Wall St sees stock rally ‘slower for longer’ as rally extends: McGeever By Reuters

By Jamie McGeever

ORLANDO, Fla. (Reuters) – A handful of mega-cap tech stocks fueled Wall Street’s boom for much of this year, but the promise of aggressive interest rate cuts has recently boosted participation in a number of stocks and sectors .

That increased magnitude should help sustain growth into next year — especially as inflation continues to edge toward the Federal Reserve’s 2.0 percent target and the economy grows at about 3.0 percent.

But what’s less clear is whether this turnaround will generate the pace of gains investors have become accustomed to. History suggests it might not, especially given the high expectations included in today’s lofty ratings and the age of this run.

If this is the case and a “slower-for-longer” equity dynamic sets in, investors may need to turn to stock-picking strategies rather than passive funds to achieve their desired returns.

MORE SPAM TO ESCAPE

The rotation is ongoing, whether it is from large caps to small caps, from defensive to cyclicals, or from growth to value.

At the end of June, the top 10 stocks accounted for a record 35% of the index’s entire market capitalization. But in the third quarter, tech underperformed the S&P 500 by its biggest margin since 2016, helping the S&P 493 outperform the so-called “Magnificent 7” Big Tech by 13%.

This shift primarily reflects investor optimism that the economy will avoid recession, however the Fed will still see the need to cut interest rates quickly to return to the so-called neutral rate.

Few areas of the economy benefit from lower interest rates than the consumer goods and real estate sectors, which are heavily represented among small-cap stocks.

More broadly, lower rates disproportionately benefit small-cap companies because the majority of their borrowing consists of short-term floating-rate debt: 53 percent, compared to just 26 percent for large-cap companies, according to Raymond James.

Importantly, it is reasonable to assume that these rotations have more leeway.

Callie Cox, chief market strategist at Ritholtz Wealth, notes that less than a third of S&P 500 stocks have kept pace with the broader index since the bull market began two years ago.

Five sectors are more than 20 percentage points behind the index’s returns from the October 2022 low, while the two aforementioned sectors – consumer discretionary and real estate – and 47 stocks have yet to recover their peaks of 2021.

OVERrated?

But this recovery game may not be good news for investors. That’s because an upward rally tends to be accompanied by weaker returns, notes Larry Adams, chief investment officer at Raymond James. He also points out that this is especially likely when a bull market enters its third year, as it is now. Returns in the third year of a bull market can average only 2%, he notes.

Another reason for caution is the earnings outlook – more than 40% of companies in the index have negative earnings growth.

With that in mind, the Russell 2000’s valuation seems a little rich. The index trades at more than 26 times forward 12-month earnings, which, excluding pandemic-distorted 2020 and 2021, is among the most expensive levels in the past quarter-century.

And forecast earnings growth for next year is now 43%, up from 32% six months ago, which also seems bullish.

A positive twist can be applied here: the ultra-low starting point means these firms’ earnings are more likely to improve than not, especially if boosted by lower borrowing costs and looser financial conditions.

On the other hand, there is a good chance that in the next 12-18 months economic growth will slow and unemployment will rise, perhaps quite significantly. The Fed probably wouldn’t be in the position to cut rates so much if the likelihood of that scenario were negligible.

Ultimately, the winners in this new environment could be stock pickers.

“Index-level gains will be more subdued,” notes Jeff Schulze, head of economic and market strategy at ClearBridge Investments. “But beneath the surface, there will be good opportunities for active managers.”

Determining who actually tops is always the hard part. Those who have been warning all year that extreme concentration will topple the market should be careful what they wish for. They now have a wider market, but returns may be poorer.

(The opinions expressed here are those of the author, a Reuters columnist.)

(By Jamie McGeever; Editing by Andrea Ricci)