Positioning for a broadening market while investing at the edge of tech

Dave S. Gilreath: ©Sheaff Brock Investment Advisors

Since rebounding from last spring’s tariff-triggered market decline, the performance of several huge tech companies has far outstripped the broader S&P 500 index, driving its performance disproportionately.

This performance gap has long existed, but it has widened since the spring, significantly in July, relegating many of the index’s member companies to second-class status.

But this is likely to change in the coming months.

Institutions and tech-centric individuals buying big growth tech stocks pell-mell have pushed up big tech valuations. But more conservative investors are understandably wary of this category’s Achilles’ heel: high volatility.

Such investors, including many physicians approaching or in retirement, like to keep some big tech shares in their portfolios to add growth. Yet, aware that vertiginous price-earnings ratios can mean fragility in the event of bad news, these investors are understandably nervous about holding these stocks or, at least, holding too many shares.

They usually believe in investing in funds that track the S&P 500 index, but they have grown nervously wary about the recent extreme skewing of its performance by big tech companies.

More than 60% of the Nasdaq index and about 35% of the S&P 500’s capitalization (the total value of shares outstanding) is now from the Magnificent Seven. These behemoth tech stocks, whose growth recently has driven the S&P 500 to one record high after another, have made index performance even narrower than usual. Though companies dart in and out of the Magnificent Seven because of share-price fluctuations, this moniker generally comprises Alphabet (Google), Amazon, Apple, Meta Platforms (Facebook), Microsoft, Nvidia and Tesla.

This performance gap poses a challenge for investors seeking equity portfolio diversification. They’d like to get the benefits of the current, artificial-intelligence-fueled phase of the digital revolution, but they’re mindful of the risks involved. At the same time, they’d like to know when market performance will likely broaden and how to prepare for this.

Two-pronged strategy

These two aspirations may seem at odds, but there’s a two-pronged strategy for pursuing both goals simultaneously, while managing risk.

One prong involves preparing for likely near-term broadening by investing in key sectors whose low valuations reflect depressed prices, despite decent earnings. Among the non-magnificent, there are many cheap stocks, so this is a good time to buy because they’re likely to get a big boost from several factors.

Among these is a likely cut in interest rates by the Federal Reserve. As overall inflation is declining and employment remains high—signs of the Federal Reserve’s success in hewing to its dual mandate — the Fed is expected to cut rates by year’s end. In early August, the market was pricing in a 95% chance of a rate cut in September.

Even if the Fed defers rate cuts, the slowing-but-still-robust economy would still likely support broadening market performance. Further, broadening performance is being signaled a recent uptick in capital markets activity—more mergers and acquisitions and IPOs.

And after all, big tech stocks can’t ascend indefinitely, and when they falter in isolation or disproportionately, investment in the rest of the S&P 500 is likely to increase.

The big unknown

The unknown that’s holding the Fed from rate cuts is the eventual impact on inflation from tariffs. Renowned market economist Ed Yardeni believes the current elevated interest rates will likely tamp down tariff-related inflation, acting as a buffer to keep prices from rising significantly. So, he doesn’t expect rate cuts this year and doesn’t think any are necessary.

Yet, the characteristically bullish Yardeni doesn’t see this as a barrier to continued, broadening market performance. He has long held that sustained high economic productivity will drive the broad market, with industrial stocks doing well, through what he calls the “Roaring 2020s.”

Jim Paulsen, a former Wall Street economist and widely published author on market topics, also expects market performance to broaden soon, as U.S. corporations’ capacity for profit “does not yet appear to be maxed out… Corporate profits in the broad market have been persistently below their post-war trendline average for the last 10 years — the longest consecutive annual period in post-war history.”

So the overall market—among large-cap companies, the S&P’s 493—has ample room to grow profits, as do smaller companies, those in the small-cap and mid-cap categories.

And generally, broadening is inevitable, as the performance of different sectors and styles is cyclical. The longer big tech outperforms, the closer it is to a decline—selling that could funnel money into weak sectors.

Buying low

Individual investors can prepare for performance broadening by investing in equal-weighted S&P 500 funds, such as Invesco S&P 500 Equal Weight ETF (RSP). Unlike cap-weighted funds, equal-weighted ones hold roughly the same exposure of all constituent stocks, neutralizing the outsized impact of huge companies.

Barron’s recently called the recent (non)performance of the equal-weight S&P 500 index “ugly.” But in the four weeks ended July 29, it was up 3.1%, indicating that a makeover may have begun. And buying low means embracing the ugly now to own true beauty later.

The S&P 500 is replete with bargains on stocks with relatively low risk, based on fundamentals. By sector, here are some companies with market caps above $10 billion and strong projected annual earnings growth — above 12% over the next five years:

• Financials. These usually improve from declining short-term interest rates. Ameriprise Financial (AMP), American Express (AXP), Capital One Financial (COF), Fiserve (FI), Moody’s Corp. (MCS), Charles Schwab Corp. (SCHW).
• Industrials. The current scenario for this sector is highly favorable because of persistent demand from manufacturers and consumers in this fully employed economy, and reshoring — the trend of U.S. companies’ re-siting foreign plants on American soil. A.O. Smith Corp. (AOS), Carrier Global Corp. (CARR), General Dynamics (GD), Lincoln Electric Holdings (LECO), Westinghouse Air Brake (WAB).
• Materials, which supply industrials with raw materials and items for manufacturing. Currently, this sector is way oversold, resulting in its extraordinarily subterranean weight in the S&P 500 of just 2% (among 11 sectors). Cyclicality indicates a rebound for this sector may be imminent. Ecolab (ECL) Reliance (RS).
• Health care. This sector is largely immune to economic downturns because people with health insurance tend to seek care. But in the current economy, health care stocks are pretty beaten up, with pharma serving as a punching bag for Health and Human Services Secretary RFK Jr. These factors have resulted in bargain-basement stock prices. Yet high demand will continue for years for products such as GLP-1 diabetes/weight loss drugs, and in general from the aging population. Boston Scientific (BSX), Idexx Laboratories (IDXX), Intuitive Surgical (ISRG), Medpace Holdings (MEDP), Bristol-Myers Squibb (BMY).

Edge of tech

The other prong of the strategy involves investing in related industries—non-tech companies whose products and services big tech and associated industries can’t do without. These companies could be called those on the edge of tech. By buying these stocks, investors can tap into the growth of the tech sector indirectly, with less exposure to its risk.

As they’re supported by big tech, companies on the edge of tech are naturally priced much higher than the current hoi polloi of the S&P 500 above, yet many still have room for growth. Edge categories and companies in them worth considering include:

• Utilities—specifically, power companies. These used to be viewed as defensive stocks — those that don’t lose much but don’t gain much either. In this era of data centers ravenous for electrical power to run AI applications, the status of power companies has changed dramatically in the last couple years. Utilities have become a strong sector, with big tech companies making deals with power companies for proprietary generation from natural and nuclear power. Constellation Energy (CEG) and Vistra Corp. (VST) have shot up 70% and 150%, respectively, in the past 12 months. Others, such as Entergy Corp. (ETR) and Southern Company (SO), are currently better buys. ETFs include SPDR utilities ETF XLU and iShares Global Utilities ETF (JXI).
• Companies that supply critical items for data centers. They’re key links in data center supply chains. Examples include Nvent Electric (NTV), electrical connection components; Honeywell (HON), electrical switches; and Eaton Corp. (ETN), power management.
• Mid-cap tech companies ripe for acquisition by big tech, which could boost share prices of the acquired firms. Mid-caps in general have outperformed the S&P 500 so far this year; Vanguard Mid-Cap ETF (VO) was up nearly 18% as of July 25—a besting that’s gone largely unnoticed. This fund’s largest holdings include some midsize companies that are ripe for acquisition by megacap tech companies. These include Constellation Energy and Amphenol (APH), an electronic and fiber-optic connections manufacturer that’s up more than 50% this year. This fund also holds defense stocks reaping substantial revenues from defense contracts. Many pure defense and aerospace/defense companies are categorized as industrials, but their products are so high-tech they could be called tech companies in industrial clothing.

As market performance broadens, this will reduce the angst of diversification-oriented individual investors seeking equity portfolio growth with reasonable risk levels. In the meantime, they can position for returns from stocks on the edge of tech.

Dave Sheaff Gilreath, CFP,^® is a Partner Advisor at Sheaff Brock Investment Advisors, powered by Allworth Financial LP, an investment advisory firm registered with the SEC. Investments mentioned in this article may be held by Allworth Financial, affiliates or related persons.