggest the bull market has room to run,” Yardeni wrote.
Some think the Magnificent 7 and other tech companies deserve their valuation because they are remarkable earnings juggernauts. Since January 2023, most shares of those seven stocks are up more than 50%, and, with the exception of Meta and Alphabet, are selling for multiples far above 22. In the second quarter, BlackRock noted that the largest six tech companies reported a 40% uptick in year-over-year second-quarter earnings, versus the 8.6% for the equal-weighted category, which avoids concentration.
“We don’t think that a market-wide broadening is a necessary occurrence insofar as earnings remain concentrated in certain sectors—the market chasing after fundamentals means that it’s doing its job!” wrote Michael Gates, head of Model Portfolio Solutions in the Americas for BlackRock’s Multi-Asset Strategies & Solutions group, in a June report.
Little Harbor’s Lundgren notes that it doesn’t require a broadening of the market or sector rotation to remain at his year-end price target of 5,500 or 5,600. He says lower interest rates and positive corporate earnings would be enough to lift stocks higher. “If this is just part and parcel of an ongoing secular bull market, do we need a rotation in leadership?” he asks.
Create A Profitable Rotation Playbook
What should investors and advisors look for if they want to play a broadening in the market? In a word: “quality.”
Ablin says he’s seeking value across almost all asset classes and sectors. “We’re taking a somewhat cautious view. We want the average stock in large cap but then we also like small caps. But what we’re sticking with is quality.”
Broadly that means companies with strong balance sheets, in cyclical sectors, generating robust cash, selling at attractive valuations and tending to flourish in a low-rate environment amid a growing economy. Furthermore, whether it’s necessary or not, a market broadening spurs investors to diversify their portfolio in a market perhaps too reliant on a tight concentration of mostly high-priced tech stocks.
“We think investors who are heavily weighted to the S&P 500 need to think about ways that they might reduce risk,” says noted value investor Bill Nygren, chief investment officer for the U.S. and portfolio manager at Oakmark. “And the nice thing is, I think you can reduce risk and simultaneously increase your return potential because the rest of the market is so much cheaper.”
Nygren, who invests with a five- to seven-year investment horizon, points out that many “average or normal” companies in the consumer durable, banking and energy sectors are fetching single-digit P/E multiples and provide a good hedge against inflation as they generate cash to buy back stock.
Looking over that horizon, Nygren thinks investors can expect “upper-single-digit” returns. “We don’t think [the recent double-digit return] is sustainable,” he says.
Big Tech No Shrinking Violets
A market broadening doesn’t mean mega-cap tech stocks will suddenly morph into shrinking violets and cede the spotlight to other sectors. Earnings growth for the seven should remain robust. Ablin notes that “these companies are able to generate more cash flow in a year than they have debt on their books.”
With many tech stocks commanding 30 times P/E multiples and higher. That level is no home for value mavens like Nygren. But investors like Gates at BlackRock remain confidently plugged into the sector. “Our team has focused on leaning more into tech-plus and where earnings have the most potential,” Gates wrote in the June report. “Right now, we think that techy sectors continue to provide us with an ample earnings engine while we buy others selectively and hunt for tactical opportunities.” He adds that he still expects double-digit earnings growth from the top seven companies over the next 12 months.
Sectors Making Their Move
“If the market was concerned about a recession on the horizon, it’s hard to believe that financials, industrials and materials would be in the leadership post,” Lundgren says. Financials and industrials are among the top three sectors in his research tracking sector trends and momentum.
The S&P 500 Financials index has returned 33.04% over the past year as of August 30, according to S&P Global, and it sells for 20.76 times trailing-12-month earnings. The sector, which includes banks, credit services, insurance and other industries, should benefit from a growing economy and low interest rates, although it still comes burdened by the lingering concerns of the 2008 financial crisis.
That’s fine with Lundgren. “I like it when the consensus view is negative,” he says. “I worry when everybody is unanimously enamored with what’s leading, like Nvidia.”
Banks are much safer now than they were before the crisis, adds Nygren. The sector, which is tracked by the Financial Select Sector SPDR ETF, should grow earnings 7.5% this year and 10% in 2025, according to New York research firm Trivariate Research.
According to the firm, earnings for industrials, which include waste management, construction and transportation, should also shoot up sharply in 2025, to 16.3% from an estimated 5.5% this year. Industrials, and one of its component industries, materials, should benefit from the expected wave of infrastructure spending.
Furthermore, industrials, along with energy companies, are building the many data centers powering artificial intelligence chips, according to a recent Morningstar report. The S&P industrials index has gained 21.68% over the past year, but it has underperformed the broader index for the year. So it has room to grow, say bulls. The big ETF tracking the sector, the Industrial Select Sector SPDR, commands a trailing-12-month P/E ratio of 28.23.
Utilities, which include gas, water and electric, have traditionally been regarded as relatively staid investments, preferred by investors such as retirees who seek income from high-dividend yields and limited downside during economic downturns. But the sector’s promising new growth prospects are tied to the glitzy AI build-out, as data centers need electricity to make chips. In an August 5 report that labels utilities as fairly valued, Morningstar expects data center electricity demand to grow 46% cumulatively by 2032. “Data center electricity demand growth is a key source of upside for U.S. utilities that we don’t think the market appreciates,” wrote analysts Travis Miller and Andrew Bischof. Investors recognize this and have bid up the sector by 21.33% the past year. Trivariate sees earnings growth at a robust 16.6% this year.
For many investors, nothing focuses the mind—or portfolio—more than a 2% one-day meltdown in stocks. The August 5 “violent selloff,” as Lundgren describes it, reminded investors that the path to higher returns won’t be a smooth one, and, as Morningstar noted recently, the market rotation is sparking heightened volatility. Furthermore, markets are historically vulnerable to sudden swoons in September and October. But stocks have recovered quickly since the sharp August drop, and the S&P 500 now stands just 1% off its all-time highs. Indeed, after a spirited sprint in the heat of summer, stocks evidently were due for a rest. The rally, contend bulls, is now fully refreshed.