By Jamie McGeever
ORLANDO, Florida (Reuters) - A handful of mega-cap technology stocks has fueled Wall Street's boom for much of this year, but the promise of aggressive interest rate cuts has broadened participation recently across a range of stocks and sectors.
This increased breadth should help sustain the rally well into next year – especially with inflation continuing to trend toward the Federal Reserve's 2.0% target and the economy growing at around a 3.0% clip.
But what's less clear is whether this rotation will generate the pace of gains investors have become accustomed to. History suggests it may not, particularly given the lofty expectations baked into today's high valuations and the age of this bull run.
If this is the case and a 'slower-for-longer' equity dynamic sets in, investors may need to turn to stock-picking strategies rather than passive funds to achieve their desired returns.
MORE ROOM TO RUN
Rotation is underway, whether it's from large caps to small caps, defensives to cyclicals, or growth to value.
At the end of June, the top 10 stocks in the S&P 500 accounted for a record 35% of the index's entire market cap. But in the third quarter tech underperformed the S&P 500 by its widest margin since 2016, which helped drive a 13% outperformance of the 'S&P 493' against the 'Magnificent 7' Big Tech names.
This shift primarily reflects investors' optimism that the economy will avoid recession, yet the Fed will still see the need to cut interest rates rapidly to return to the so-called neutral rate.
Few areas of the economy benefit from lower interest rates more than the consumer and real estate sectors, which are heavily represented among small-cap stocks.
More broadly, lower rates benefit small caps disproportionately because the majority of their borrowing consists of short-term floating rate debt: 53% compared with only 26% for large-cap companies, according to Raymond James.
Importantly, it's reasonable to assume that these rotations have more room to run.
Callie Cox, chief market strategist at Ritholtz Wealth, notes that less than one third of S&P 500 stocks have kept up with the broader index since the bull market began two years ago.
Five sectors are more than 20 percentage points behind the index's returns since the October 2022 low, while the two sectors mentioned above – consumer discretionary and real estate - and 47 stocks have yet to reclaim their 2021 peaks.
OVER-VALUED?
But this game of catch-up may not be all good news for investors. That's because a broadening rally tends to be accompanied by more muted returns, as Raymond James's Chief Investment Officer Larry Adams notes. He also points out that this is particularly likely when a bull market is entering its third year, as is the case now. Returns in the third year of a bull market can average only 2%, he notes.
Another reason for caution is the earnings outlook - more than 40% of the companies in the Russell 2000 index have negative earnings growth.
Given this, the Russell 2000's valuation looks a bit rich. The index is trading at more than 26 times 12-month forward earnings, which, excluding the pandemic-distorted years of 2020 and 2021, is among the most expensive levels in the last quarter century.
And expected earnings growth next year is now 43%, up from 32% six months ago, which also appears to be on the optimistic side.
A positive spin can be applied here: the ultra-low starting point means these firms' earnings are more likely to improve than not, especially if they're enhanced by lower borrowing costs and looser financial conditions.
On the other hand, there's a good chance that over the next 12-18 months economic growth will slow and unemployment will rise, perhaps quite significantly. The Fed probably wouldn't be positioning to cut rates so much if the likelihood of this scenario were negligible.
Ultimately, the winners in this new environment could be stock pickers.
"Gains at an index level will be more muted," notes Jeff Schulze, head of economic and market strategy at ClearBridge Investments. "But underneath the surface, there will be good opportunities for active managers."
Determining who actually outperforms is always the tricky part. Those who warned all year that extreme concentration would topple the market should be careful what they wish for. Now they're getting a broader market but returns may be weaker.
(The opinions expressed here are those of the author, a columnist for Reuters.)
(By Jamie McGeever; Editing by Andrea Ricci)