Will artificial intelligence change everything, including how we value stocks?

Forget baseball. This spring it’s the artificial intelligence question at the top of financial advisors’ minds when they’re trying to determine the endurance of the record-setting stock rally. Do big capitalization stocks such as Nvidia and Microsoft have the staying power to keep fueling the strength in growth stocks overall?

To continue the national pastime metaphor, there are many more innings to go in the rally in growth stocks—if the economy has a soft landing, if the Fed cuts interest rates and if AI firms and others continue to produce solid earnings, as they are all expected to do. But make no mistake: Stocks’ journey higher this year will be pockmarked with volatility and buffeted by many crosscurrents, namely inflation.

Furthermore, given growth’s surge and pricey valuations, it might be prudent for advisors to trim the growth holdings in their clients’ portfolios and funnel some profits into value (those equities trading below estimates of the companies’ intrinsic value). This will offer clients diversity while they’re still participating in the overall rally. Contrarian value plays such as real estate, energy and utilities are the favorites of some of the top strategists.

“The challenge [in evaluating the market] this time is we have the Magnificent 7 stocks, and AI is here to stay and could really drive growth stocks, especially in a presidential election year,” says Adam Lampe, chief executive officer and co-founder of Mint Wealth Management, a Houston firm.

The S&P 500 has gained 27% over the past year, and it hit a record 5,248 in March. Jimmy Lee, CEO of the Wealth Consulting Group, a Las Vegas-based RIA with $7.9 billion in client assets, sees the index returning between 10% and 20% this year. “I believe we are literally in the national anthem stage of AI [investment], meaning we’re just getting started,” he says.

Filling up the AI bandwagon, some Wall Street brokerage giants are raising their 2024 forecasts for the S&P. Wells Fargo, the biggest bull, forecasts 5,535.

As they seek value opportunities, advisors and investors must be mindful that growth has been a stalwart performer against its value cousin. Over the past year, growth has returned 32.85%, outrunning value’s 20.30% gain. And, as of April 15, 2024, the Russell 1000 Growth index returned 17.18% on an annualized basis over the previous 15 years, while the Russell 1000 Value index turned in 12.11% over the same period, so value isn’t exactly cheap either.

Overall, the broader market is trading at a 3% premium to Morningstar’s fair value estimate, according to David Sekera, the firm’s chief market strategist. Specifically, growth stocks commanded an 8% premium to Morningstar’s fair value as of March 22. And six of the big-cap Magnificent 7, which includes Tesla and Microsoft along with AI chipmaker Nvidia, are fairly valued, notes Sekera.

When they look at the oft-used price-to-earnings ratio, the S&P is giving some advisors and investors ticker shock, as it’s trading at 24.79 times, up from 22.23 a year ago. Some strategists see the market growing earnings about 10% this year.

One Wall Street favorite, Tesla, has fallen more than 36% this year as of April 16, and some other Magnificent 7 stocks like Apple are running out of momentum. Both those businesses have seen their revenues hit a wall.

 “The market is probably getting kind of stretched,” argues Sekera, who recommends investors underweight growth and overweight value, which he estimates is trading at a 6% discount to fair value. “Over time, investors will realize better returns from the value category,” says the strategist, who thinks advisors and investors should lighten up on sectors such as industrials, transportation and airlines.

Choosing between growth or value needn’t be a Beyoncé-or-Swift dilemma. A sensibly diversified portfolio should hold a bit of both equity classes. Morningstar’s top-rated and top performing mutual fund bets in either category are the Fidelity Blue Chip Growth Fund, which is up more than 50%, and the Oakmark Select fund, which has returned 37% for value investors.

Some bulls see promising earnings growth in the technology sector, which is benefiting from AI investment. “In an environment in which recession continues to get postponed, then you should see the market broaden out and these other sectors participate, not at the expense of growth stocks or tech stocks, but alongside them,” says Mark Luschini, chief investment strategist at Janney Montgomery Scott, which manages $138 billion.

Whether they’re looking at growth or value, however, it’s incumbent upon advisors to be aware of the potential risks to the rally. In the run-up to record stock highs, investors have mostly shrugged off concerns about inflation, geopolitical issues and domestic politics. That changed this spring, as inflation and war concerns momentarily shook the markets.

“These are known unknowns,” says Luschini. “We know they’re out there; we know they could get worse.”

There are other people in the “things-can-indeed-get-worse” camp. That’s where you can put Jamie Dimon, the CEO and chairman of JPMorgan Chase, the nation’s biggest bank. In announcing first-quarter results for the bank, Dimon warned that “a number of significant uncertain forces,” such as persistent inflation and wars could threaten the economy.

Indeed, these two issues occasionally arise to scare the dickens out of investors. In April, the Labor Department reported that inflation had risen 3.5% from the prior year, which was hotter than expected. The market was indeed startled, closing lower on the news. (The Federal Reserve has a 2% inflation target, though a growing chorus of economists say the number is unrealistic.) Equities will likely recover, as many strategists think such disappointing data might simply delay the cuts in the federal funds rate that investors are betting on rather than force the feds to do a 360 and raise rates instead to fight inflation.

The Israel-Hamas and Ukraine-Russia wars might be the biggest thing on the minds of Washington politicos, but Wall Street and many strategists have largely taken a see-no-evil approach, regarding them as noise, despite the inflationary pressures caused by the war in Ukraine.

But fears about the conflict in Israel expanding throughout the Middle East exploded into reality when Iran fired drones and missiles into Israel in April in retaliation for Israel striking Iran’s Damascus consulate. It won’t be just noise to the economy if the U.S. is drawn into either conflict (beyond just sending weapons and dollars) or if the cost of a barrel of oil soars beyond its current $85 because a war has disrupted global supply.

Market strategists and advisors are mostly divided on the potential market impact of the 2024 election. Some think a win for incumbent Joe Biden would favor growth stocks while value stocks would benefit under Trump.

Jim Thorne, chief market strategist at Wellington-Altus, a wealth advisory firm in Winnipeg, Manitoba, with $25 billion in assets, dismisses election concerns as “noise” as well. He thinks any U.S. industrial policy that aims to bring manufacturing back to the U.S. would be “setting the country up for economic prosperity” and he believes either candidate would continue that policy.

Past is prologue, the saying goes. And Sekera finds justification for his more cautious view of the rally in history. “Since 2010, only 14% of the time has the market traded at a 3% premium or more,” he points out. “So, not very often are we in this kind of valuation territory.”

But some bulls argue that the potential of AI to dramatically transform business and the economy in unforeseen ways also puts the market in a “unique” place. The massive investment build for AI infrastructure will keep companies such as Nvidia on a glide path to continued robust earnings and sales for many years, they argue.

“There are unique times in history where we go through big structural change, and that’s where we are now,” says Thorne, of Wellington-Altus. “We’re talking about developing a brand-new industry.”

Lee and other AI bulls say investors should stay plugged into the tech sector. Robert Hagstrom, chief investment officer at EquityCompass, a Baltimore-based RIA with $5 billion in AUM, sees better-than-market earnings growth in the information technology and communication services sectors. Both industries are benefiting from a “tsunami” of spending by companies seeking the productivity AI provides, he wrote in a recent note.

Hagstrom, who’s written several books on Warren Buffett, sees information technology growing earnings per share more than 20% this year and communication services seeing that growth at 30%. Both are easily outpacing the 9.5% he projects for the S&P 500.

“So, the two sectors that are the strongest in the market are growing two to three times faster than the market,” Hagstrom tells Financial Advisor. “And that’s because of AI.”

In pivoting to value, Morningstar’s Sekera says investors will find solid investment opportunities among what he calls the “three U’s”: the underperformed, the unloved and the undervalued.

“Right now, I would say real estate is probably the most hated sector on the Street,” he says.

Given that Morningstar expects the fed funds rate to fall to a range of 4% to 4.25% by the end of 2024, Sekera finds dividend-paying stocks appealing, and they’re often found in the value category.

Not surprisingly, he’s steering clear of the downbeat urban office market and favoring real estate classes with much more defensive characteristics. One such sector is healthcare, which trades at just a 1% premium to his fair value. “Hospitals, medical offices and research facilities are all doing just fine,” he says.

He also likes utilities, which have lost 5% since 2021, significantly underperforming the broader market amid rising interest rates. “The market has overcorrected to the downside,” Sekera wrote in a market note. “Fundamentally we think the outlook for the utility sector is as strong as it has ever been.” The sector is benefiting from the shift to renewable energy and investment in the electric grid.

He also perceives “a significant number of undervalued opportunities” in energy, which he sees as a natural hedge against more geopolitical risk or sustained high inflation, according to his note.

The S&P 500 has indeed been volatile. The index fell below 5,100 in mid-April, hit by sticky inflation, geopolitical concerns and weakness in the mega-cap companies Apple and Tesla.

The S&P’s ride to bulls’ targeted projections indeed won’t be smooth, but advisors playing in both growth and value will be winners even when they roll out the tarp and call the growth game over. But don’t underestimate growth or its ability to run into extra innings.

“The thing to remember,” says Hagstrom, “is that bull markets keep going as long as earnings keep growing. And it appears U.S. GDP is on solid ground.”