The new buzzword in the stock market is “rotation.” This Wall Street jargon comes up when the dominant market trends fade in favor of new ones. The question for investors is what the new trends will be and how best to position for the rotation.
This time around, the main trend has been the huge rally in mega-sized technology stocks fueled in part by the artificial intelligence boom. Those gains sputtered during July while small-cap stocks and value stocks took the lead. That loss of momentum was followed this last week by the worst stock market selloff in two years, sparked by fears of a recession and big bets unwinding in Japan. The Morningstar US Market Index dropped roughly 3% in a single day.
Markets have since rebounded and are still up 11% for 2024. But it’s unclear whether investors can expect to return to the easy gains they enjoyed earlier this year. That’s especially the case given mounting evidence that the economy is slowing. So where should investors be looking?
Strategists point to “quality companies”—those with stronger balance sheets, less debt, and more growth prospects—and less-buzzy sectors like utilities, industrials, and energy, which they say are good bets to weather the market volatility they expect in the months ahead.
“These are sectors that we think will do well in the future and have really been underappreciated by the market,” says Paul Christopher, head of global investment strategy at the Wells Fargo Investment Institute. “They traded at lower multiples, and we think they have long-term prospects.”
Meanwhile, though small-company stocks have recently enjoyed support, opinions are mixed on whether this group, with their close ties to a softening US economy, will be significant winners in any rotation.
Focus on Nuts and Bolts
Christopher says a coming wave of infrastructure spending will help support his overweight allocation to the industrials, materials, and energy sectors. These sectors represent the nuts and bolts of the economy. They’re certainly not as glamorous as the Nvidias and Microsofts of the world, but they are essential to economic growth. “It’s related to factory building and bringing home production from China, that sort of thing,” he says.
Strategists from Bank of America share that view. In a recent note to clients, they described the beneficiaries of “old school” capital expenditure spending, like infrastructure and manufacturing, as “more compelling” than the larger tech firms weighted more heavily in the stock market’s major indexes.
Michael Clarfeld, a portfolio manager at ClearBridge Investments, points specifically to the utilities sectors as a good bet. “The growth rate for the sector in the next ten years is going to be much higher than it was in the last ten or 20 years,” he says. That’s thanks to a combination of factors, including the ongoing transition to electric energy from fossil fuels, the need to build more AI infrastructure, and the need to make electrical infrastructure more resilient to climate change and natural disasters. “All three of these things are driving higher growth in the years ahead than we’ve seen for some time,” he adds. Combine that with relatively low valuations for the sector and the potential for dividend growth, and you have a solid lower-risk bet for the future.
Investors Don’t Need to Abandon AI
Investors who still want an entry point into the digital economy and AI momentum trade will find one in the “old school” sectors. Industrial and energy companies are responsible for building and maintaining the data centers that power AI chips. This knowledge has already sparked a resurgence of investor interest in utilities. The Morningstar US Utilities Index is up about 18% this year, well ahead of the broader market. “All this is a great way to play the AI theme, but from a cheaper starting point,” Christopher says.
Morningstar chief US market strategist Dave Sekera says that while this trade may have already played itself out at a sector level, there are still winners to be found. “After trading at a deep discount last fall, the utilities sector now trades at a 5% premium to fair value. While the sector average may be overvalued, we continue to see a number of attractive stocks in the utilities sector,” he writes.
Large Caps Remain Solid
Though smaller-capitalization stocks popped in the early days of the rotation away from big tech, the category has trailed the broader market. The Morningstar US Small Cap Index is down 3.6% over the past week, compared with 2.4% losses for the Total Market Index, and it’s only up 2.4% for the year. The Morningstar US Large Cap Index has outperformed the broader market for the year.
One issue for small-company stocks is that their fortunes are more closely linked to the US economy. If the economy slows materially—or worse, slides into a recession—that would be bad news for these stocks.
Small caps have “made some progress, but it definitely wasn’t the kind of breakout everybody was talking about a couple a couple of weeks ago,” says George Smith, portfolio strategist for LPL Financial. He says he currently favors large caps because of their strong fundamentals. Christopher agrees: ”We like large caps, so we’ll stay there. We think that’s where you’ll find the most quality.”
Smith adds that retaining an overweight allocation to large caps relative to small caps over the past few weeks has “proved to be a good call.”
That’s not to say that the market’s smaller players don’t have potential. Sekera argues that from a valuation perspective, small-cap stocks look attractive. That’s compounded by the fact that the Federal Reserve is poised to cut interest rates. “We suspect small-cap stocks still have a long path of outperformance ahead,” he writes.
Prepare for Volatility
A painful side effect of the market’s rotation has been heightened volatility. After months of relatively steady and predictable gains, the stock market has been significantly choppier over the past few weeks, with more trading days ending in the red. Strategists expect those bumps to continue.
Smith points out that historically, September and October tend to bring lackluster market returns. That’s not to mention the potential market swings surrounding the US election in November. He reminds investors this is normal: “volatility and drawdowns are the price of admission to the markets.”
The silver lining is that market dips often make for good buying opportunities for patient investors, and Smith doesn’t think the market has bottomed out just yet. “We’ve got our shopping lists out, and we’re ready to pounce when the bargains arrive,” he says.
What About Big Tech?
Another positive of the recent selloff was a move lower in valuations across the board. After losing some ground, companies that once looked too expensive to consider could be more attractive now, analysts say. This includes some of the Magnificent Seven tech giants—Nvidia NVDA, Tesla TSLA, Meta Platforms META, Apple AAPL, Amazon.com AMZN, Microsoft MSFT, and Alphabet GOOGL/GOOG.
“While the volatility in tech has been dramatic in recent days, we think the global correction has uncovered structural opportunities across many quality tech segments,” Solita Marcelli, chief investment officer, Americas, at UBS Global Wealth Management, wrote in a recent note to clients. However, she emphasized that she prefers “companies with strong balance sheets and a track record of earnings growth.”
Two of the Magnificent Seven—Amazon and Microsoft—are now considered undervalued by Morningstar analysts. “Valuations are starting to look more interesting, but overall, the technology sector still isn’t super cheap,” Eric Compton, director of equity research at Morningstar, said recently.
Smith also sees value in the tech leaders. “We still do like the Mag Seven,” he says, pointing to their powerful earnings growth and overall resilience. Such qualities are especially important when there are warning signs about weakness in the US economy.
Bottom Line for Investors
Overall, Christopher encourages investors to “stick with quality,” even if the market remains choppy. “Everything’s going to go down right now for a little while, but hopefully the quality picks will go down less, and then you’re in a better position to add to them later, when they’re even more attractively priced and when we get an economic recovery,” he says. He believes that shift will happen early next year, “So hang on here.”
