U.S. equities ride tech wave amid valuation concerns

In a year marked by robust gains for U.S. equities, technology stocks have remained the driving force behind the market’s surge. 

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Yet Peter Hardy, senior client portfolio manager, global value equities with American Century Investments in Kansas City, Mo., questions the long-term viability of this trend due to stretched valuations and concerns about the market’s breadth.

Hardy pointed to a “risk-on rally” ignited by enthusiasm around artificial intelligence (AI) in late May that has extended well into the third quarter. 

Notably, growth stocks have outperformed value stocks, with the Nasdaq boasting a 30% rise while the Russell 1000 Value index has only managed a modest 2% uptick, he said.

“The market is ignoring a lot of risk that led to declines in 2022,” Hardy said.

Investors are also downplaying the potential negative impacts of rising interest rates on earnings, he said, and instead focusing on the future growth potential of AI.

“AI is a major phenomenon and likely to be an impactful force for economic growth,” Hardy said. 

However, he also cautioned that the market has assigned substantial economic value to AI while concrete benefits may be a “long ways down the road.”

In this AI-driven rally, Hardy said major players like Microsoft and Apple have taken centre stage.

Hardy acknowledged these companies’ quality but points to their expensive valuations as a concern. 

“While people think about these things as a growth dynamic, they are impacting value investors,” Hardy said, indicating that even as the market focuses on growth, the short-term valuations of these tech giants are stretched.

He said market breadth, or the distribution of gains across various sectors and companies, is also a concern.

The market remains narrow with returns still concentrated among a few benchmark leaders.

Regarding rising yields and the historical relationship between higher interest rates and equity volatility, Hardy said the market has defied expectations.

“One of the most interesting things that has occurred during the quarter is that the outlook for interest rates has somewhat improved, but yields have gone up,” he said. And long-duration growth stocks have outperformed short-duration value stocks in the face of rising rates.

In light of these dynamics, Hardy emphasizes his team’s approach of investing in financially productive companies with attractive dividends. He said he remains cautious of the potential lagging impacts of rising rates on economic growth and corporate profitability, despite the current benign outlook for interest rate increases.

In this environment, Hardy said he focuses on opportunities in sectors such as consumer staples, health care and insurance, where pathways to earnings and valuation improvements have been identified.

“They’ve become more attractive throughout the year as they’ve underperformed in this risk-on rally,” he said. 

Hardy also highlighted utilities as an area of the market that has faced negative returns but presents attractive opportunities amid the risk-on market sentiment.