Market Dynamics Amid Interest Rate Cuts

By Jamie McGeever
ORLANDO, Florida (Reuters) – A handful of mega-cap technology stocks has fueled Wall Street’s boom for much of this year, but the promise of aggressive interest rate cuts has broadened participation recently across a range of stocks and sectors.

This increased breadth should help sustain the rally well into next year – especially with inflation continuing to trend toward the Federal Reserve’s 2.0% target and the economy growing at around a 3.0% clip.

Investor Sentiment and Valuations

However, it’s unclear whether this rotation will generate the pace of gains investors have become accustomed to. History suggests it may not, particularly given the lofty expectations baked into today’s high valuations and the age of this bull 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.

Room for Growth

Rotation is underway, whether it’s from large caps to small caps, defensives to cyclicals, or growth to value.

At the end of June, the top 10 stocks in the S&P 500 accounted for a record 35% of the index’s entire market cap. But in the third quarter, tech underperformed the S&P 500 by its widest margin since 2016, driving a 13% outperformance of the ‘S&P 493’ against the ‘Magnificent 7’ Big Tech names.

This shift reflects investors’ optimism that the economy will avoid recession while the Fed will still see the need to cut interest rates rapidly to return to the so-called neutral rate.

Few areas of the economy benefit from lower interest rates more than the consumer and real estate sectors, which are heavily represented among small-cap stocks. Lower rates benefit small caps disproportionately because most of their borrowing consists of short-term floating rate debt: 53% compared with only 26% for large-cap companies, according to Raymond James.

Importantly, these rotations may have more room to run. Callie Cox, chief market strategist at Ritholtz Wealth, notes that less than one third of S&P 500 stocks have kept up with the broader index since the bull market began two years ago. Five sectors lag behind the index’s returns since the October 2022 low, while consumer discretionary and real estate, along with 47 stocks, have yet to reclaim their 2021 peaks.

Evaluating Returns and Risks

While this catch-up may offer hope, it also raises caution. A broadening rally is typically accompanied by more muted returns, especially as a bull market enters its third year, where annual returns can average only 2%. Additionally, over 40% of the companies in the Russell 2000 index have negative earnings growth, and the index trades at more than 26 times 12-month forward earnings, suggesting a valuation that looks rich.

Expected earnings growth next year is projected at 43%, up from 32% six months prior, which may be overly optimistic. The low starting point means these firms’ earnings are likely to improve, particularly with lower borrowing costs and looser financial conditions. However, economic growth may slow, and unemployment could rise over the next 12-18 months, which the Fed wouldn’t anticipate if the risks were minimal.

Ultimately, stock pickers may find more opportunities in this environment. “Gains at an index level will be more muted,” notes Jeff Schulze, head of economic and market strategy at ClearBridge Investments. “But underneath the surface, there will be good opportunities for active managers.”

Identifying who outperforms remains a challenge. Those who warned that extreme concentration might topple the market should be cautious; a broader market may still yield weaker returns.