As the S&P 500 reaches unprecedented levels, the narrative fueling its ascent has notably shifted from anticipation of interest rate reductions to robust economic expansion powering the equity markets.
Remarkably, since March 2020, the S&P 500 index has surged by 130% to achieve a new zenith, now valued at 21 times the forthcoming year’s anticipated earnings. This valuation is hardly considered economical. The surge over the previous year was significantly driven by the exceptional performance of a select group of seven prominent stocks. It’s common knowledge among Wall Street circles that the Federal Reserve intends to postpone any rate cuts until it’s assured that inflation is under control.
Investors have adjusted their stock trading strategy, responding to an evolving market landscape where the frontrunners in gains are also changing. Despite these shifts, the essence of a bull market remains intact.
Are We Heading Towards a Market Correction?
These aspects, among others, expose the market to potential short-term adjustments, typically defined as a 10% decline. Historical data shows that, on average, the market experiences such a correction annually since 1929, suggesting another may be imminent.
However, any forthcoming correction should be seen as an opportunity for investment. The foundation for continued market growth no longer hinges on the anticipation of Federal Reserve rate cuts but is supported by a strong economic outlook. This is expected to foster earnings growth across a broader spectrum of companies, thereby diversifying the rally.
Andrew Slimmon, a portfolio manager with Morgan Stanley Investment Management, succinctly puts it: a flourishing economy directly translates to robust earnings. Moreover, a stable economic environment allows the Federal Reserve the luxury of time in adjusting rates. Slimmon points out the risk of economic downturns associated with premature rate cuts, which could undermine expected earnings growth.
The economy displays minimal signs of deceleration. With a 2.5% growth in the U.S. real GDP in 2023, outpacing recession forecasts or more severe financial crises, expectations are set for continued growth albeit at a moderated pace in the following years according to Bloomberg’s consensus estimates.
Despite the skepticism, actual economic performance has consistently outperformed expectations, as indicated by the rising Citi Economic Surprise Index since the start of the year.
What Makes the ‘Magnificent Seven’ So Important?
Looking ahead, Wall Street analysts anticipate an 11% increase in earnings for S&P 500 companies this year, following a modest 2% gain in 2023. Projections for the subsequent year suggest a 13% increase, diminishing the likelihood of a bear market.
The disproportionate rewards to the largest companies in recent years led to significant gains, particularly for the “Magnificent Seven,” a group of leading technology firms. These companies have outpaced the average S&P 500 entity in earnings growth in 2023, contributing significantly to the index’s 24% rise last year.
These tech giants are at the forefront of artificial intelligence, cloud computing, and future technologies, promising continued earnings growth. However, as the economy grows, the earnings potential of other market segments is expected to rise, eventually equalizing with the Magnificent Seven by year-end.
This presents an opportune moment to diversify into more affordable sectors of the market that stand to benefit from economic growth, such as cyclical, value-oriented stocks, and industries like industrials, energy, and financials.
One strategy to capitalize on this theme is through the S&P 500 Equal Weight Index, which assigns equal importance to all S&P companies, unlike the capitalization-weighted approach that favors larger corporations. Despite trailing behind the S&P 500 over the past year, the Equal Weight Index recently reached a new high, having last outperformed the capitalization-weighted index in 2022 when rising interest rates adversely affected large-cap growth stocks.
Even among the market’s top performers, changes are underway, with Microsoft ascending to the largest company in the index, Nvidia making it to the third spot, and Tesla falling out of the top 10, replaced by Berkshire Hathaway in the seventh position.
Final Thoughts
In conclusion, the financial landscape is constantly evolving, and the recent shift towards robust economic growth as the primary driver of the stock market presents both opportunities and challenges for investors. The rise of the S&P 500 to record highs, driven in part by the performance of a select few companies, highlights the market’s potential vulnerability to corrections. Yet, these moments are not just pitfalls but opportunities for those prepared to seize them.
The outlook for the stock market remains positive, underpinned by a strong economy poised to fuel earnings growth across a more diverse range of companies. This broadening of growth prospects suggests a move away from reliance on a handful of technology giants towards a more inclusive rally, offering investors a chance to diversify their portfolios and invest in sectors that stand to benefit from economic expansion.
The future of investing lies in recognizing the potential across the entire market spectrum, driven by the solid foundation of a strong economy, and being ready to adapt our strategies to harness the growth that lies ahead.