One of the big investment themes for next year and beyond is going to be the broadening of the market. It is a trend that emerged during the summer as tech stocks were sold off, during what is being seen as a July rotation, and has resulted in a move away from a concentration on tech stocks to a market broadening where a wider range of stocks come into play.
The benefits are potentially numerous, with the central belief being that when the market is broadening, an increasing number of stocks are rallying and economic conditions will support earnings growth and profitability, creating the possibility of greater opportunities for investors along the way.
All the signs are, due in part to this rotation, that stocks appear to be heading deep into 2024 with a powerful tailwind and brighter outlook.
Wei Li, global chief investment strategist at Blackrock, sees a clear broadening trend. She says that looking back on 2024, all sectors beat expectations for second quarter earnings, driving this broad margin expansion.
“Looking ahead, we are expecting broad based earnings growth over the next 12 months with the gap between tech and the rest narrowing – a departure from the concentrated market up ‘til now,” Li says.
Matt Britzman, senior equity analyst at Hargreaves Lansdown, said this market shift is a positive for the market and investors. “The broadening out from big tech, which was priced for perfection, looks like a positive step for the market’s long-term health.”
Innovation broadening
For Rahul Bhushan, managing director of ARK Invest Europe, a thematic-focused asset manager, the outlook points very much to market broadening, beyond just market changes.
“As the economic outlook stabilises, borrowing costs decline, inflation ticks lower and oil prices either remain stable or fall further due to the current hydrocarbon glut, the market setup is primed for a broadening beyond the ‘magnificent seven’ to the ongoing S&P 493 rally and even further out to innovation equities and thematic sectors,” he says.
This creates a scenario for investment opportunities. Bhushan believes market broadening creates a prime environment for future-focused industries like artificial intelligence (AI), genomics and clean energy, which are positioned to benefit from increased capital flow and investment.
“For instance, global AI spending is projected to reach $500bn by 2024, reflecting a compound annual growth rate of 20%,” Bhushan says. “Renewables are forecasted to account for 90% of global electricity capacity growth by 2025.
“These trends underscore the opportune entry point to long-term secular themes and ETFs that are poised for significant expansion,” he adds.
Although Liz Ann Sonders, chief investment officer at Charles Schwab, says what we have is a tale of two markets: resilience at the index level, but weakness at the individual stock level.
Using Nasdaq as an example, at the index level drawdown has been 7%, but at an individual stock level that has been 38%. “That is a hell of a lot of churn and rotation under the surface,” she says.
This presents a more complex way of viewing the market changes.
It does though make investor choices a little clearer: investors should opt for “high-quality” stocks in the broadening environment, Sonders says. “We have been focused on things like strong balance sheets, strong cashflows and high interest coverage. These are the things that matter,” she says. “There is a bias [higher] up the cap spectrum. But even within the small cap indexes there is a huge performance differential using a quality demarcation.”
Sector rallies
But given the nature of market broadening it is axiomatic that a range of investments could well benefit within the market. Value stocks, for example, are trading at a discount on price-to- earnings and include sectors such as financials and industrials. And some investors believe rallies in these sectors, as well as small caps, could go further.
There is no doubt that July’s broadened stock rally brought into view the market’s small-cap segment. That same month, the Russell 2000 index of smaller stocks saw its largest outperformance over mega caps in decades, returning more than 10%, while the Nasdaq-100 index lost 1.6%.
Currently, at 15.1 times forward earnings, the small-cap benchmark is trading at a discount to its long-term average and the S&P 500’s forward price-earnings ratio of 20.4 times.
“We believe that a multi-factor approach to small caps, which we consider to be an attractive asset class, should be represented in diversified portfolios,” says Dina Ting, Franklin Templeton’s head of global index portfolio management.
And stocks with value traits – which emphasise holdings that are inexpensive relative to their fundamentals – have underperformed in recent months and in the year-to-date through August 8, not only within the small-cap but also for the mid- cap segment.
But that is not the full story. Zoom out further and we see the Russell 2000 Value index has outperformed the Russell 2000 Growth index over the past 25 years by 1.82% on an annualised basis.
“In our opinion, anchoring quality-tilted stocks, marked by profitable companies with capital efficiency and momentum, together with value and low-volatility factors can hedge against risks,” Ting says.
Mid-cap appeal
In addition, there are other areas investors should be investigating, some that have been overlooked, Ting says. “The market rotation away from mega-cap stocks has fuelled attention to the often-overlooked, mid-cap segment and led to a preference for interest-rate-sensitive small-cap stocks following indications from the US Federal Reserve over lower borrowing costs to come,” she says.
Yet despite the attractive risk/reward profile of mid-caps, which usually feature more established customer bases and brands than their smaller-cap peers, investors tend to be under-allocated to the segment, Ting says.
To put this in perspective, investments in large-cap funds and exchange-traded funds are about nine times greater than those in mid-cap funds and ETFs. And US mid-cap stocks – as measured by the S&P MidCap 400 index – have outperformed their large-cap – as measured by the S&P 500 index – and small-cap – as measured by the S&P Small Cap 600 index – counterparts over the past three decades.
“In our analysis, many mid-sized companies hit the so-called ‘sweet spot’ in that they feature a lower risk profile than small caps and faster growth prospects than large caps,” Ting says.
Exposure to mid-cap indexes also offers the added benefit of diversification. At the end of July, technology sector holdings comprised 29% of the Russell 1000 index compared to just 13% in the Russell Midcap index.
And while, when you look closer, utility companies were the best performers – an 18% total return for the mid-cap index – they held the smallest sector weighting within large-cap benchmarks.
“Beyond the market-cap criteria, we believe that multi-factor strategies can target allocation and pursue stronger risk-adjusted returns for a smoother ride over the long term compared to traditional market-cap-based indexing,” Ting adds.
And she noted that in her view, a forward-looking, rules-based index design that analyses individual stock exposure against a well-vetted mix of factors – quality, value, momentum and low volatility – can serve as a middle ground between active and passive management. “The process may provide exposure to high-quality companies at a reasonable price, while also potentially avoiding value traps,” she says.
Niche opportunities
And opportunities exist in different geographical regions as the market broadening shapes markets across the globe. “We do find opportunities in some niche areas outside the United States,” says Philip Straehl, Americas chief investment officer at Morningstar Wealth.
These, he adds, include some emerging markets, especially Chinese technology stocks. For Straehl, such stocks held up better during the recent volatility. He also points to positions in quality European stocks.
Yet at the same time, Straehl offers a different take on the more upbeat picture of market broadening, saying there is a case for taking a more defensive approach. “We had started to build more defensive ballast in our portfolio,” he says, pointing to defensive plays like consumer staples and real estate investment trusts as being the investments of choice in such a positioning.
And the shift to market broadening is not without its challenges. “The re-rating, or increasing share prices, of industries is broadening and rolling through the global equity markets,” says Chris Buchbinder, an equity portfolio manager at Capital Group. “But with re-rating comes higher valuations, so as active investors we must be wary of groups of stocks associated with market trends and focus on the prospects of individual companies to deliver top-line growth.”
Global hunt
It does, therefore, Buchbinder believes, make sense to think globally “in the hunt for companies with dominant market positions and strong potential demand for their offerings”.
Market broadening therefore presents an interesting picture for Buchbinder, as different factors have to be considered. “While US stock markets are likely to do well, they likely will not be the only source of superior returns. But with questions lingering over inflation, rates and global trade, selective investing will be critical,” he says.
For Buchbinder the situation means investors should ultimately look at the opportunities outside of the US. “The seven leading contributors in 2023 within the MSCI EAFE index, a broad measure of developed markets in Europe and Asia, have out-paced their US-based cohort since the beginning of 2022, rising more than 40%,” he says.
Although he also focuses on investors looking to exploit the situation in the here and now. “For investors seeking income, technology, aerospace and energy companies have been introducing or increasing dividends,” he says.
At the same time, he also notes the broadening market offers positive economic fundamentals that will underpin the whole investor outlook. “We expect solid economic growth for the remainder of this year and through 2025,” Buchbinder says. “This will likely lead to an environment of expanding earnings growth across industries and sectors. This, in turn should lead to a broadening market rally, as profit growth is a primary driver of returns.”
Good rally
What has been interesting during all of this is the market had continued its solid rally with the S&P 500 gaining 19% year-to-date with reinvested dividends, contributing to a total return of 61% since the market bottom in 2022.
As has been the trend, much of this performance has been driven by large cap technology stocks over the past 18 months, but the broadening market scenario shows solid signs that other parts of the market are boosting the picture as well.
It possibly does highlight the important truism that while investing trends may come and go, it comes down to something of the tried and true principles of investing that enable investors to grow their portfolios and achieve their financial goals over years, as well as decades.
Looking forward, Straehl offers such solid long-termist investor advice, despite the changing nature of the market. “Keep your eye on the long term and don’t overreact to short-term news,” he says. “If anything, use it as an opportunity to buy assets that might have fallen more than what the fundamentals justify.”
A point shared by Cathie Wood, ARK Invest’s chief investment officer. “We encourage investors to reassess portfolio concentration risk and consider ways to diversify exposure,” she says.
The market may change, but the central tenets of successful investing do not.
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