Is it time to rebalance because of mega caps?

Coming up, we look at outperformance of mega cap stocks and how that may be causing client portfolios to be unbalanced.

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From Thrivent Asset Management, welcome to Advisor’s Market360™. A podcast for you, the driven financial advisor.

For the past year, most economists have been forecasting a recession – or at the very least, a slowdown. But the economy has proven to be surprisingly resilient so far this year. And while we are not out of the woods yet, there remains a chance that the Federal Reserve, or Fed, will pull off a soft landing – even as it is in the midst of discussing whether to raise rates once more or hold.

While many factors were at play in the first half of this year, one thing that has helped keep the economy chugging along is the strong performance of equities – specifically, a small number of mega-cap tech stocks known as the “Magnificent Seven.” But because of the surge of these mega caps, the breadth of the equity market has been incredibly narrow.

Steve Lowe, Thrivent’s chief investment strategist, had this to say about the topic, and in particular, the Nasdaq 100^®, which tracks the 100 largest companies by market capitalization that are listed on the Nasdaq stock exchange, excluding financial sector firms:

“It's been one of the narrowest markets on record. So, you can look at the Nasdaq 100, which is the large cap tech names. They had a record first half [of the year], up about 40%. So, that outperforms about 80% of the full years, historically, that the Nasdaq 100 has posted. And it's driven by a handful of mega-cap names, the so-called ‘Magnificent Seven.’ Those seven stocks drove S&P [500]. The average return in the first half of the year was 90% for them versus single digits for the rest. They’re household names: Apple, Amazon, Meta, Microsoft, Alphabet, Tesla – and Nvidia in particular, that was up more than 200% in the first half of the year.”

To unpack that a bit: the narrowness of the market is apparent when comparing the S&P 500 index to an equal-weighted version of the index. The traditional market cap-weighted S&P 500 index tracks the average performance of 500 large-cap stocks – including the mega caps we’re discussing today – and its equal-weighted counterpart assigns each constituent a fixed equal weight. And recently, there’s been a 10% difference in returns year-to-date between them.

So, what is fueling this run-up for the Magnificent Seven – besides the fact that these are well-run, very profitable companies? Two things:

The first is artificial intelligence, or AI. Many mega-cap tech stocks are expected to continue to benefit from further developments that harness the power of AI and the technological backbone it requires.

The second is reduced volatility. Mega caps have also benefitted from investors who turn to them for less volatility when they expect a slowing environment. Large caps tend to be more well-known, proven companies with better corporate structures compared to small-cap companies. However, that comes with a price – perhaps a little too pricey considering historical market cycles. Keep listening as we discuss the present issues, and later, an opportunity to pick up stocks that are undervalued elsewhere.

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The AI revolution may make it seem as though the Magnificent Seven are unstoppable. And perhaps that will be the case, as AI promises to be a new foundational computing paradigm. For a deeper dive on AI developments, you may want to revisit a previous episode of this podcast titled “Investing in an AI-driven future,” which was released in late March of this year.

In a broader context, the concentrated outperformance of the Magnificent Seven is reason for near-term caution – after all, the market is filled with examples of asset classes reverting to their long-term averages. Also, while large-cap outperformance relative to smaller companies is expected late in the economic cycle, high valuation and outsized gains in the most heavily weighted stocks opens them up to near-term vulnerability.

Style-wise, large- and mega-caps are growth stocks, which may benefit from a tailwind if the economy slows. But right now, investors looking to buffer volatility with these expensive large-cap growth stocks should know that they will have to pay more in the near term.

The net is that the trajectory of large caps this year, compared to smaller stocks, might have pulled client portfolios out of balance. Large-cap allocations made at the beginning of the year, especially large-cap growth, might be outsized at this mid-year point. It’s smart to consider rebalancing client portfolios to keep them consistent with their risk profiles. One option would be to sell some positions in these allocations at their currently higher price and buy into another segment of the market. The good news is that the segment we’re about to discuss is selling at a discount.

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As you think about appropriate ways to rebalance your clients’ portfolios, we’ve identified five things to consider:

One: small- and mid-cap stocks, or “smid” for short, currently seem to be cheap ­­– not only in comparison to large caps, but also from a historical perspective. Mid caps have been selling at a discount since 2020.

Two: smid stocks tend to perform better as the economy bottoms or when a bottom is anticipated in advance of a cyclical upturn. Thrivent Asset Management analysts expect that bottom could come later this year or in early 2024.

Three: considering the style box, value stocks also performed better than growth stocks in upturns or in anticipation of one.

Four: to narrow down to one market cap within smid, it may be prudent to look at mid caps because, in general, they have better risk profiles and are more established than small caps.

And five: investors wanting to participate in AI outside of large caps can find smaller, underappreciated companies that play supporting roles in AI development.

These five factors might cause you to ask: What’s cheap or undervalued right now? What’s positioned well for a recession? And what offers potentially lower risk? The answer may be mid-cap value stocks – and coming up, we’ll take a look at Thrivent Mid Cap Value Fund.

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Here’s why mid-cap value may be worth considering now. Let’s take a look at Thrivent Mid Cap Value Fund to explore the opportunity.

The Fund’s approach is to seek a combination of value and high quality. High quality stocks – those with strong balance sheets and earnings – become important in a slow economy, as they can sustain their earnings.

The Fund seeks companies with stable or increasing operating performance as defined by return on invested capital, or ROIC. With inflation and economic growth slowing, stable return on invested capital is important because it helps identify companies that have been able to avoid profit margin compression and negative operating leverage.

Graham Wong, CFA, one of the two senior portfolio managers on the Fund puts it this way:

“We try to own high-quality companies that are neglected or undervalued. So, we look for stocks with an asymmetric reward/risk profile. What this means is, first, we start with the downside. Can we quantify the downside and is it limited? And usually, we define that as around less than 20% downside. On the upside, we look for multiple times of that. So, call it three times more upside to get to the asymmetric reward/risk ratio.”

As Wong’s team thinks about our current position in the economic cycle and how that might affect portfolio construction, Wong offered this historical example from 2020 and how his team analyzed the economic cycle in relation to the mid-cap value fund at that time:

“What we do is, we always ask the question: where do we think we are in the cycle? At the time, given that we were in the tenth year of a long economic cycle, it just felt like the right thing to be a little bit more defensive and own later cycle names. And we really benefitted from that in the sharp correction in March/April of 2020. At the bottom, we were actually able to follow our valuation process and we noticed that a lot of the cyclical companies were trading at excessive discounts. So, we were able to pivot to those companies that we were stocking. And so, we benefitted on the way down, pivoted to more cyclical, early cycle companies, and benefitted on the way up.”

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As we discussed earlier, developments in AI helped fuel the present-day rally in mega caps. But there are long-term implications and opportunities in other areas of the market, too – areas in which investors can participate in the growth of AI.

There are small- and mid-cap companies involved in AI that might slip through the cracks. Thrivent Mid Cap Value Fund’s team and the analysts that support it put in lots of work to uncover companies that see the potential of AI and can harness it for new products and services. Maybe, for example, there’s a development firm creating a novel AI application or platform that might be a household name in a decade from now, or companies that Nvidia buys transistors from. Graham Wong shared an example:

“Names like Jabil, which is an EMS electronic manufacturing service company – they're not the Teslas of the world, they're not the Apples of the world, but they make the items for them. They've pivoted to become a high-margin, high-free-cash-flow company as the industry has consolidated and was a big winner for us.”

So, what’s the takeaway? The run-up in mega cap tech stocks may have created significantly unbalanced portfolios for some of your clients. Even if you do annual reviews, now’s a good time to double check portfolios, and if rebalancing is needed, it might be an opportunity to look at discounted options elsewhere.

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We hope you found some actionable insights in this episode that can help inform your thinking for the months ahead. More episodes of Advisor’s Market360™ are available wherever you listen to podcasts. Email us at podcast@thriventfunds.com with your feedback, questions, and topic suggestions for future episodes. And as always, you can learn more about us at thriventfunds.com and find other insights of interest to you, the driven financial advisor. Bye for now.

(Disclosures)

All information and representations herein are as of September 5, 2023, unless otherwise noted.

Investing involves risks, including the possible loss of principal. The prospectus and summary prospectus contain more complete information on the investment objectives, risks, charges and expenses of the fund, and other information, which investors should read and consider carefully before investing. Prospectuses are available at thriventfunds.com.

There are risks associated with the Fund. Medium-sized companies often have greater price volatility, lower trading volume, and less liquidity than larger, more established companies. The Fund’s value is influenced by a number of factors, including the performance of the broader market, and risks specific to the Fund’s asset classes, investment styles, and issuers. The Adviser's assessment of investments may prove incorrect, resulting in losses or poor performance. Securities markets generally tend to move in cycles with periods when security prices rise and periods when security prices decline. These and other risks are described in the prospectus.

Past performance is not necessarily indicative of future results.

Any indexes shown are unmanaged and do not reflect the typical costs of investing. Investors cannot invest directly in an index.

This podcast refers to specific securities which Thrivent Mutual Funds may own. A complete listing of the holdings for each of the Thrivent Mutual Funds is available on thriventfunds.com.

As of June 30, 2023, the top ten holdings of Thrivent Mid Cap Value Fund were Celanese Corporation at 2.49%, Sensata Technologies at 2.42%, Carlyle Group at 2.35%, JB Hunt Transport Services at 2.27%, Berry Plastics Group at 2.16%, Laboratory Corporation of America at 2.04%, U.S. Foods Holding Corporation at 2.03%, Pioneer Natural Resources Company at 1.99%, Barnes Group at 1.96%, and Carlisle Companies at 1.93%. A complete listing of the holdings for the Fund is available at thriventfunds.com.

Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product.  Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

Thrivent Asset Management, a division of Thrivent, offers financial professionals a variety of investment products to help meet their clients’ needs. Thrivent Distributors, LLC is a member of FINRA and SIPC and a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans.