The S&P 500 Index reached an all-time high in mid-February, driven to a large extent by the performance of a handful of mega-cap technology stocks. But can such concentration of returns persist, and what are the options for an investor seeking to build a diversified equity exposure in the US?
Daniel Casali, chief investment strategist at wealth management company Evelyn Partners, says: “In 2023, the select group of Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta Platforms and Tesla returned an incredible 107 per cent, far outpacing the broader MSCI USA index, which delivered a relatively subdued but still healthy 27 per cent to investors.”
Those seven stocks now represent more than 28 per cent of the total index.
Casali says the current health of the US economy and its corporate sector will mean a broader range of stocks drive market returns this year.
“Companies have adeptly raised their prices, passing on the impact of higher inflation to their customers,” he says.
“Although wages have risen, they haven’t kept pace with those price rises, leading to a decline in employment costs as a proportion of the price of goods and services. Factors, including China joining the World Trade Organization and technological advances, have enabled an increased supply of labour and accessibility to overseas job markets. This has contributed to improving profit margins, supporting earnings growth.
“We see this trend continuing. Even if margins contracted slightly and there was only modest growth in company sales, our analysis suggests that company earnings could continue to grow. Consensus forecasts project 11 per cent growth in earnings in 2024, which is possible,” Casali adds.
Small caps performing well
It may not be as simple as moving further down the market-cap scale, according to Kepler research analyst Alan Ray, who says that while much focus has been on the gains made by the large-cap indices, “the smaller companies index – the Russell 2000 – did relatively well in 2023, rising 17 per cent”.
“But, like the large-cap index, a narrow group of sectors led performance, and two-thirds of sectors underperformed. Small caps are more sensitive to interest rates, and to inflation, and so with hindsight this gap is explicable. Higher debt costs and inflation make life harder for smaller companies – the market knows this and reacts when rates rise,” Ray adds.
Even if margins contracted slightly and there was only modest growth in company sales, our analysis suggests that company earnings could continue to grow
One feature of the US economy of late has been the resilience of gross domestic product growth, occurring at the same time as markets ponder the possibility of interest rate cuts.
Analysts at consultancy GlobalData TS Lombard think one positive feature of US markets is that equities are no longer whipsawing based on investor expectations around monetary policy, but instead are focused on the actual GDP data being positive, and on company earnings, which have generally been robust.
But their view is that with valuations already high, “expensive US valuations limit the upside in the medium term, although positioning data suggests investors are still managing risk carefully. We prefer Europe to the US, and remain cautious on China”.
Steven Blitz, chief US economist at the company, says market expectations that interest rate cuts may be on the horizon, further boosting equity market returns, are likely to be unfulfilled.
He said the latest US inflation data indicates that services inflation is not falling, making it difficult for policymakers to justify cutting rates at present.
Lower rates would typically be expected to help longer-duration and growth equities much more so than value stocks, but also smaller company stocks.
So if the market’s expectations around the direction of rates were to permanently shift to a view that higher for longer is the new normal, then certain stocks would probably benefit more than others. But where is the value?
The 493
Excluding the large-cap tech stocks in the index, there are 493 other stocks in the large-cap benchmark.
Ninety One US equity investor Paul Vincent is among those to have been looking away from the mega caps. He says a central reason to invest in the big tech stocks is the capacity for those companies to grow, regardless of wider economic conditions.
But he says that with US GDP being as strong as it is, more companies have the ability to grow and so there can be more focus on valuation.
Vincent had previously invested in Nvidia, but sold it on the basis of valuation, noting: “There is an element of [artificial intelligence] being in a hype cycle right now, but otherwise I think the majority of those stocks are actually reasonably valued.”
Expensive US valuations limit the upside in the medium term, although positioning data suggests investors are still managing risk carefully. We prefer Europe to the US, and remain cautious on China
Instead, he is focusing on the US consumer, and on stocks that are often called consumer staples. Those equities tend to be out of favour at a time when higher interest rates are pushing bond yields higher, he says.
This is because the income generated from those consumer staples is often viewed as being bond-like in nature, and so competes with the yield on bonds for capital.
If interest rates, and consequently bond yields, have peaked, then the yields on those types of equities may be viewed more attractively by the market.
Vincent says many of those types of stocks have been deeply out of favour with the market as rates rose, but a combination of the improved economic environment and the peak in rates may make those equities attractive now.
Smaller victories?
As mentioned earlier, lower interest rates and more positive economic news would be expected to benefit smaller companies, where liquidity and cyclicality are more relevant than among mid caps.
But if rates remain at present levels, rather than fall from here, would that not imply bad news for smaller companies?
Rupert Rucker, who manages a US small and mid-cap fund at Schroders, says valuations are currently at such a discounted level relative to large caps that any such concern may already be reflected in the price.
He says that while higher interest rates would be expected to hurt the liquidity of smaller companies, “in the US, small caps are mostly very big companies. Many of the ones we own would be large caps in the UK.”
Rucker says that while technological change is driving the growth of mega-cap businesses, the US government’s “Chips Act” — the stimulus package introduced by President Joe Biden — is the key driver of the growth in the small and mid-cap universe.
He says this is leading to significant fiscal spending in the country, and the primary beneficiaries of this spending are smaller and mid-cap, and domestically focused companies.
Fran Radano, who runs the North American Income trust at Abrdn, says consumer spending is now the primary reason for the strong GDP growth in the US economy, with retail sales rising in December by more than had been expected.
Even if the US economy is diverted from the “goldilocks” outlook of recent months, the potential for rates to have peaked means its equity market may not require another burst of technological innovation to thrive.
David Thorpe is investment editor at FT Adviser
