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Market Analysis

Wall Street anticipates'slower for longer' equities increase as surge widens: McGeever
Amos Simanungkalit · 5.5K Views

15

A select group of mega-cap tech stocks has driven Wall Street's surge for much of the year, but recent expectations of aggressive interest rate cuts have expanded the rally across various sectors and stocks. This growing market participation is expected to help sustain the rally into next year, especially as inflation trends toward the Federal Reserve's 2% target and the economy maintains around 3% growth.

However, it's uncertain whether this shift will maintain the strong gains investors have come to expect. History suggests that the market might not see the same pace of growth, particularly with high valuations and an aging bull market in play. If growth slows, investors may need to adopt stock-picking strategies rather than rely on passive funds to meet their return goals.

STILL ROOM FOR GROWTH

A rotation is taking place across different areas of the market, such as large caps shifting to small caps, defensives moving toward cyclicals, and growth stocks transitioning to value.

At the end of June, the top 10 stocks in the S&P 500 represented a record 35% of the index's total market cap. However, in the third quarter, technology stocks underperformed the S&P 500 by the widest margin since 2016. This shift helped the rest of the index outperform the so-called 'Magnificent 7' Big Tech names by 13%.

This rotation reflects investor confidence that the economy will avoid a recession, while the Fed may still need to cut rates to reach a neutral rate. Lower interest rates, particularly benefiting sectors like consumer and real estate, are represented more heavily in small-cap stocks.

Smaller companies tend to benefit more from lower rates because a larger portion of their debt is short-term floating rate. Data from Raymond James reveals that 53% of small-cap debt is short-term, compared to just 26% for large-cap firms. As such, it’s likely that this market rotation has further to go.

Callie Cox, chief market strategist at Ritholtz Wealth, notes that since the bull market started two years ago, fewer than a third of S&P 500 stocks have kept pace with the broader index. Five sectors trail the index by more than 20 percentage points since the October 2022 low, with consumer discretionary and real estate sectors still lagging, along with 47 stocks that have yet to reclaim their 2021 highs.

ARE VALUATIONS TOO HIGH?

This catch-up rally may not be entirely positive for investors, as a broader market rally often coincides with more modest returns. Raymond James's Chief Investment Officer Larry Adams points out that, as a bull market enters its third year, returns historically average just 2%.

Another reason for caution is the earnings outlook. More than 40% of companies in the Russell 2000 index are experiencing negative earnings growth. The index is trading at over 26 times its 12-month forward earnings, one of the highest valuations in the past 25 years, excluding the pandemic years.

Earnings growth expectations for the next year have risen to 43%, up from 32% six months ago, which seems overly optimistic. However, with such low starting points, there’s room for earnings improvement, especially with lower borrowing costs and easier financial conditions.

On the flip side, economic growth may slow, and unemployment could rise over the next 12-18 months. The Fed's potential rate cuts signal concern about this scenario.

Ultimately, this environment could favor stock pickers over index investors. Jeff Schulze, head of economic and market strategy at ClearBridge Investments, notes that while index-level gains may slow, active managers will have opportunities to outperform beneath the surface. Still, the challenge lies in identifying those who can consistently outpace the market. Those who warned about the dangers of market concentration might get what they wanted: a broader market, but with potentially weaker returns.

 

 

 

 

 

 

Paraphrasing text from "Reuters" all rights reserved by the original author.

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