What stocks might come out ahead after the Magnificent 7?

After an early summer of record-setting by the S&P 500 Index, there’s been a stunning shift: Gains have faded for the clutch of mega-capitalization technology stocks, known as the Magnificent 7 - Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla. Meanwhile, many other stocks, both large and small, advanced as investors grew more confident in an economic “soft landing” in which growth slows but doesn’t stall out. Despite recent investor concerns about an economic slowdown and market turbulence, Morgan Stanley’s strategists believe a soft landing remains the most likely scenario from here. 

The question for many investors now is whether they can expect more broad-based market gains from here. As the Magnificent 7 stocks’ momentum wanes, Morgan Stanley’s Global Investment Committee is optimistic about the other 493 stocks in the large-cap index, particularly quality “cyclical” stocks in industries such as financial services, energy and industrial goods, whose performance tends to rise and fall with the economy. However, we are less optimistic about small-cap stocks.

Not only could large-cap cyclical companies benefit from falling interest rates, but such businesses, especially those that are exposed to global markets, can also benefit from a potentially weaker U.S. dollar that can boost sales internationally as their products are more affordable to foreign buyers.

Other reasons to like large stocks:

• While earnings growth for the Magnificent 7 has long outpaced the rest of the index, recent analyst estimates suggest this trend may reverse over the second half of 2024 and into 2025, with profitability picking up for the other 493 stocks while slowing for the big tech names.
• Consider the historical performance of the cap-weighted S&P 500 (which gives the most weight to the biggest stocks, like the Magnificent 7) relative to the equal-weighted version of the index (which holds the same amount of each stock and thus is a better proxy for the other 493). Only twice before has the cap-weighted S&P 500 beat the equal-weighted version by such a wide margin (in the late 1990s and the late 2010s), and both times, the reversal of this dynamic was fierce and persistent. In fact, history suggests that when market breadth accelerates to recent levels and the equal-weighted index is making new all-time highs, it outperforms the cap-weighted one over the next six months 80% of the time.

Keep in mind that past performance is not indicative of future results and there is no guarantee analyst estimates will come to pass.

Smaller stocks are cheap, especially relative to mega caps, but that is not a reason to overlook potential drawbacks.

Consider this: Some 60% of the stocks in the smaller-cap Russell 2000 Index struggle with profitability. While lower rates tend to benefit smaller companies in particular, the Federal Reserve’s expected rate cuts will likely be too slow and too shallow to resolve this deeper profitability issue. On top of that, analysts are still cutting their estimates of future performance for small-cap stocks, and even potentially advantageous changes in tax policy, should Republicans prevail in the U.S. election, may still take time.

Considering all this, the Global Investment Committee:

• prefers large caps to small caps,
• sticks with our preferences for active stock-picking and the equal-weighted S&P 500.

Keep in mind the importance of being discerning, and watch for potential opportunities in large-cap quality cyclicals, in sectors like:

• financials,
• energy,
• industrials,
• aerospace and defense,
• select power generation and grid infrastructure, and
• residential real estate investment trusts (REITs).

Meanwhile, avoid chasing recent gains in small caps, as their rally is likely not sustainable.

We continue to favor greater exposure to investments in:

• Japan,
• gold,
• hedge funds and
• investment-grade credit.

For a weekly recap of the markets and thoughts on the week ahead, visit our weekly Market Dashboard.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from July 2024, “Rotation Duration.”