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 benchmark Standard & Poor’s 500 Index surged to a high of 5,669 on July 16 thanks to a cluster of mega-cap, high-growth stocks such as Nvidia, Meta and Alphabet, dubbed the Magnificent 7.
As summer inexorably rolls into fall, some market strategists say they are expecting these mega caps, tech stocks eventually giving way to other sectors among the remaining 493 to become the main drivers to 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, citing strong company 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 Feds nears the beginning of its rate cutting cycle,” said 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 rear-view mirror, and Walsh said, “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.”
More generally, 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 in an easing monetary policy environment, 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 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,” Jack Ablin, whose Chicago-based RIA manages more than $50 billion AUM, told Financial Advisor.
Market strategists disagree on exactly when the broadening of the market, or sector rotation, began – some think as early as March 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 also 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,” David Lundgren, chief market strategist and portfolio manager at Little Harbor Advisors, an advisory firm in Marblehead, Mass, said.
Lundgren, who views the market mostly through 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 Ai 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 added. “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 ranges 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 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 said in the note.
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 7 stocks are up more than 50%, and, with the exception of Meta and Alphabet, are selling for multiples far above 22 on the S&P 500. And 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 disfavors 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!,” declared Michael Gates, head of Model Portfolio Solutions in the Americas for BlackRock's Multi-Asset Strategies & Solutions group.
And Lundgren of Little Harbor noted 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 said 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 rotation in leadership?” he asked, rhetorically.
Create a Profitable Rotation Playbook
How should investors and advisors play the market broadening? In a word: quality.
“Here’s how we’re playing it,” Ablin of Cresset explained, adding 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 those are companies with strong balance sheets, in cyclical sectors, generating robust cash, selling at attractive valuations and tend to flourish in a low-rate environment amid a growing economy. Furthermore, whether 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 and P 500 need to think about ways that they might reduce risk,” advised noted value investor Bill Nygren, chief investment officer-U.S. and portfolio manager at Oakmark Investments. “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, pointed out that many “average or normal” companies in the consumer durable, banking and energy sectors are fetching single-digits P-E multiples and provide 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 double-digit return recently) is sustainable,” he told FA.
Big Tech No Shrinking Violets
A market broadening doesn’t mean mega-cap tech stocks will morph into shrinking violets and cede the spotlight totally right away to other sectors. Earnings growth for the seven should remain robust and Cresset’s Ablin noted 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 and higher, it’s no home for value mavens like Nygren. But others such as Gates of BlackRock remain confidently plugged into the sector. “Our team has focused on leaning more into tech+ and where earnings have the most potential,” Gates said. “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.” The manager 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,” said Lundgren of Little Harbor. And financials and industrials are the among the top three sectors in his research that tracks sectors’ trend and momentum.
S&P 500 Financials index has returned 33.04% over the past year as of Aug. 30, according to S&P Global, and 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 might still be infected with lingering concerns from the financial crisis of 2008.
That’s fine with strategists like Lundgren. “I like it when the consensus view is negative or really concerned about something that’s leading,” he said. “I worry when everybody is unanimously enamored with what’s leading like Nvidia.” Lundgren also likes the many cyclical industries in 24-industry sector, which gives its performance depth and endurance.
Furthermore, banks are much safter now than they were before the crisis, adds Oakmark’s 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 Trivariate, earnings for industrials, which includes 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, Industrial Select Sector SPDR, commands a TTM P-E of 28.23.
Utilities traditionally were regarded as relatively staid investments for retirees and others seeking income from high dividend yields and limited downside should the economy turns south. But the sector’s promising new growth prospects are tied to the glitzy AI buildout, 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 US utilities that we don’t think the market appreciates,” said analysts Travis Miller and Andrew Bischof. Investors recognize this and have bidden up the sector, which includes gas, water and electricity, 21.33% the past year, and 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, September and October are historically vulnerable to sudden swoons. But stocks have recovered quickly since the sharp August drop and the S&P now stands just 1% off 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.