Wall St Anticipates ‘Slower for Longer’ Equity Growth as Rally Widens: McGeever By Reuters

By Jamie McGeever

ORLANDO, Florida – A select group of mega-cap technology stocks has driven Wall Street’s rally for most of this year, but the prospect of aggressive interest rate cuts has recently expanded participation across various stocks and sectors.

This increased breadth could support the rally well into the next year, especially as inflation continues to approach the Federal Reserve’s 2.0% target and the economy grows at around a 3.0% pace.

However, it’s uncertain whether this shift will lead to the same level of gains that investors have grown accustomed to. Historical trends indicate it might not, particularly considering the high expectations reflected in today’s elevated valuations and the extended duration of the current bull market.

If this scenario unfolds and a ‘slower-for-longer’ equity environment emerges, investors might have to adopt stock-picking strategies rather than relying on passive funds to achieve their investment goals.

MORE ROOM TO RUN

A rotation is underway, whether it be from large-cap to small-cap stocks, from defensive to cyclical sectors, or from growth to value investments.

As of the end of June, the top 10 stocks in the S&P 500 accounted for a record 35% of the index’s total market capitalization. However, in the third quarter, technology underperformed the S&P 500 by the largest margin since 2016, contributing to a 13% outperformance of the ‘S&P 493’ compared to the ‘Magnificent 7’ tech giants.

This shift largely reflects investors’ optimism that the economy will avoid a recession while the Federal Reserve moves to cut interest rates to reach a neutral rate.

Lower interest rates particularly benefit the consumer and real estate sectors, which dominate small-cap stocks. Overall, small caps stand to gain disproportionately from lower rates since a substantial portion of their borrowing consists of short-term floating rate debt, as highlighted by financial analysts.

It’s reasonable to assume that these rotations have further potential for growth. Commenting on the market, Callie Cox, chief market strategist at Ritholtz Wealth, pointed out that less than one-third of S&P 500 stocks have kept pace with the broader index since the bull market began two years ago. Five sectors are lagging behind the index’s returns by more than 20 percentage points since the October 2022 low, and several stocks have not yet recovered their 2021 highs.

OVER-VALUED?

However, the trend of recovery may not all bode well for investors. A broad rally usually accompanies more subdued returns, as noted by Larry Adams, Chief Investment Officer at a financial services firm. He emphasized that this phenomenon is especially likely when a bull market enters its third year, which is the current situation. Historically, returns during the third year of a bull market can average only 2%.

Another factor to consider is the earnings outlook — over 40% of companies in the index are facing negative earnings growth.

Given this context, the valuation of the Russell 2000 index appears somewhat stretched, trading at over 26 times forward earnings. This level is among the highest observed in the past quarter-century, excluding the distortions of the pandemic years.

Moreover, expected earnings growth for next year has risen to 43%, up from 32% six months ago, which could be overly optimistic.

On a positive note, the low starting point for earnings suggests that these companies might experience improvements, especially with the potential for reduced borrowing costs and more favorable financial conditions.

Conversely, there is a significant likelihood that economic growth could decelerate and unemployment could rise notably in the next 12-18 months. The Federal Reserve’s plans for rate cuts may hinge on the potential of this scenario.

Ultimately, those who thrive in this evolving environment could be the stock pickers. Jeff Schulze, head of economic and market strategy at another investment firm, remarked, "Gains at an index level will be more muted, but underneath the surface, there will be good opportunities for active managers."

Finding who will outperform is always a challenge. Critics of the market’s previous concentration should be cautious; while a broader market is emerging, it may lead to weaker overall returns.

(The opinions expressed here are those of the author, a columnist for a major news organization.)

(By Jamie McGeever; Editing by Andrea Ricci)