The Flyover
- The dominant “Mag 7” stocks are losing their luster. What could that mean?
- Rotation of leadership in markets is healthy. Beyond being healthy, it’s vital.
- The New Year and a new administration could quicken the pace of something that would otherwise happen naturally anyway.
- Looking ahead, there is reason for optimism. But expectations need to be realistic.
I’ve written and talked about the Magnificent 7 stocks quite a bit these past couple years. Everyone has. They’ve been the darlings within the markets and have seemed to become proxies for the economy as a whole. As a refresher, this group consists of the mega-cap companies Apple, Amazon, Google (aka Alphabet), Nvidia, Facebook (aka Meta), Microsoft, and Tesla. Collectively, they have accounted for a large portion of the market’s returns recently and an underlying concern has always been what this might mean for the genuine health of the markets. In essence, is this a good or a bad thing?
As I’ve written in the past, history gives us a sense of what to expect after these uncommon periods of concentrated market leadership. The lesson is that if smaller and unprofitable companies lead, things don’t typically end well. But when that narrow leadership is provided by larger companies with a true sense of purpose within an economy, the period that follows their leadership tends to continue positively. And we all know the products and services of those companies listed above have key roles in most people’s everyday lives. It’s not unreasonable to say they truly do have a sense of the pulse of the consumer and the economy around the world.
This implies a stable foundation as we look ahead to what may come next. If history rhymes, we have reason to believe the markets will hold up well as leadership rotates away from these Magnificent 7. Literally thousands of other companies will see their stocks receive inflows that had previously been dedicated so heavily to just that short list. I’ve written before about how I’ve hoped and expected this to be the case. It looks like we may be taking the next step in this virtuous market cycle now.
Before I go much further, it’s important to point out that the reelection of a President Trump does play a role in this story, but he is not its lead character. His promised policies would indeed be supportive of this cycle, which I’ll explain more in a moment; but the larger story is around the natural behavior of business and interest rate cycles and longstanding financial market phenomena.
Let’s take a quick look at that list of 7 companies again. With the extremely clear exception of Elon Musk from Tesla, President Trump and the CEOs of these companies haven’t exactly been great pals. I’m pointing this out to reinforce the fact that as these stocks see their market leadership fade, it isn’t primarily due to Donald Trump. This same cycle would be playing out under a President Harris, too, albeit at a likely slower pace. This is important to keep in mind because my view is that the coming leadership change is more about healthy underpinnings than about vendettas or perceived punishments of some sort.
What specifically should we be expecting as leadership rotates? Does this mean the past leadership will become laggards that should be sold? Should investors change their positioning to heavily overweight past laggards like small caps?
I would recommend against that type of dramatic reaction. Remember, we’re talking about a lengthy process of an internal shift, not a cataclysmic event that upends the world as we know it. These economically sensitive 7 stocks aren’t necessarily vulnerable just because their strongest days relative to the rest of the market may be behind them. They don’t have to fall so others can rise. Instead, as more investment capital is allocated to other companies, they may tread water and simply rest for a period. That’s not a dangerous position to be in, and it doesn’t mean they can’t perform well in the future just because they are no longer the only games in town, so to speak.
I would not be in the camp that says those stocks are to be sold so others can be bought. And I don’t think that’s going to evolve into a common message from anyone in the asset management community. Instead, I expect a larger percentage of each new dollar invested into the markets to be allocated to companies outside just those 7. The expected result is that the other 490+ stocks that comprise the S&P 500 and thousands of other stocks that make up the mid and small cap universes will see more inflows. This, in turn, should lead to outperformance of those stocks relative to the Mag 7 names alone.
So far I’ve spoken to the natural market forces of rotation, something that just happens as markets evolve over time. But let’s add the Trump factor to see how this might quicken the pace.
President-elect Trump has promised to tackle what he feels are onerous regulations. For the purposes of practical discussion, we will assume he intends to right size excessive regulations rather than lay waste to necessary guardrails within the system. With this in mind, it’s important to understand that big regulations greatly benefit big companies. Oftentimes, these huge companies actually help shape those regulations. They are commonly consulted by government agencies, not to mention they have lobbyists of their own. This isn’t meant to sound nefarious, it’s just a reality. These are some of our world’s largest employers and key contributors to society on many levels. It only makes sense they’d have an outsized voice when it comes to shaping policy. The resulting policies and regulations can act like a fence between them and their smaller competitors. The more regulations in place, often the higher that fence.
Should Trump 2.0 be successful in leveling this playing field, it’s logical this would be a better scenario for the earnings potential of the mid and small sized companies in our country and beyond. Keep in mind that an efficient system doesn’t lead to a net sum of zero. Right sized regulations create plenty of opportunities for all by growing the size of the field and not merely deciding winners and losers.
Given this backdrop, it makes sense to take steps in the direction of smaller companies, but not bold leaps and bounds.
There are a couple reasons for patience and realism. One is that Presidents simply don’t get everything they want. Yes, this includes Donald Trump. There is no assurance he’ll be able to provide any specific tailwind to this rotation.
Let’s consider for a second the creation of DOGE (Department of Government Efficiency), the brainchild of Elon Musk in partnership with Vivek Ramaswamy. This can best be likened to the Grace Commission established in 1982 by President Reagan with prominent businessman J. Peter Grace, CEO of W.R. Grace & Co. Over 18 months, Grace created 36 task forces chaired by 161 leaders in business, academia and labor to scrutinize the depths of federal operations. In January 1984, the commission presented its final report, offering 2,478 recommendations to reduce the national deficit. Despite its ambitious goals and widespread publicity, there was limited implementation, and most proposals were not enacted. In short, the sweeping savings and broad reforms it envisioned never materialized. Can DOGE be different? It could be, certainly with the influences of a man like Elon Musk at the helm. Nevertheless, this is a cautionary tale about the hope that sometimes comes with any form of government ambition.
Another reason to keep a level head is that we aren’t likely to see as sharp a decline in interest rate policy from the Federal Reserve as had been expected a year or so ago. Keep in mind that conventional thinking at the beginning of this year was that Jerome Powell and the Federal Reserve would cut interest rates many more times than they have to this point. Now it seems likely they’ll soon announce a pause in cuts altogether. Those anticipated lower rates would have been fuel for the small and mid-cap fire. Bear in mind that interest rates (ie, borrowing costs) matter much more to smaller companies than mega-caps. So, while those borrowing costs have come down, they haven’t created the profit margin expansion for those more modest sized companies that had been anticipated.
I could build a longer list, but for the sake of space I’ll just say the jury is out on how quickly the winds of positive change can work down the market capitalization ranks. There has recently been a tug-of-war in the analyst community as a result. Some notable investment firms have upgraded their views on the small-mid cap space while others have kept their expectations subdued. This will be an active debate within the markets going forward and I expect the small-mid advocates to be proven right, but neither by a landslide nor in short order. I will be looking for any progress on that regulatory front because one other key element to small and mid-cap outperformance has been an active mergers and acquisitions market. Recent years have seen a chilled climate for M&A and should that space warm up even a bit, it’ll have a positive impact for not just small and mid-size businesses, but also the banks involved in consummating the deals.
On this topic of rotation in general, I’ve also heard a lot of debate lately about if the United States is the only country worthy of investment. After all, the incoming President is crystal clear about putting America first and possibly even at the wishful expense of other nations. Beware the counter-factual potential here. As I mentioned above, Presidential desires of all sorts are rarely turned to reality. Remember, for example, when a new President Biden had no good words at all to say about the fossil fuel industry? The common logic was his administration would be painful for the oil and gas sectors and investing in them would be a big mistake. Quite the opposite played out as that sector was actually one of the better performers throughout his tenure. Applying this dose of reality to the coming 4 years, I’d suggest maintaining some global exposure in a portfolio. Many data points can be cited to build a case for having exposure to non-US markets and I recently saw this one referenced on CNBC: At present, the US economy’s share of global GDP sits at an expected 26% for the new year but US stock market capitalization is approaching 70% of all market capitalization worldwide. Mark Twain is credited with saying reports of his demise were greatly exaggerated. The same is true with the death of the value of diversification. Nobody can know when new trends will emerge, but I don’t think it’s outrageous to think that while President Trump goes about his agenda of putting America first (which is what a US President should do, not just use as a slogan), foreign markets may actually thrive as well.
The Takeaways:
- With the US economy still posting healthy data readings, corporate earnings having doubled from the pandemic-driven low in 2020 (Bloomberg 9/30/24), and household net worth reaching new highs according to the US Bureau of Labor Statistics (10/31/24), things look pretty good across the country.
- We’re now starting to see signs of life in stocks beyond the Magnificent 7.
- These things validate a sense of optimism among investors looking ahead.
- But it is critical to keep expectations in check. Market valuations are not outrageous, but they certainly aren’t cheap.
- Volatility is likely on the rise as we see a pause in interest rate cuts coupled with a potentially erratic start of President Trump’s second term.
- Those that keep a balanced posture and don’t overreact to what can look like euphoric highs or catastrophic dips ahead will find themselves comfortably ahead of inflation and Treasury bond returns in the years to come.
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