The stock market has recently experienced a significant rotation among leadership, which has naturally received extensive coverage in the financial media. The rotation has primarily been a shift from large tech stocks to value-oriented stocks, most notably into U.S. small-cap. The magnitude of this rotation draws parallels with what we witnessed when the Pfizer vaccine was announced in November of 2020 and, perhaps even more tellingly, the rotation out of dot-com tech stocks in 2000.
The question now is how sustainable this recent rotation will be. Similar rotations in the last five years have proved transitory, but there are some notable metrics that would suggest the recent rotation has a higher probability of being sustained. These include:
- The magnitude of the price swing of this rotation is significant enough to represent a shift in market leadership.
- The valuation difference between large-cap tech stocks and the rest of the market, measured by price-to-earnings and price-to-cash flow ratios, is historically wide, favoring a reversion to the mean.
- The prior earnings superiority of large-cap tech stocks, notably the “Magnificent 7”, compared to the rest of the stock market has been narrowing this quarter. Importantly, by early 2025 earnings growth rates for the Magnificent 7 and the other 493 stocks in the S&P 500 Index should be nearly equal.
- While I embrace the productivity potential from artificial intelligence, there is a growing mismatch between mentions of AI and actual spending on AI. This potentially creates unusually high expectations that AI-related stocks will keep raising forward earnings and revenue guidance needed to keep up their outsized stock price gains.
In a short period of time, we have witnessed a significant rotation in stock market leadership, as shown in the following table.
| Index Total Returns from 7/10/2024 – 8/16/2024 | |
|---|---|
| S&P 500 Index | -1.3% |
| S&P 500 Equal Weighted Index | +3.4% |
| Bloomberg Magnificent 7 Price Return Index | -9.6% |
| Russell 2000 Index | +4.5% |
Source: Bloomberg
This rotation may have meaningful implications for portfolio construction.
- Greater stock market participation among a larger number of stocks bodes well for balanced and actively managed portfolios. This contrasts with the highly-concentrated stock market returns in the first six months of this year where less than a quarter of the S&P 500 constituents outperformed the actual index. This is one of the lowest measures of stocks exceeding the index in the last 40 years, as shown in the following chart.
Record Low Percentage of Stocks Outperforming the S&P 500 Index
Source: Apollo; Bloomberg, Apollo Chief Economist. Note: Annual data is from January 1 to December 31 for each year. The 2024 data is as of July 2, 2024 (year-to-date). - Small and mid-cap stocks may well be in the early innings of a multi-year rally.
- Portfolios which pay greater heed to valuation have better potential in a return-seeking and risk-mitigating market environment.
- While maintaining a decided bias to U.S. stocks in an overall asset allocation continues to be a strong strategy, monitoring the possible valuation opportunities in non-U.S. stocks also deserves attention.
- The first half of 2024 witnessed generally flat returns in the bond market, but as interest rates have modestly declined, bond returns have been positive in July and yield opportunities, net of inflation, are modestly positive.
As I look ahead to the coming months, the upcoming election will garner considerable focus on its potential impact on the markets. Fortunately, in my investment career, I have experienced eight presidential elections and about six bear markets. Throughout those years, the primary emphasis has been on highlighting micro factors, notably the ability of resilient companies to create shareholder value through sound capital allocation. Having a perspective of macro factors, including elections, assists in understanding where the risks are. Combining the micro with the macro enhances overall portfolio decision-making.