Disclaimer: Views in this blog do not promote, and are not directly connected to any Legal & General Investment Management (LGIM) product or service. Views are from a range of LGIM investment professionals and do not necessarily reflect the views of LGIM. For investment professionals only.

29 Oct 2024
3 min read

An ‘immaculate broadening out’? We don’t think so

Hopes are building around US small caps, but we believe valuations could make the vulnerable if the economy slows.

broaden equity

The below is an extract from our Q4 Asset Allocation Outlook.

For 18 months beginning in January 2003, the Magnificent 7 group of US stocks became the dominant investment theme, rising by over 100% in 2023 and a further 50% in the first half of 2024.[1]

While their outsized returns were obviously good news for those who owned the group, it felt like their dominance was storing up danger for the future as the S&P became ever more reliant on a small group of companies.

Indeed, as we discussed in our previous quarterly update, the outperformance of momentum as an investment style – buying the winners – can often be punctuated by sharp reversals. As investors crowd into a theme, the risks of the exits being equally crowded on the way out, creating disorderly price action, rise commensurately.

When it came in July, the proximate cause of the reversal wasn’t found in Silicon Valley, but in Tokyo. The Bank of Japan’s decision to raise interest rates undermined popular carry trades – borrowing in low-yielding yen to invest elsewhere – leading investors to scramble for cash by selling the largest, most liquid elements of their portfolios. In July, at which point the Magnificent 7 still accounted for over a third of S&P 500 market cap,[2] it felt like this event would portend a deeply damaging phase for US equities.

What happened next was strange, therefore. The Magnificent 7 initially declined by around 18%, settling around 10% off their peak.[3] At the same time, the S&P 500 went on to touch its prior high. In that respect, it appeared that the S&P 500 managed, against the odds, to achieve an ‘immaculate broadening out’, with leadership shifting away from the Magnificent 7 without paying a price in overall index points. What happened, and will it continue?

Out with the new, in with the old

Through the volatility, two things changed the market narrative. First, expectations for the Fed Funds rate fell sharply, with rate expectations for the end of 2024 declining by 70bps from the end of June. Second, the oil price fell by nearly 20% over the same period[4] as worries about demand grew, and supply remained strong. For consumers, the cost of money and the cost of energy are perhaps the two most critical prices, and accordingly the market’s mood toward ‘old economy’ consumer-facing areas improved.

Can this broadening out continue, perhaps led by the resurgent small cap Russell 2000? We’re not convinced.

It is worth noting that US small caps are not especially cheap. According to Bloomberg data, the 12-month forward price-to-earnings multiple of the small cap Russell 2000 is currently ahead of tech-heavy Nasdaq. The expected earnings growth for next year before exceptional items is similar for the two indices at around 20%. That’s despite the small cap index tending to exhibit greater earnings cyclicality, with its members more exposed to US macro conditions and generally offering a lower quality credit profile than the megacap tech names.

Going cheap?

That makes us somewhat sceptical that the broadening out will gain momentum. Tech has become cheaper relative to the market at a time when its earnings delivery has remained steady.

Small caps, meanwhile, appear somewhat expensive relative to their history and vulnerable should the US economy slow further from here.

The Magnificent 7 may not be as magnificent as they once appeared, but strong earnings delivery, less over-ownership and a less demanding valuation suggests it’s too early to count the group out.

The above is an extract from our Q4 Asset Allocation Outlook.

 
[1] Bloomberg as at 17 September 2024
[2] ibid
[3] ibid
[4] ibid

Market Cycle United States Asset allocation Multi-asset
Generic author image

Robert Griffiths

Global Equity Strategist

Rob joined LGIM as an equity strategist in April 2024, having spent more than 15 years as an equity strategist on the sell side. Outside…

More about Robert

Recommended content for you

Learn more about our business

Legal & General Investment Management is one of the world's largest asset managers, with capabilities across asset classes to meet our clients' objectives and a longstanding commitment to responsible investing.

Image of London skyscrapers

Explore Trending topics

Sign up for blog email alerts

Receive the latest articles in a weekly digest by registering via the email preference centre