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As we roll into spring in the northern hemisphere, investment themes that were hard to see in 2023 now appear on the verge of blossoming.
The “Magnificent 7” made up less than 20% of the S&P 500 Index at the start of 2023. That group drove two-thirds of 2023’s performance and has continued to outpace the Index in 2024. Market concentration now stands at a 50-year high, with that group now composing nearly 30% of the Index.
That trend, however, looks like it is starting to crack. We are down to the “Magnificent 5,” with Tesla and Apple posting negative returns for the year to date. We observed increased market breadth late in 2023 and expect to see breadth improve as 2024 progresses, largely through improved returns for the “S&P 493” along with small- and mid-cap stocks.
Historically, concentration has increased during periods of economic uncertainty. As macro uncertainty abates, market breadth improves. That’s exactly what we are seeing today, with expectations of a hard landing shifting to expectations of a soft landing, and perhaps no landing at all. This may be an ideal time to consider extending equity allocations, with the flexibility to neutralize risks posed by concentrated markets should this take time to unfold fully.
We are forecasting a combination of modest growth and moderating inflation and interest rates. That should be an increasingly favorable environment for small- and mid-cap stocks, which dramatically lagged in 2023 and have materially lagged index returns for most of the past 13 years. Small caps have not been this undervalued relative to large caps since the dot-com bubble.
Adding to that, the small- and mid-cap universes have become increasingly inefficient given less sell-side coverage, more ETF trading, and the rapid increase in unprofitable small caps in the Russell 2000 following the SPAC boom of 2020 – 2021. The upshot is that not only do we believe small- and mid-caps are on the verge of a period of outperformance, but we also think these conditions will be favorable for active managers.
Like small caps, value has meaningfully lagged in 2023 and for most of the past decade (although value outperformed in Europe and Japan in 2023). That underperformance has continued in 2024. That has caused US market indices to become not only more concentrated with mega-cap stocks, but also in terms of sector and factor. For clients benchmarked against these indices, their exposures are increasingly tilted toward these areas. And given the US’s large weight in global indices, this concentration is present in global portfolios as well.
Since many client portfolios have become skewed toward growth from market action, and therefore exposed to the risk of a reversal, value stocks provide an attractive combination of upside potential and portfolio diversification. Value allocations can be oriented toward quality, thematic or individual opportunities, or dividends for those seeking income as rates begin to moderate.
Japanese nominal GDP growth was near 0% for 30 years. It is now in the 3% – 5% range. The economy appears to be leaving behind the deflationary environment that has dogged it for years, helped along by robust wage growth and corporate pricing power. Investors have also been encouraged by corporate reform measures that are taking hold in earnest, with companies increasingly focusing on return on capital. The corporate reform story is real and still has many years to play out.
These material changes are in the context of, in our view, reasonable valuations. Even after its year-to-date gains, Japan’s equity market is at its median valuation on 20-year history and is priced at two-thirds the multiple of the US. All told, we believe this remains an attractive entry point for what continues to be a fundamentally driven rally.
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Japan equity: Reason to believe
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Toshiki Izumi, CFA, CMA