Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief US Equity Strategist. Today on the podcast I’ll be discussing how to position as we head into the new year.
It's Monday, Dec 16th at 11:30am in New York. So let’s get after it.
The big question for most investors trying to beat the S&P 500 is whether returns will continue to be dominated by the Magnificent 7 and a few other high quality large cap stocks or if we will see a sustainable broadening out of performance to new areas. Truth be told, 2024 has been a year during which investors have oscillated between a view of broadening out or continued narrowing. This preference has coincided with the ever-changing macro view about growth and inflation and how the Fed would respond.
To recount this past year, our original framework suggested investors would have to contend with markets reacting to these different macro-outcomes. More specifically, whether the economy would end up in a soft landing, a hard landing or a “no landing” outcome of accelerating growth and inflation. Getting this view right helped us navigate what kinds of stocks, sectors and factors would outperform during the year. The perfect portfolio this year would have been overweight broad cyclicals like energy, industrials and financials in the first quarter, followed by a Magnificent 7 tilt in early 2Q that got more defensive over the summer before shifting back toward high quality cyclicals in late third quarter. Lately, that cyclical tilt has included some lower quality stocks while the Magnificent 7 has had a big resurgence in the past few weeks. We attributed these shifts to the changing perceptions on the macro which have been more uncertain than normal.
Going into next year, I think this pattern continues, and it currently makes sense to have a barbell of large cap high quality cyclicals and growth stocks even though small caps and the biggest losers of the prior year tend to outperform in January as portfolios rebalance. We remain up the quality curve because it appears the seasonal low quality cyclical small cap rally was pulled forward this year due to the decisive election outcome. In addition to the large hedges being removed, there was also a spike in many confidence surveys which further spilled into excitement about this small cap lower quality rotation.
Therefore, it makes sense that the short-term euphoria is now taking a break with the rotation back toward large cap quality mentioned earlier. The fundamental driver of this rotation is earnings. Both earnings revisions and the expected growth rate of earnings next year remain much better for higher quality stocks and sectors. Given the uncertainty around policy sequencing and implementation on tariffs, immigration and how much the Fed can cut rates next year, we suspect equity markets will tread a bit more conservatively in the first quarter than what we observed this fall.
The biggest risks to the upside would be a more modest implementation of tariffs, a de-emphasis on deportations of working illegal immigrants and perhaps more aggressive de-regulation that is viewed as pro-growth. Other variables worth watching closely include how quickly and aggressively the new department of government efficiency acts with respect to shrinking the size of the Federal agencies. While I am hopeful this new effort can prove the skeptics wrong, success may prove to be growth negative in the near term given how much the government has been driving overall GDP growth for the past few years. In my view, a true broadening out of the economy and the stock market is contingent on a smaller government both in terms of regulation and absolute size. In my view this is the most exciting potential change for taxpayers, smaller businesses and markets overall. However, it is also likely to take several years to fully manifest.
In the meantime, I wish you a happy holiday season and healthy and prosperous New Year.
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