It’s a Good Year for Stock-Pickers. Here’s Why

Key Takeaways

• Subramanian made some headlines when she raised the year-end S&P 500 target to 5,400. In early May, Subramanian is still very constructive on equities.
• The “Magnificent Seven” still make up a lot of the weight of the benchmark in 2024, but even within that Magnificent Seven cohort, we’ve seen a lot of differentiation.
• We should start thinking about who’s going to use generative AI to get more labor-light. We should look for other beneficiaries of this environment that might focus more around the idea that we’re shifting from just pure globalization to an environment that’s become a little bit more protectionist.
• In terms of risks to investors, Subramanian worries less about large-cap public equities and more about some of the private equity, private credit areas that haven’t necessarily been marked to this new reality.
• One thing Subramanian learned in her career is that emotions do not belong in the investment environment. She’s also learned that equities and, in particular, S&P 500 equities really benefit from lengthening your time horizon.

Laura Lallos: I’m Laura Lallos with Morningstar. After strong first quarter, the stock market has been choppy lately. What might be in store for the rest of the year, and where are the best investment opportunities? I’m here today with Savita Subramanian from Bank of America Global Research. She is the head of US equity and quantitative strategy, and Savita will be our opening keynote speaker at this year’s Morningstar Investment Conference in Chicago.

Thank you for joining us, Savita.

Savita Subramanian: Thanks so much for having me, Laura.

Where Does the Year-End S&P 500 Target Stand Today?

Lallos: So earlier this year, you made some headlines when you raised your year-end S&P 500 target to 5,400. So, where do you stand today in early May?

Subramanian: Still very constructive on equities. We launched with, I think, probably one of the most bullish forecasts out there, with a 5,000 target, and blew through that number very early in the year. We’ve now retraced, we’re back to where we started, but my sense is we are still in this environment where investors are climbing that wall of worry when it comes to large-cap US equities. When I look at positioning of pension funds, asset managers, asset owners, there’s really a lower allocation to equities than one might imagine. There are just a few stocks where we’re seeing euphoric sentiment, but for the broader market, we’re actually seeing relatively high levels of pessimism. I think we’ve shifted from everybody worried about a recession a couple of years ago to now everybody worried about stagflation is the new bear case that we hear a lot. And in our view, the market’s probably going to do OK. We’ve seen inflation moderate pretty aggressively. Companies have cut costs and navigated very volatile costs, input costs over the last few years. And we’re now on better footing in terms of knowing what’s ahead of us. We know how the Fed is going to get off of zero rates. We’re already there. We’re at 5%. Maybe we get no cuts this year, but I think that could be an environment where equities do just fine, in particular large-cap US equities.

The Role of the ‘Magnificent Seven’ in 2024′s Stock Market Forecast

Lallos: The Magnificent Seven drove 2023 stock market performance, as we know, but how important are these stocks to your forecast this year?

Subramanian: This year, I think they are still big components of the benchmark. They still make up a lot of the weight of the benchmark, but even within that Magnificent Seven cohort, we’ve seen a lot of differentiation this year. Some of these companies are doing magnificently, and others are starting to roll over. I think it’s really going to be more of a stock-picker’s year. And we’re already seeing that. We’re also seeing the market broaden out beyond just mega-cap tech, which makes sense, because last year, mega-cap tech companies were in cost-cutting mode. They were doing layoffs. They were downsizing capacity, and they were cutting capex. This year, they’re no longer in aggressive cost-cutting mode and they’re actually amplifying or accelerating capex in terms of chips and data center spend, etc. So there are more draws on tech free cash flow this year than what we saw last year.

Meanwhile, nontech companies are actually capex takers. So if you think about all of those chips that need to be powered up, there’s a huge infrastructure grid spend program taking place today that’s actually benefiting some of these old economy parts of the market, like utilities, like power, energy, etc. So I think this is the year where the Magnificent Seven and mega-cap tech is obviously still very important, as they represent a critical weight in the benchmark, but the real action might be taking place elsewhere or at a single-stock level. So that’s our view for the remainder of 2024.

What Themes and Sectors Investors Should Pay Attention To

Lallos: Are there overlooked themes or sectors that investors should be paying attention to now? Obviously, artificial intelligence is still a dominant one, but what are some of the areas that investors might not be thinking of?

Subramanian: Well, I think we should start thinking about who’s going to use generative AI to get more labor-light. And there’s a big part of the S&P that’s focused on where services can be disrupted by generative AI. And this has already started to happen in meaningful ways. One example of this is call centers. Call centers are now almost obsolete given the fact that you can replace a lot of these people with processes. And what that translates into is much more visible earnings, meaningful cost cuts, because labor is the biggest component of US corporate costs, and I think that that’s what’s likely to happen elsewhere. So, for example, if you look at sectors like financial services, IT services, business services, these are areas that are very labor-intensive and haven’t necessarily automated as much as other parts of the economy. These are areas that I think are ripe for becoming more labor-light, more efficient, more productive. And that’s a very strong bull case. What we found in our quantitative work is that within every sector, companies that are becoming labor-light tend to outperform their labor-intensive peers. So, if the whole S&P has an option to use generative AI to become lighter when it comes to labor, that’s a pretty bullish theme.

On top of that, I think we should look for other beneficiaries of this environment that might focus more around the idea that we’re shifting from just pure globalization, companies moving around the world frictionlessly, to an environment that’s become a little bit more protectionist. But in tandem with that, we’ve seen a lot more economic activity move from rest of world back to the US, Canada, Mexico, the North America corridor. Interestingly, half of the import activity that used to take place with China is now been moved to Mexico and Canada. So, I think those are some of the other themes that we can think about are, transport has become that much more attractive in an environment where you’re moving more stuff around in a more local area. We’re also seeing signs of manufacturing and labor remaining really tight in the US despite the fact that labor costs are so high, it’s still very hard to source labor in some of these industries that are focused on reshoring or nearshoring or friend-shoring or whatever you want to call it. So, those are some of the other cross currents that I think are interesting and also playing into more demand for metal, more demand for oil, more demand for some of these commodities that are actually starting to look a little bit more attractive.

On top of that, what I think is really interesting when it comes to commodities is that these companies now have discipline. And when you look at energy companies or metals and mining companies, they now have, for the first time, real discipline around supply and cash return. They’re not necessarily flooding the market with supply and spending on capex the minute you see a hint of price inflation. They’re actually remaining very disciplined, more focused on capital return than spending to increase capacity, which creates a much more predictable earnings environment rather than the boom/bust earnings that we’ve seen for commodity companies in prior cycles. So, I think that’s another really important shift or a sea change that we’ve seen in the markets over the last 10 years. Basically, investors have told these companies you can no longer just spend on capex. You need to think about returning capital, decarbonizing, etc. And we’ve got a much more disciplined, healthy, and potentially higher multiple sector today in some of these commodities areas.

Risks Investors Should Watch Out for in the Stock Market Today

Lallos: Are there risks on the horizon that investors should be watching out for? And are there areas that might be dangerously exposed to these risks?

Subramanian: Yeah, absolutely. I mean, there’s always risks. There’s always a bull market somewhere, and there’s always a bear market somewhere else. And what I worry more about than large-cap public equities, which are marked to market on a millisecond basis, and they reflect the current interest rate and inflationary backdrop, I worry more about some of the private equity, private credit areas that haven’t necessarily been marked to this new reality. And the reason I worry is that a lot of asset owners have shifted out of public equity into private, less-liquid areas for growth. And just over the last 20 years, we’ve seen the amount of private equity and private capital in the average US pension fund quadruple. And that is a risk going forward unless interest rates and inflation mean-revert back to those super low levels that we saw over the last 10 years, which I think is hard to argue for, given a lot of the structural changes that we’ve seen.

So I worry more about the areas outside of the public equity benchmark that are generally pretty well-capitalized. I think with small caps, you have to think twice about refinancing risk, but for larger companies, we don’t really see a lot of outsized risks around interest rates remaining high because a lot of these companies have actually paid down debt and then locked in very long-dated fixed-rate debt obligations.

So that’s where I think the real risks may reside is more in private equity and less-liquid areas of the market that have yet to be marked to this new higher interest rate, higher inflation, higher-everything-for-longer environments that we seem to find ourselves in, as well as select smaller companies that are still struggling against a wall of refinancing risk in the near term. Those are the areas that we’re more worried about. Those are the areas where we would really need to see the Fed start aggressively cutting interest rates in order to unleash performance.

Advice for US Equity Investors Today

Lallos: So to wrap things up, what’s your best piece of advice for US equity investors today?

Subramanian: The one thing I’ve learned in my career is that emotions do not belong in the investment environment. I’ve learned that the best days for stocks usually follow the worst days. So when you’re feeling very, very bearish and the world feels like it’s ending and your portfolio is down demonstrably, think twice before selling everything. I’ve also learned that equities and, in particular, S&P 500 equities really benefit from lengthening your time horizon. And what we found is that the probability of losing money in the S&P 500 by holding it for one day, it’s almost 50-50. You have like a 53% chance based on historical data of a gain and a 47% chance of a loss. It’s almost a coin flip. But if you extend your time period out, your holding period out, by a year or two or 10 years, your probability of losing money drops very dramatically. And in fact, if you look at a 10-year time horizon, the S&P has had very few decades of negative total return. That has happened just a very small percentage of the time, whereas 90%-plus of the time you will post gains over a decade. That same phenomenon is not true for other asset classes. It’s not true for real assets, for commodities. So I think it’s a unique phenomenon of US equities, which I think is important to highlight.

Lallos: Great. Well, thank you again, Savita, and I look forward to seeing you at our conference in June.

Subramanian: Likewise. Thanks so much, Laura.

Watch more from the Morningstar Investment Conference 2024 here.