Extreme Distortions Everywhere: A Moment for Active Management
Powerful investment themes, such as AI, can capture the market’s collective imagination. Taken to an extreme, however, they can also trigger distortions across and within the markets.
In our 2Q 2024 Equity Outlook, we examine key historic distortions—wrought primarily by the Magnificent Seven’s recent bull run—that have formed across investment sectors and styles. While we remain generally constructive on equities, we recommend that investors and asset allocators make various adjustments to navigate these distortions and potentially take advantage of changing trends over the next 12 months.
While we acknowledge that strong investment themes can capture investors’ imaginations for longer than history might suggest, we fear that extreme market consensus presents a far greater threat to the future performance of equity portfolios. In short, we believe this is a moment tailor-made for active management.
—Raheel Siddiqui, Senior Research Analyst, Global Equity Research
Even in the face of higher interest rates and slowing loan growth, U.S. economic growth has remained resilient and leads the world. We believe rising bond yields and tightening credit spreads are indicative of strength in nominal GDP growth. At the same time, we detect a cyclical upturn in global industrial production (see the left side of figure 1), a trend that has historically tended to last three-to-eight quarters. 1 These developments support our near-term constructive stance on equities in general, and the U.S. in particular.
We believe a potential pickup in global industrial activity also argues for a broadening stock market away from the Magnificent Seven—including Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla—and into sectors that are sensitive to global growth such as Energy, Materials and Industrials, which we are now overweight.
Additionally, we expect inflation to pick up globally by mid-year, further boosting earnings. It also supports our overweight stance on inflation-sensitive sectors—Energy, Materials and Industrial—and underweight on Consumer Discretionary, Information Technology and Communication Services. And from a style standpoint, we are now overweight value vs. growth, which is consistent with our sector allocation.
Rising equity risk appetite has been a key driver of Technology’s run over the last year. We expect risk-seeking to diminish as U.S. growth, still stronger than the rest of the world, begins to moderate, as shown on the right side of figure 1. This dynamic supports our constructive view on U.S. equities overall, while underweighting Technology and overweighting the low beta and unloved Utilities, Consumer Staples and Health Care sectors, which are now trading at historically notable P/E discount to the S&P 500 (see figure 2).
In the following sections, we take a closer look at a few of the distortions in the equity market--wrought primarily by the Mag 7’s recent bull run--and what they could portend for equity investors over the next 12 months.
A confluence of factors—including surprisingly strong economic growth, robust corporate earnings, a net dovish Federal Reserve, healthy market liquidity and bullish sentiment in the largest corner of the stock market—has propelled a spectacular 40% rise in the S&P 500 since the start of 2023. With that run, however, came an even more spectacular polarization at the sector level.
Two tech-dominated sectors—Communication Services and Information Technology—have collectively outperformed the S&P 500 by 40% since the start of 2023; meanwhile, seven other sectors—Utilities, Energy, Consumer Staples, Real Estate, Health Care, Materials, and Financials—trailed the S&P 500 by an average 27%. Utilities fared worst, declining 4% during this period and lagging the broader index by 44%. 2
While AI exuberance remains elevated, the risks to the continued outperformance of the Technology and Communication Services sectors, in our view, have steadily risen.
Consider that, over the past six months, the market beta of the Mag 7 has held steady at an elevated 1.42, similar to a cyclical stock.3 (That figure implies in our view that for every 1% movement in the broader index, the Mag 7 would move 1.42% in the same direction.) However, the earnings sensitivity of the Mag 7 to the broader economy has increased dramatically: As shown on the left side of figure 3, six months ago the earnings sensitivity of the Mag 7 to nominal GDP was about half of the rest of the S&P 500; since then, the Mag 7’s earnings sensitivity has nearly doubled. In other words, Mag 7 earnings are now about as cyclical as the rest of the S&P 500.
A primary justification for the high valuations among the Mag 7 has been the predictability and dependability of the group’s earnings relative to the rest of the S&P 500. In our view, however, that argument has gotten harder to make.
To see why, consider the right side of figure 3, which plots the relationship between price-to-book value and return on equity for various industries over the next 12 months. (The chart suggests to us that industries lying above the dotted line are trading at a relative premium to what is justified by their current profitability, while those below the line are trading at a relative discount.) Given that it appears the Mag 7’s business fundamentals are now nearly as cyclical as the rest of the market, we believe that the group’s 26% valuation premium relative to profitability-adjusted fair value is harder to justify—which makes them potentially vulnerable to underperformance. Meanwhile, at the sector level, Communication Services and Information Technology now boast the lowest accumulation of short interest within the Russell 3000.
In our view, these are signs of significant and perhaps unsustainable bullishness that, when combined with related intra-index and sectoral distortions, prompt us to ask: Are these recent trends more likely to extend—or reverse—over the next twelve months?
We attempt to answer this crucial question in the next section by examining the market through various lenses, including sector positioning, sector weights and return-risk ratio cycles.
Sector positioning is extreme
“Positioning” measures how much of a portfolio is allocated to a certain asset class or sector. Not long ago, in the fall of 2022, Tech positioning among discretionary investors (e.g. mutual funds and hedge funds) had plummeted to the 0th percentile of all periods since 2010, while Utilities positioning had risen above the 90th percentile.4
Six quarters later, the script has flipped: Tech positioning now stands at the 94th percentile, while Utilities positioning has dropped to 3rd percentile.5 By historical standards, there simply isn’t much more room to push that gap—thereby, in our view, increasing the risk of a trend reversal should AI-linked tech earnings growth begin to fall short of elevated investor expectations.
To be sure, there are fundamental reasons for the recent polarization: Relative to any S&P 500 sector, Tech is the most exposed to the growth factor, Utilities the least; Tech is relatively insensitive to higher policy rates (due to its ample cash reserves), while highly levered Utilities are much more rate-sensitive; Tech provides exposure to currently favorable factors—including high beta, large size, and quality—while Utilities do not; finally, Tech is riding the massive AI tide, whereas Utilities—while integral to powering the AI transformation—have failed to attract a commensurate degree of investor attention. That said, current extreme positioning suggests to us that many of these considerations could be fully priced in, and then some.
Meanwhile, the current degree of sector concentration within the S&P 500 has reached near-historic proportions. As shown in figure 4, the two largest sectors by market cap—Information Technology and Communication Services—now represent nearly 39% of the S&P 500, a level temporarily breached on only three other occasions in the past 60 years, during the Iranian Oil Shock of 1978-79, the peak of the Dotcom bubble in 2000, and the mid-2021 COVID Tech boom.6
History tells us that sector concentration extremes tend to be rare and short-lived. We find that eventual reversions to the mean often mark the peaks or troughs in cycles of investor optimism, foreshadowing the end of a trend and the beginning of the underperformance of the largest two sectors, which can be accompanied by an uncomfortable degree of volatility.
Return/Risk ratio cycles may augur swift reversals
We believe attempting to time the precise peaks and troughs in risk assets remains a fool’s errand. However, our research suggests a potentially powerful approach—using return/risk (RR) ratio cycles—that we believe can help decipher when an investment theme (or sector) has potentially reached a positive or negative performance extreme.
The Sharpe ratio is a common tool for comparing the risk-adjusted performance of different portfolios. Yet we find a modified version of this concept can also help investors get a better statistical handle on when potentially perilous and unsustainable “groupthink” has set in.
We observe that stocks associated with an enduring investment theme tend to rise or fall alongside an active debate among bulls and bears. This debate introduces natural volatility in the market—hence the saying, “Nothing goes up or down in a straight line.” When an investment theme continues to trend but its volatility collapses, that’s roughly the time, we believe, that thesis has morphed into consensus, the debate has fizzled and groupthink has set in. When this happens, stock prices often hurtle without much volatility, pushing the absolute value of their RR ratio higher.
Based on our research, groupthink tends to be self-correcting, often quickly. Extended RR ratios, we find, are often a prelude to trend reversals, and as debate and volatility come back to life, RR ratios begin to retreat. This dynamic creates an RR ratio cycle—one that, we believe, can be very helpful in assessing turning points of both deeply loved and deeply out-of-favor investment themes and sectors.
Our analysis shows that rolling 1-year trailing RR ratio captures this dynamic well and tends to cycle through peaks and troughs along with investor optimism or pessimism. (We calculate a sector’s RR ratio is calculated as a sector’s 1-year return relative to the broader index, divided by the standard deviation of that relative return.)
Sector Rotations
Consider the RR ratio cycles of two currently polarized sectors: Information Technology and Utilities. As shown in figure 5, the Information Technology sector’s RR ratio ranks in the 98th percentile of data going back more than three decades, while the Utilities sector’s ratio ranks in only the 5th percentile over the same period.
Consider the RR ratio cycles of two currently polarized sectors: Information Technology and Utilities. As shown in figure 5, the Information Technology sector’s RR ratio ranks in the 98th percentile of data going back more than three decades, while the Utilities sector’s ratio ranks in only the 5th percentile over the same period.
Instances of such extreme groupthink across this many sectors in the S&P 500 are historically rare. In fact, our observed groupthink across sectors now ranks in the 99th percentile of data going back over three decades—on par with the sector polarization last seen during the dot-com frenzy in 2000. We believe reversions across this many sectors are a potential risk to portfolios and an opportunity to take advantage of changing trends.
Growth-to-Value Rotation
We believe RR ratio cycles also offer valuable perspective on the potential rotation from growth stocks into value stocks.
As shown in figure 6, the 1-year trailing RR ratio for the Russell 1000 Growth index versus the Russell 1000 Value index performance peaked at the 99th percentile in mid-January and has since been falling. This suggests to us that the year-long rotation from value to growth may have reached its cyclical peak, implying that growth stocks may be poised to underperform value stocks over the next 12 months.
Over the past seven years, we find that the peaks and troughs in the RR ratio cycle have effectively delineated periods of outperformance among growth and value stocks. Given the market’s highly polarized sector sentiment, extremes in sector positioning and abiding enthusiasm for AI, we think an eventual rotation from growth into value could be more intense than usual, and thereby suggest underweighting growth versus value over the next 12 months.
We think current conditions present a significant opportunity for skilled active managers who can potentially take advantage of value and sentiment dislocations and capitalize on rotations away from groupthink. In our view, sector rotation and prudent stock selection are more critical than ever in order to manage the elevated risk within themes and sectors.
History shows that compelling investment themes can invite groupthink among market participants, which in turn can produce unsustainable distortions across various sectors. Thanks to Tech and AI, here we may be again.
In light of the various distortions we have examined above, we believe investors should consider making some timely portfolio adjustments.
In our assessment, underweighting the Tech sector and focusing on thoughtful security selection may prove a better way to capitalize on the AI theme while managing potentially rising risks in a sector dominated by extreme sentiment and momentum. Additional thoughts on where we see opportunities in the market, informed by our RR ratio cycle methodology, include:
Sectors (U.S.)
Overweight: Energy, Financials, Industrials, Materials, Consumer Staples, Healthcare, Utilities
Underweight: Information Technology, Communication Services, Consumer Discretionary
Equity Styles
Overweight: Value vs. Growth; Small vs. Large
Portfolio Factors (U.S.)
Overweight: Small Size, Value, High Dividend Yield, Low Leverage
Underweight: Beta, Growth, Quality, Foreign Sales Exposure
Key Regions and Markets
Overweight: USA, Japan, India
Underweight: EAFE, EM, Europe, Canada, United Kingdom, China
The targeted investment horizon for these recommendations is 12 months, but we expect more frequent changes at the sub-index level in response to changing market dynamics.
We acknowledge that strong investment themes, such as AI, can capture investors’ imaginations for longer than history might suggest. However, we fear that the excesses of groupthink present a far greater threat to the future performance of equity portfolios.
For detailed recommendations across sectors, factors, style and geographies, see the section titled “Investment Themes and Views.”