Stock market outlook: It’s time for diversification

A strong corporate earnings rebound could be the tailwind that drives stock prices in 2024.

Heading into the new year, the economy continues to send mixed signals. But when it comes to the stock market, one key metric is clear: corporate earnings.

In the U.S., Wall Street analysts expect earnings for companies in the S&P 500 Index to rise nearly 12% in 2024, based on consensus data compiled by FactSet. That’s along with an expected 6.1% earnings boost in international markets and a robust 18% gain in emerging markets.

Given the difficulties of 2023, it’s logical to expect an earnings rebound in 2024. But there are several risks that could result in substantial earnings revisions, including sluggish consumer spending, slowing economic growth in Europe and China, and rising geopolitical risk from the wars in Ukraine and Israel.

“I don’t think it’s going to be a terrible year for corporate earnings, but I think we’re more likely to see 6% to 8% growth in the U.S.,” says Capital Group economist Jared Franz, “and potentially higher in some emerging markets.”

Investors might look to 2023’s market leaders — U.S. mega-cap stocks driving the artificial intelligence (AI) revolution — as a continued source of strength in 2024 as applications roll out across the economy and potentially lead to further earnings growth.

Investor stock portfolios may be overconcentrated

However, you’ve probably heard by now that the U.S. stock market is top-heavy. What you might not know is the S&P 500 Index is more heavily concentrated than it was at the peak of the dot-com era.

As of September, the five largest companies in the S&P 500 accounted for 24% of the market capitalization of the index. That compares with a 19% weighting for the five largest companies in the index as of March 2000.

As for market gains, just seven companies — Apple, Meta, Microsoft, NVIDIA, Amazon, Alphabet and Tesla — accounted for a staggering 130% of the index’s total return in the first 10 months of 2023. In other words, without the so-called Magnificent Seven, the S&P 500 would have posted a decline.

Diversification remains essential

Such levels of concentration represent potential risks for investors, particularly those in passive index investments, which seek to replicate a benchmark’s return pattern. While tech innovators may very well continue to lead in 2024, investors should consider diversifying their stock holdings, where applicable, according to equity portfolio manager Lawrence Kymisis.

“Many of these tech leaders can continue to be good long-term investments, but I think investors should be wary of investing in a small number of companies with similar business models at such concentrated levels,” says Kymisis, an equity portfolio manager with EuroPacific Growth Fund®. “Given the level of economic uncertainty heading into 2024, I believe diversification is as essential as ever. And I believe we at Capital Group can identify great companies across industries in markets around the world, including U.S. tech leaders.”

A quick comparison of major international equity indexes with the S&P 500 shows non-U.S. markets are less concentrated and suggests they may offer a broader range of opportunities. As of October 31, 2023, the 10 largest companies in the S&P 500 accounted for a 31.2% weighting of the index. In contrast, the 10 largest companies in the MSCI EAFE Index, a broad measure of developed non-U.S. markets, accounted for 15.2% of the index weighting.

Compelling trends are surfacing across international markets

“That is not to suggest any form of diversification will benefit investors,” Kymisis adds. “There are plenty of fish in the sea, but our job as active portfolio managers is to identify those companies with the potential to be among the next wave of market leaders.”

U.S. technology giants do not hold a monopoly on innovation. Europe is home to pioneering companies driving breakthroughs across health care, aerospace and other industries.

For example, AstraZeneca, the British-Swedish COVID vaccine developer and maker of lung cancer treatment Tagrisso, has invested aggressively in research and development, resulting in a deep pipeline of oncological and rare disease therapies in late-stage development.

Air travel is a secular growth industry in a lot of countries, and demand is growing for new airplanes. With regulators in Europe and across the globe imposing stricter emissions requirements, innovation will also be key in solving sustainability challenges in the aerospace industry.

“Airlines will be incentivized to order the newest, most efficient planes, creating a tailwind for leading-edge manufacturers,” says Michael Cohen, an equity portfolio manager for International Growth and Income Fund.

To illustrate this theme of seeking efficiency, France’s Safran, the world’s top producer of narrow-body aircraft engines, through its partnership with General Electric, is developing engines that could reduce emissions by 20%.