This Bull Market Is Broadening
As discussed last week in our mid-year investment themes, the stock market continues to hit new all-time highs. The S&P 500 has gained 19% year-to-date with reinvested dividends, contributing to a total return of 61% since the market bottom in 2022. While much of this performance has been driven by large-cap technology stocks over the past 18 months, there are now signs that other parts of the market are benefiting as well.
These shifts highlight the critical fact that while investing trends may come and go, the core principles of investing help investors protect and compound their wealth and hit their goals in full market cycles. What should investors know about diversifying across sectors and styles over the next several quarters?
Performance is broadening beyond large-cap growth
While investors tend to focus on major market indices and the one or two areas driving recent returns, the reality is that performance leadership tends to change over time. Large-cap tech stocks have dominated headlines recently, and for good reason – the Magnificent Seven stocks have gained 192% over the past year and a half.
This is partly due to excitement over artificial intelligence breakthroughs and partly because lower interest rates are generally favorable for growth. This recent performance is also a reversal of the tech crash in 2022 when the Fed hiked rates.
However, as the chart above shows, signals are emerging that other areas of the market are beginning to participate, with three important implications for investors.
First, recent economic reports around easing inflation have propelled areas such as small-cap stocks and large-cap value, which are market areas much more sensitive to input costs and interest rates. These companies also tend to be more U.S.-focused, so they often outperform when there is positive news on economic growth. So, the prospect of the Fed lowering rates due to positive inflation data has catalyzed many of these stocks higher.
Growth and value can each outperform over long periods
Second, value stocks have performed better recently due to these same factors. Notably, this has not been at the expense of growth stocks, per se. Instead, value stocks may be in the early stages of catching up after lagging for the past 18 months.
What exactly are value and growth stocks? While their exact definitions can differ among investors, these factors tend to be characterized by each stock’s valuation level. Those with lower valuations tend to be described as “value,” while those with higher valuations are classified as “growth.”
More broadly, value investors hope that a stock’s share price will adjust based on what it “should” be worth based on fundamentals such as earnings. On the other hand, growth investors hope that a company will continue to grow substantially and are less concerned about the current valuation level or share price.
The chart above shows how value and growth have fluctuated over time. Growth stocks outperformed during the dot-com boom in the late 1990s and early 2000s. This then gave way to strong outperformance of value stocks through much of the 2000s.
This cyclical rotation from growth to value and back has occurred numerous times throughout market cycles, driving much of the academic research around the value premium. So, while growth stocks have strongly outperformed most recently, leadership changes are not unusual.
Diversifying across styles helps to reduce portfolio risk
Finally, the outperformance of growth stocks does not mean that diversification is no longer relevant. In fact, the opposite is true: diversifying across styles allows investors to benefit from recent market trends while also protecting their portfolios from potential risks.
For example, the accompanying chart shows that those parts of the market that have performed well also have excessive valuations. The price-to-earnings ratio of large-cap growth is now 28.4, driving the overall S&P 500 index P/E to 21.2.
In contrast, large-cap value only has a P/E of 15.7, while small-cap value is far less expensive at 13.8. This is the case even though small-cap value stocks are expected to experience earnings growth rates similar to large-cap growth stocks over the next twelve months.
Performance has also broadened across sectors. Ten of the eleven S&P 500 sectors have positive returns this year, with only the real estate sector slightly negative. Many sectors, including financials, utilities, consumer discretionary, industrials, consumer staples, healthcare, and energy, have year-to-date gains of 8% or more.
While tech stocks have received most of the attention, and a few individual stocks have significantly outperformed the market, there are signs that other sectors are benefiting from the rally as well.
The bottom line: History shows that long-term investing isn’t just about “predicting winners” – it’s also about diversifying across styles, sectors, and more. Market leadership not only changes over time but also can do so swiftly. Staying diversified allows long-term investors to benefit from opportunities while also having a smoother ride as they work toward their financial goals.