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This Year’s Market Leaders May Start to Lag

Three key themes that have dominated the stock market this year could reverse in the coming months. Here’s how to prepare.

Major U.S. stock market indices are in positive territory, but that doesn’t reflect how challenging this year has been, and may continue to be, for most investors.

The three themes that have worked best this year – S&P 500 stocks, small caps and technology – are all at risk of reversing as valuations get extended at the same time that trade risk grows, interest rates rise and the dollar strengthens.

Below I outline why I see growing headwinds to the status quo for each of these dominant themes:

  • S&P 500 leadership: U.S. stocks have outperformed the rest of the world thanks to strong domestic economic and earnings growth. But that outperformance is now at extreme levels. Political stresses that contributed to rocky foreign markets in several parts of the world seem likely to stabilize in the second half of this year. Meantime, anxiety around U.S. politics is likely to rise as we approach the midterm election. Plus, higher interest rates, a stronger dollar and rising inflation could hurt U.S. corporate profit margins and earnings growth going forward.
  • Small cap outperformance: Here my main concern is tied to valuations as the Russell 2000, a proxy for smaller stocks, is up 11% while the S&P 500 is up 4%. A big reason for small cap outperformance has been the expectation that smaller companies would be insulated from problems created by trade tensions. I think that theme may have been overplayed as smaller companies may not be immune from the supply chain disruptions I foresee.
  • Tech dominance: This may be my most provocative assertion: The almighty tech sector may not be impervious to the strong dollar, slowing global economic cycle or trade tensions. Nearly 59% of the sector’s earnings are dependent on non-U.S. customers, a key fact that many investors may not appreciate.

Bottom Line: The investment environment can shift even if second quarter earnings growth remains robust (which I expect) and gross domestic product growth continues to climb. Investors may start to focus more on tougher financial conditions in the U.S. thanks to the Federal Reserve’s plan to continue raising interest rates, a stronger U.S. dollar and rising inflation.

If that happens, recent winners could start to fade. This potential shift makes midyear a good time for investors to rebalance their portfolios, reducing their positions in this year’s winners and potentially locking in profits, and shifting into underperformers that could benefit if extremes in market performance mean revert. For the portfolios we manage, we’ll be looking at more defensive names, international stocks and cash as we watch closely for a shift in market leadership in the second half of the year.

Risk Considerations

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations. Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected .

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging and frontier markets, since these countries may have relatively unstable governments and less established markets and economies.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.  Technology stocks may be especially volatile.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes. Morgan Stanley Wealth Management retains the right to change representative indices at any time.

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