by Denise Chisholm, Director of Quantitative Market Strategy, Fidelity Investments
These key areas show potential, says strategist Denise Chisholm.
Key takeaways
- Despite their higher valuations, I believe US stocks could continue to outperform developed international marketsâdue to the earnings advantage of US companies.
- The continuation of a broad-based earnings recovery could fuel gains among technology and other cyclical sectors.
- Small caps look cheap. They could benefit disproportionately, and make up for some lost ground, if interest rates finally begin to fall later this year.
The stock market has wasted no time in continuing its bull-market march in the first half of 2024.
Higher-than-expected inflation and economic growth contributed to a modest drop in the S&P 500Âź in April, as investors worried that this continued economic strength might cause the Fed to delay any interest rate cuts. Yet even so, the index had returned almost 12% year to date as of late May, bolstered by an improving outlook for corporate earnings.
Some investors worry that US stocks have gotten too expensive after this latest leg of a more-than-19-month rally. But I think the market could have more room to run. My research focuses on analyzing market history to uncover patterns and probabilities that can help inform the current outlook. Recently, this analysis has been turning up several factors contributing to a positive outlook for US stocks in general, and technology and small caps in particular.
Here's why I think these 3 areas may offer potential opportunity in the second half of the year.
1. US stocks deserve their premium valuations
US stocks look expensive relative to their developed international cousins. As of last month, the median price-to-earnings (P/E) ratio for S&P 500 constituents was near its highest level since 1990 relative to the median P/E for the MSCI EAFE index, which tracks developed-market international stocks.
Historically, however, US stocks have fared well after being expensive relative to international stocks. Since 1990, when US stocks have been in the priciest 25% of their range compared to international stocks, theyâve outperformed international over the next 12 months 84% of the time.1
That may be counterintuitive, but the reason is simple: US companiesâ faster earnings growth helps justify their higher valuations. Earnings growth has been stronger in the US than in other developed markets.
Moreover, that faster earnings growth canât simply be explained by the heavier presence in the US of high-growth sectors like technology. Even after controlling for differences in sector weights, US stocks have produced stronger earnings growth and profit margins than developed international stocks in recent decades. As the chart below shows, that advantage has increased steadily since 1990âlikely contributing to the US marketâs long run of outperformance.
Past performance is no guarantee of future results. See footnote section below for index definitions. Chart shows average historical difference in earnings-per-share growth for the S&P 500 versus the MSCI EAFE, with weighting adjustments made to neutralize differences in sector composition. Data is from January 1990 through April 2024. Sources: Haver Analytics and Fidelity Investments.
I sometimes note that cheap stocks can be cheap for good reason. The opposite can also be true: In some cases, companies with high valuations earn them through strong, improving results. I believe thatâs what weâve been seeing with US stocks.
2. An overall earnings recovery may further boost tech stocks and other cyclicals
After suffering profit declines in 2023, US stocks appear to be in the early stages of an earnings recovery. Corporate profits grew by more than 8% during the 12 months through March. As of mid-May, analysts were forecasting 11% earnings growth for the S&P for the 2024 calendar year.2
A few trends have been contributing to this earnings acceleration. Those include productivity gains, slowing inflation on goods and labor, loosening lending standards for businesses, and growth in new manufacturing orders. All of these trends have historically been associated with improving profit growth.
Stocks have historically posted strong returns in similar historical periodsâwhich I evaluated by looking at past periods when earnings growth has accelerated to between 10% and 30%. Technology and other economically cyclical sectors have led the market during those periods, while defensive sectors such as utilities have tended to underperform. Given that history, tech could be poised to keep up its momentum.
3. Falling rates could provide a catalyst to undervalued small caps
Small caps look historically inexpensive compared to large caps. Based on average price-to-book ratios, small caps were recently in the cheapest 5% of their historical range versus large caps (price-to-book is stock price divided by book value, which is measured as assets minus liabilities divided by the number of shares outstanding). In every other historical period since 1990 when small-cap valuations were this low relative to large caps, small-cap stocks outperformed over the next 12 months.
Shares of small companies got so cheap in part because interest rates rose so sharply over the last 2 years. Small firms are particularly sensitive to rising rates, because much of their financing comes from floating-rate debt such as bank loans. This means that when interest rates rise, so does the cost of servicing their debts.
In my opinion, and according to my analysis, interest rates are still likely to fall from here, even if the decline takes longer than investors previously expected. A shift from rising rates to falling rates could turn small capsâ headwind into a tailwind. In the past, small caps outperformed large caps, on average, during periods with falling interest rates and accelerating economic growthâa scenario we could experience in the coming months.
In conclusion
To be sure, past performance is no guarantee of future results, and the market is never short of surprises.
Yet my analysis suggests that investors looking for a tactical edge could have a few areas to consider as we enter the second half of 2024. In particular, I think US stocks could outperform developed international equities, technology and other cyclical sectors could beat out defensive stocks, and small caps could beat large caps.
Investors interested in exploring these themes further may have many investment options to choose from, including mutual funds and ETFs managed by Fidelity. Investors can also research mutual funds and ETFsLog In Required offered by all providers, not just Fidelity.
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