Jump Start podcast: Is excessive market optimism a risk?(5:16)
CIO's Jon Gordon on the trading week ahead: US equities, China stimulus and US relations, and the BoE.

Thought of the day

The S&P 500 climbed 2.6% last week, taking its year-to-date advance to 14.9%, with a rise in jobless claims kindling enthusiasm that a cooling labor market will make it easier for the Federal Reserve to end rate hiking soon.

But the rally continues to be driven by a small coterie of mega-cap technology firms. The FANG+ index, which tracks the top 10 most traded technology stocks, rose 4% on the week and is now up 74% so far in 2023. An equal weighted version of the S&P index, which dilutes the impact of these mega-cap stocks, is up just 4.9% so far this year—following a 2.5% gain last week.

While the narrowness of the rally should be a concern to investors, it also generates opportunities for investors. Valuations among some of the best performers are now looking stretched, and we expect the gap between the leaders and the laggards to close.

Invest in emerging market and select European opportunities relative to the US. We have a most preferred view on emerging market equities and expect them to deliver mid- to high-single-digit positive returns this year. Having lagged global equities by around 5.5 percentage points year-to-date (MSCI EM vs. MSCI AC World, USD terms), we think EM stocks will likely catch up in the months ahead. Our EM earnings forecasts for next year have been revised upward (13% vs. 7% for developed markets), and we see current valuations as attractive with EM as a whole trading at a roughly 45% discount to developed markets on a 12-month forward price-to-book (P/B) basis, with China also trading at an appealing discount.

The market outlook for parts of the Eurozone also looks promising, and we particularly like consumer discretionary, Germany, and small- and mid-cap companies in the region. European consumer stocks, including the consumer discretionary sector, look poised to benefit from an improving consumer outlook as wages rise, inflation pressures ease, and central banks stop hiking.

Consider rebalancing away from tech to “the rest” in the US and adding to value versus growth globally. Within US equities, we recommend investors consider switching into equal-weighted indexes where the majority of stocks have catch-up potential. Investors can also consider shifting to our most preferred US sectors that combine defensive and quality cyclical exposure in case of a soft landing (including consumer staples, energy, and industrials).

From a style perspective, we favor an allocation to value over growth globally. Value stocks have underperformed their growth counterparts by 20 percentage points so far this year (MSCI All Country World data), largely due to the AI-driven tech rally, as of 19 June. But we think they can catch up in the coming months as we expect the wide gulf between growth sector performance and fundamentals (leading indicators of earnings and real yields) to narrow if central banks keep rates elevated or accept a period of higher-than-target inflation—an environment that has historically supported the outperformance of value stocks.

Capital preservation strategies. After strong year-to-date returns for US, growth, and IT stocks, investors need to think about how to balance potentially attractive longer-term gains with elevated valuations and near-term risks. In our view, the risk-reward of direct exposure of these areas is relatively unappealing versus asymmetric exposure. As a result, we recommend that investors make use of capital preservation strategies to maintain both upside exposure and some downside protection.

So, in our view the narrowness of the rally supports our preference for fixed income over equities at present. However, the unbalanced nature of the rally has left several markets and sectors behind, creating an opportunity for catchup.