The US stock market rally is showing signs of broadening as investors shift their focus beyond the mega-cap tech stocks that have been driving gains. A more reassuring economic outlook and dovish signals from the Federal Reserve have prompted investors to seek winners in sectors such as financials, industrials, and energy, which are outperforming the S&P 500's year-to-date gain of 9.7%. This broader rally indicates that market leadership is becoming less concentrated and less susceptible to a correction.
The Magnificent Seven tech stocks, including Nvidia and Meta Platforms (formerly Facebook), have been responsible for a significant portion of the S&P 500's gain so far this year. However, the rally in other sectors such as financials, industrials, and energy is reducing the dominance of these mega-cap tech stocks. This shift suggests that investors are becoming more confident in the resilience of the economy and are looking for opportunities outside of the technology sector.
The belief that the economy will remain resilient while inflation fades has also contributed to the broadening of the market rally. Investors are optimistic that the economy will continue to perform well, even as concerns about inflation ease. This positive sentiment has further fueled the search for winners in sectors beyond the mega-cap tech stocks.
The 2024 equity market performance has been driven by companies and sectors associated with artificial intelligence (AI). The Information Technology (IT) and Communication Services sectors have surged over 20%, accounting for 71% of the S&P 500 Index’s year-to-date return. Earnings growth in the Communication Services and Information Technology sectors has been significant, with 44% and 25% growth respectively in the first quarter. Bloomberg consensus data suggests a broadening in profitability starting in the fourth quarter. Wells Fargo recommends trimming gains in the Information Technology and Communication Services sectors and bringing weightings back to neutral. They also suggest taking advantage of recent weakness in the Energy, Health Care, Industrials, and Materials sectors. Wells Fargo notes that upcoming events, such as the November elections and potential delays in disinflation, may cause market volatility. However, they believe that market pullbacks could offer opportunities to diversify sector exposure within U.S. large-cap equities.
While the broader rally is a positive sign, there are still risks that could impact its trajectory. If the economy begins to flounder or experiences excessive inflation, the broadening trend could be at risk. However, for now, investors are finding reassurance in the expanding market rally and the opportunities it presents. Some investors, however, believe that the market is due for a pullback after a 27% gain since late October.
According to Morgan Stanley strategist Mike Wilson, the stock market leadership is expected to remain narrow despite the broadening rally. Wilson believes that the ongoing policy mix of heavy fiscal spending and tight interest rate policy is crowding out many companies and consumers in an unsustainable way. This has led investors to bid up the few stocks of companies that are doing well in this environment. Wilson expects this narrow market performance to persist until the bond market pushes back via a higher term premium or growth slows down. Economic growth surprise indices have been trending lower all year, with the S&P 500 taking the weaker data in its stride. Wilson recommends a barbell position of large-cap quality growth stocks and defensive stocks, while fading cyclicals and avoiding broadening out. Despite the broadening rally, Wilson's analysis suggests that the market leadership is likely to remain narrow due to the ongoing policy mix and economic trends.
US stock market breadth has been terrible, with extreme internal divergences breaking historical records. Poor market breadth in US equities has historically preceded business cycle recessions and associated bear markets. The poor breadth currently being registered in the US equity market is an early warning sign of underlying imbalances in the economy. Sectors such as alternative energy, cryptocurrency, and artificial intelligence are experiencing misallocations of resources. The correction of these imbalances is likely to figure prominently in the next business cycle recession. The timing of the correction is often linked to exogenous shocks, such as an oil price shock. Stock market price action can provide a leading signal of a recession-triggering economic shock. Investors should pay attention to extreme divergences in price performance between sectors and be alert to potential exogenous economic shocks.
The stock market rally is showing signs of broadening as investors seek winners beyond the mega-cap tech stocks. However, Morgan Stanley's Wilson believes that the market leadership will remain narrow due to the ongoing policy mix and economic trends. This suggests that while the rally is broadening, the concentration of market leadership is expected to persist. Investors should consider a barbell position of large-cap quality growth stocks and defensive stocks, while being cautious about cyclicals and broadening out.