In 2023, a narrow group of tech giants and communication services stocks, the so-called “Magnificent Seven” (Mag 7), dominated stock market gains, while the rest of the S&P 500^® Index lagged well behind.

During a period of more restrictive monetary policy and greater economic uncertainty, it’s not surprising that investors have gravitated toward the Mag 7, with their durable earnings and strong fundamentals.

But while these stocks have served as a popular flight-to-quality trade, now may be the right time to find opportunity in areas that were left behind in a rising rate environment.

Narrow leadership

On the heels of exceptional 2023 performance from the largest market capitalization stocks of the S&P 500, the degree of index concentration is at levels we’ve only seen a couple of other times – one being the late-’90s dot-com bubble and the other the 1972 “Nifty 50” era. Given the similarities in the tech-centric business models of companies in the top 5, this level of index concentration diminishes the impact of return drivers from other market segments. In our view, investors should be aware of such top-heavy and narrow performance.

Investors also need to consider the risks of crowded positioning in this market segment. According to a Bank of America survey in January, the “most crowded” trades deemed by global managers was “Long Magnificent Seven” (61% of those polled), which has climbed steadily higher in the polling over the preceding three months. A large number of investors trading in a particular market segment can lead to increased volatility and the risk of a drawdown event.

Fed policy shift opens door for broader market leadership

There are several economic and market factors that can contribute to a broadening of stock market returns, one of which is more accommodative monetary policy. Lower interest rates can boost market liquidity and encourage investors to participate across a wider range of stocks.

In December, the Federal Reserve (Fed) signaled its intent to transition from a 24-month tightening campaign to an easing cycle. This dovish pivot from combating inflation to steering a soft landing triggered a rally and market rotation. After a host of industries traded down in 2023 due to higher interest rates and the prospect of a recession, we began to see a more normalized market where out-of-favor areas were performing again. With the market gaining confidence in an economic soft landing and expectations for a more accommodative monetary policy taking hold, we expect to see this broadening of returns continue.

Where to look for opportunities

Defensive areas of the market lagged throughout 2023 as the Fed aggressively raised rates, but we believe certain sectors are poised to perform relatively well. For example, we expect healthcare and utilities to have a strong 2024 because they offer resilient earnings regardless of the economic backdrop, and their cost of capital is declining as monetary policy eases. For utilities, we are also positive on the generational transformation in power consumption that is currently underway, along with its associated capital expenditure.

Small- and mid-caps, as well as companies with financial leverage, also stand to benefit from cheaper funding costs. These companies are more reliant upon capital markets, and their funding costs are now less expensive than it would have been two months ago.

From a valuation perspective, we believe opportunities exist in overlooked areas of the market. The S&P 500^® Equal Weight Index, which offers a more balanced representation of market valuation across all stocks in the Index, trades at nearly half the valuation of the Bloomberg Mag 7 Total Return Index on the forward price-to-earnings ratio.

Seeking diverse returns

With the reversal in the direction of Fed policy, we think investors should look for diverse return drivers across different market segments, sizes, and styles. The rally at the end of the 2023 showed renewed strength in areas that priced in a recession, such as financials, casino operators, and consumer discretionary stocks. This rotation reflected market confidence in a soft landing. We expect this broadening of returns to continue in 2024.

There are still risks to monitor – namely a reacceleration of inflation or a hard-landing recession scenario – but the outlook is improving for a normalized market, in our view. By seeking value in overlooked areas outside the largest tech companies, we believe investors can position portfolios for more diverse market leadership.

 

IMPORTANT INFORMATION

Smaller capitalization securities may be less stable and more susceptible to adverse developments, and may be more volatile and less liquid than larger capitalization securities.

Technology industries can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants, and general economic conditions. A concentrated investment in a single industry could be more volatile than the performance of less concentrated investments and the market as a whole.

Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.