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What happened last week?
The S&P 500, Dow and Nasdaq gained 1.68%, 1.96% and 1.73%. Stocks are trying to find their place after a post-election reaction, 3Q24 earnings, and a Fed that is easing but at a pace dependent on the incoming data. The stock market has responded to the prospects of lower taxes and a lighter regulatory touch with Consumer Discretionary being the month’s best-performing sector, so far, followed by Financials and Energy.
This week will provide clues on home prices, consumer confidence, the Fed’s thinking at its last policy meeting, and inflation.
3 Things to Know
Broaden Investment Horizons
We continue to expect the US economy to outgrow the developed world in the next two years. But US EPS growth is becoming somewhat less exceptional after a poor year for global trade and the hits from rising interest rates and currency pressures.
With recessionary expectations, this weakened many industries in 2023. But now, EPS gains are broadening across industries and regions of the world.
While the US is certainly seeing broadening profit gains, US market cap has been rising significantly faster than EPS with an ever more confident outlook among investors in US large cap technology firms.
As we will discuss in our Wealth Outlook 2025 report scheduled for December 11, 2025, we believe there will be specific beneficiaries of US deregulation with global applicability. These include energy and power infrastructure and transportation as well as banks and digital assets innovators.
At a time when the new US administration is still forming, we would still emphasize a greater need for diversification after the strong US-led bull run of the past two years.
US Megacap Tech Drives High Levels of Equity Valuations
If one wants to stay focused solely on US opportunities, consider that profitable US small and mid-cap growth shares trade at 19.3X expected EPS over the coming year compared to 27.8x for large caps.
This is in line with long-term average valuation, while large cap growth trades about 33% above its own average. Our continued focus here is not on “submerging” companies with high leverage, but instead, growing firms where investors have not already judged them as the long-term victors in their industry.
We see these more domestically-focused firms as less impacted by potential tariff conflicts and retaliation if trade friction resumes.
With great products, great execution and a share of “good fortune,” three US-tech related firms have risen to more than $10 trillion in value, or about the value of all the publicly-traded firms in Asia or Europe.
The largest US technology goods producers bear trade war risks, with significant production and demand in China. In recent years, they have sustained performance in a way that bucks historical trends.
For the past three decades, a strategy of holding only the largest 10 equities in the S&P 500 by market cap and rebalancing each year underperforms the S&P 500.
Yet in the past two years, the “buy the largest stocks” strategy outperformed the S&P 500 by a record amount. This occurred as the largest tech-related firms saw rapid EPS gains in 2023, bucking the economy-wide performance.
Yet it has been accompanied by both increased valuation and idiosyncratic risks for these shares.
Lessons from 2016 — Highly Discreet Market Adjustments
The share price gains from the 2016 election through 1H 2017 suggests promise. For example, in that six-month period, banks gained far more than they have in the past few weeks.
To the extent that Fed rate cuts steepen the US yield curve, it generates improved economics for lenders. Expectations of deregulation have already boosted large bank share prices, but the gains have come on low valuations and severe underperformance for nearly two decades.
Importantly, the returns of the longer 2017-2019 period are informative. As we discussed above, non-US shares have lagged behind the US returns for a record 15 years.
But even with “trade wars” and 200 basis points of Fed tightening, shares outside the US provided a 13% annualized return during the period. This was at a valuation for equities with a weaker US dollar than we observe today.
See our weekly CIO Strategy Bulletin for more details