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Investment insights from Capital Group

Global Equities
Can this stock market rally continue?
Caroline Randall
Equity Portfolio Manager
Gregory Wendt
Equity Portfolio Manager

Talk about surprises. Investors were convinced stock markets would zig this year. So naturally they zagged.

While investors braced for a seemingly inevitable U.S. recession and related market weakness, the S&P 500 Index made a surprising rebound, advancing 16.9% for the six months ended 30 June 2023. Europe and Japan, faced with their own economic challenges, have extended their strong runs as well, climbing 13.6% and 13.0% respectively, as measured by the MSCI Europe and MSCI Japan indexes in US dollar terms.

“Markets have a history of surprising investors and showing resilience when circumstances appear bleak,” says portfolio manager Caroline Randall. “The lesson for investors who don’t want to miss these opportunities? Be brave and stay invested in companies that can weather a potential storm.”

Major stock markets have soared more than 25% from bear market lows

Sources: Capital Group, MSCI, Refinitiv Datastream, Standard & Poor’s. Data calculations reflect total returns in USD. Price-to-earnings-per-share (P/E) multiples are calculated on a forward 12-month basis. Current price to earnings (P/E) ratio is a metric widely used to determine whether a company is overvalued or undervalued. It is calculated by dividing the company's current share price by earnings per share. Data as of June 30, 2023. The bear market in the S&P 500 that began on January 3, 2022, reached its lowest point, or market cycle bottom, on October 12, 2022. Past results are not predictive of results in future periods.

Stranded on the sidelines

Indeed, the good news may be a mixed blessing for some. That’s because investors fled both stock and bond markets in 2022, shifting assets to cash and cash alternatives amid deteriorating economic conditions. Money market accounts held a record US$5.43 trillion as of 30 June 2023. With stock prices higher than they were six months ago and a U.S. recession still in the cards, many may feel even more uncertain about getting back in the market than they did in January.

“With all the uncertainty swirling around us — uncertainty about inflation, rates, war and recession — it is understandable that people feel uncomfortable,” Randall says. “But if you wait to invest until you have seen enough data to feel confident about investing, it's probably going to be too late because the rest of the market has that information. My message for investors is, get comfortable with the uncomfortable.”

Here are some reasons long-term investors may want to consider leaving the sidelines and using a more balanced investing approach that includes a mix of stocks and bonds as well as cash.

Record cash levels are a bullish sign

The record level of assets in cash and cash alternatives could represent a catalyst for further market gains. History shows that money market assets have peaked at or near past market bottoms. During the depths of the COVID pandemic in May 2020, money market fund totals peaked just weeks after the S&P 500 troughed in March.

Asset flows followed a similar pattern during the global financial crisis, when money market fund assets peaked two months before the S&P 500 bottomed on 9 March  2009. The stock market recorded a 40% return over the subsequent three months and a 55% return over the following six months.

As inflation peaks and the Federal Reserve eventually ends its rate tightening cycle, cash is likely going to be looking for a home, potentially driving returns for stocks and bonds. Now may be the right time for investors to work with their financial professionals and review overall asset allocations. For cautious investors who may invest their cash gradually over the next six months or more, the return potential may outweigh the risk of getting back into the market too early.

Investors’ flight to cash has been followed by strong returns

Sources: Capital Group, Bloomberg Index Services Ltd., Investment Company Institute (ICI), Standard & Poor’s. As of June 30, 2023. Past results are not predictive of results in future periods.

The narrow market rally may broaden

To date, the U.S stock market rally has been limited in scope. For the year to 5 June, 90% of returns for the S&P 500 have been concentrated among a small group of technology companies, such as Microsoft, NVIDIA, Meta and Alphabet. Investor enthusiasm for breakthroughs in artificial intelligence sent some share prices and valuations soaring. Chipmaker NVIDIA, largely known for its video game chips, eclipsed US$1 trillion in market value after making bullish comments in May about potential revenue from demand for its processors used in artificial intelligence (AI) computing.

Valuations among these stocks have soared. But other areas of the U.S. market  - and markets in Europe and Asia - may offer more compelling valuations. The price-to-earnings ratio for the S&P 500 technology sector was 27.4 times earnings as of 30 June, compared with 19.5 times earnings for the broader S&P 500. The valuation for the broader MSCI Europe Index, at 12.4 times earnings, was below its 10-year average of 14.2, even after recent strong returns.

“You have to pay close attention to individual markets and individual companies,” Randall says. “Because the market leadership has been incredibly narrow, I think that there are still some interesting investment opportunities across a range of sectors and geographies.”

Historically, narrow market rallies have often been followed by steady gains for the broader market. To be sure, investors must consider that should euphoria over AI subside, a pullback in tech stocks could stifle a broader rally. As of June, however, all 11 sectors in the S&P 500 generated positive results.

The broader S&P 500 has shown solid gains after a narrow market rally

Sources: Capital Group, Refinitiv Datastream, Standard & Poor’s. Significant declines in market breadth are measured as dates upon which the ratio of the S&P 500 Equal Weight Index to the S&P 500 Index falls below the first quintile, or 20%, of the total range between 12/31/2004 and 7/5/2023. The value of the S&P 500 Equal Weight Index reflects the simple average of price changes across every index constituent, while the S&P 500 Index applies a weighted average based on market capitalization. As a result, a declining ratio between the S&P 500 Equal Weight Index and the S&P 500 Index reflects a higher concentration of positive returns among a smaller number of index constituents. The forward return averages above are calculated based upon the dates that fall within the bottom 20% of the range (first quintile) in which market leadership has been most concentrated. Past results are not predictive of results in future periods. As of July 5, 2023.

Tailwinds are emerging beyond U.S. tech

So where might cautious investors look for opportunity? For portfolio manager Greg Wendt, innovation is key to identifying investment opportunity, not only within the technology sector, but across the economy.

“Innovation has always been a pathway for growth and long-term success,” says Wendt, who has been following a wave of advances in the medical devices industry and among consumer companies.

Companies like Insulet and Dexcom are developing devices for diabetics that enable remote monitoring and delivery of medications such as insulin at critical moments using predictive algorithms. “Because so many surgical procedures were delayed during the pandemic, I also expect pent-up demand to drive growth for many of these medical device companies,” Wendt adds.

One of the most surprising developments in 2023 has been the strength of Japan’s stock market. Corporate reforms have been initiated in Japan that are making companies more compelling for investors. Among these are actions to increase dividend payout ratios and share buybacks. In addition, a weaker dollar has been a tailwind for U.S.-based investors.

“The corporate mindset in Japan is shifting towards understanding the need to better reward shareholders, and as a result we're seeing some improving and different attitudes around raising dividend payout ratios for companies,” Randall says.

Some notable companies have also undergone transformations of their own to become more competitive globally. Within the traditional film and camera industry, for example, Olympus has transformed itself into the world’s leading supplier of endoscopes, medical instruments with image sensors used to explore internal organs, and Fujifilm has evolved into a participant in health care, offering drug development and manufacturing services to pharmaceutical companies.

In Europe, economic growth has been unexpectedly positive, and the continent has navigated its energy challenges and the war in Ukraine better than many anticipated. “Germany in particular survived what could have been a very tough winter, and a lot of German companies have global businesses,” Randall says. For example, if you look at a company like DHL Group, it is a global logistics company with a high quality e-commerce delivery service and has extensive operations across Europe, the U.S. and China, Randall notes.

We may have reached maximum pessimism

Challenges, of course, remain. Although inflation is easing, it continues to be elevated. Central banks including the Fed have indicated that they are not finished raising interest rates. And a recession, albeit a shallow one, remains likely at some point.

“We've never seen a full employment recession before,” Wendt says. “That's why I think the recession will be a reasonably shallow one, and I don’t think we’ll be up late at night trying to figure out how we're going to get through it.”

So, have stocks entered a new bull market?

“I think it is fair to ask whether the October 2022 market lows were the lows for this cycle,” Wendt continues. “I believe that they are. That doesn’t mean we are off to the races, but we may have already been through the period of maximum pessimism. History has taught us that markets can do surprising things, often when conditions appear bleak.”

Caroline Randall is a portfolio manager at Capital Group. She also serves on the Capital Group Management Committee. She has 24 years of investment experience and has been with Capital Group for 16 years. She holds both a master’s and bachelor’s degree in economics from the University of Cambridge. Caroline is based in London.

Greg Wendt is an equity portfolio manager at Capital Group. He has 35 years of investment industry experience, all with Capital Group. Earlier in his career, as an equity investment analyst at Capital, Greg covered U.S. casinos & gaming, leisure facilities, restaurants, merchandising and small-cap companies. He holds an MBA from Harvard Business School and a bachelor’s degree in economics from the University of Chicago. Greg is based in San Francisco.

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