What You Need to Know About This Historic Stock Market Phenomenon

Powerhouses Driving Market Growth

Throughout the first half of the year, stock market performance has already surpassed average election year returns, while the economy continued to display resiliency against high interest rates. At the heart of this robust growth are what the media refer to as the “Magnificent 7” – Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, and Tesla. These tech giants are so influential that, collectively, they now rank as the second largest stock market by market capitalization globally.

Artificial intelligence (AI) fever has provided a spark for several of the “Magnificent 7” members, boosting their earnings growth well beyond that of the broad stock market. Furthermore, their stock price has followed an even more rapid growth trajectory with investors assuming that current earnings growth rate is sustainable going forward. We are just beginning to understand the potential impacts of Artificial Intelligence on productivity and growth, so there is a wide range of potential outcomes for these stocks in the future. Nonetheless, investors have priced in high expectations for the future yet to be met as heavy AI investing and excitement is yet to translate into meaningful revenue. Both things can be true at the same time, AI can be a great long-term growth engine while exhibiting speculative frenzy in the short run.

Historical Highs: Unprecedented Market Concentration

According to Global Financial Data Inc., US stock market concentration is at its highest in 150 years, with the top 10 companies making up over 34% of the index – a record surpassing the previous high of 32% in 1962. Historically, high concentration levels have preceded significant market events. However, they do not necessarily predict doom. For instance, the market continued to surge well into the early 1970s, even after top stocks grew to 32% of the market in the mid-1950s and early 1960s. In both of those instances, the markets “broadened,” meaning stocks that were lagging in performance started to outperform.

Within the context of today’s market, if the economy remains resilient and inflation retreats to 2%, the setup could be similar as smaller segments of the market are expected to lead earnings growth by next year.

Furthermore, these companies are currently trading at a discount compared to their larger counterparts, offering attractive long-term growth potential.

Higher rates have been a hurdle for smaller businesses due to their larger debt burdens. A stable economy, paired with clarity on inflation and interest rates, could ignite a broader market rally reminiscent of past patterns.

From a portfolio perspective, Highland’s core US equity allocation is anchored around the S&P 500 which has naturally provided exposure to the recent Magnificent 7 rally. At the same time, we are maintaining exposure to segments of the market trading at a discount to large US companies both domestically and overseas. The goal is to balance a variety of potential outcomes. Whether it is broadening of the rally outlined earlier or simply AI failing to deliver on the promise where recent highflying names start leading toward the downside, like in 2022 where median return among Magnificent 7 stocks was negative 44%.*

High Interest Rates: The Fed in the Spotlight

The economy’s resilience amid rising rates is partly due to households and corporations refinancing debt at low rates, creating a spending cushion. Additionally, ongoing fiscal deficits are mitigating some negative impacts of higher rates. The Atlanta Fed’s GDP Nowcast projects a 1.7% real annualized GDP growth for Q2, driven by consumer spending.

However, prolonged elevated interest rates introduce a plethora of risks that could jeopardize economic momentum exhibited over the last twelve months. Concerns from the beginning of the year that the economy could overheat are mostly gone. Lower income households, more reliant on credit cards for spending, are facing increasing pressure from high rates. Even the beneficiaries of a low-rate environment are impacted as their loans mature and they need refinancing.

Going forward, the focus will increasingly shift toward the Fed and the timing and size of interest rate cuts. More specifically, the focus will be whether the Fed commits policy error by waiting too long to cut rates before negative impact becomes too burdensome for the economy and triggers a recession. While not necessarily a sign of an impending recession, the labor market has started to show softening signs as both job openings and quits have retreated to pre-pandemic levels. As inflationary pressure continues to ease up, current interest rate policy becomes increasingly restrictive:

The Importance of Diversification

The investing environment today and the inherent uncertainty of markets is why Highland continuously emphasizes diversification and a goal-based investing approach. We structure our portfolios and model financial plans to withstand a broad range of market outcomes and extreme environments. Beyond that, the focus should be on value-add factors that are independent of the market environment and that do not require forecasting, such as reducing fees, tax-loss harvesting, optimal asset location, rebalancing, etc. For questions about the current environment or Highland’s approach, please reach out to one our advisors or contact us here info@highlandprivate.com.

*SOURCE: J.P. Morgan (7.1.2024)