Narrow market highlights opportunities in value stocks

The U.S. equities market has seen a dramatic rebound this year, but there’s a catch: it’s driven by only a handful of companies.

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Peter Hardy, senior client portfolio manager, global value equities with American Century Investments in Kansas City, Mo., said this “narrow market” raises concerns about the rally’s sustainability and the risks it poses to investors. But it also presents unique opportunities for value stocks.

“Value stocks tend to do well based on lower expectations,” Hardy said.

Technology giants such as Apple, Microsoft, Nvidia, Amazon, Alphabet, Meta and Tesla have been the primary drivers of market returns, fuelled by positive developments in artificial intelligence (AI) and its expected long-term impact on various industries.

However, “without those securities, the market is basically flat,” he said.

The S&P 500 was up 13.7% for the year to June 21, and the Nasdaq was up more than 29%. However, the equal-weight version of the S&P 500, which mutes the gains of the largest companies, is up only 3.9% for the period.

Hardy also cautioned that the risks present in 2022, including inflationary pressures and higher interest rates, are still relevant. Higher interest rates can hinder future economic growth, typically with a 12-month lag.

Recent events such as bank failures in the U.S., uncertainties in the U.K. gilt market and China’s economic growth — or lack thereof — contribute to existing risks. “Looming issues” in the U.S. commercial real estate market are also starting to appear, Hardy said.

The dilemma for investors is whether or not they should participate in the speculative rally.

“We know AI is going to be a major force for the next 20 years, but determining who the ultimate winners and losers are and how it generally gets monetized is a bit uncertain,” he said.

In addition, the valuations of tech companies have already factored in anticipated AI-related earnings, which are not immune to a broader economic slowdown either. Historically, narrow markets have not been good for the overall market, Hardy said, and are often followed by muted returns.

Hardy said he looks to quality companies with stable earnings, cash flow, and clean balance sheets, as those companies tend to outperform during periods of uncertainty, with dividends playing an important role in generating total returns.

Consumer staples, which have remained relatively flat this year, present an opportunity due to improved profit margins resulting from increased prices and reduced cost pressures, Hardy said.

“Attractively valued names are now more attractively valued,” he said.

He also looks to health-care stocks, noting that health-care utilization rates are rebounding, indicating that people are resuming elective procedures postponed during the pandemic. This recovery can drive earnings growth for companies independent of the economic cycle.