By Todd Ahlsten, chief investment officer of Parnassus Investments
The S&P 500 has had a remarkable run for the past two years, delivering more than 20% returns annually. A closer look reveals a defining characteristic – the narrow market breadth, meaning that a small number of stocks have driven most of the performance.
In this case, a small number of tech mega caps drove the charge, with seven stocks accounting for 53% of the S&P 500’s returns in 2024. Together, they rose 57% last year compared with a 13% gain for the other 493 stocks in the S&P 500 index.
This differential was created by the fact that many areas of the US economy beyond technology have faced cyclical headwinds in recent years.
While the overall economy never entered recession territory, many sectors, such as financials, industrials, materials and healthcare, encountered ‘rolling recessions’ that brought declines in earnings resulting from pandemic aftershocks, high and lingering inflation and rising interest rates.
At the same time, artificial intelligence (AI) innovation spurred heavy capital spending on technology, including AI-powered chips, infrastructure and datacentres. Nvidia and Amazon saw their stocks reach record highs in 2024 as a result.
It’s not unusual to see a handful of companies lead the market for several years consecutively. Eventually, however, this narrow leadership rotates to other parts of the market as market cycles shift with both economic and fundamental data. In new market cycles, new market leaders tend to emerge.
These shifts can sometimes come unexpectedly because of business and macro drivers, such as competitive dynamics and interest rate or policy changes, that can impact an industry’s or sector’s earnings growth.
Nvidia’s stock dipped after DeepSeek released a new AI model that reportedly performs on par with popular chatbots like ChatGPT, at a fraction of the cost. If DeepSeek’s approach can be replicated, it could lead to changes in how companies invest in AI technology.
The transformative potential of AI over the long-term remains attractive, but investors must be mindful of disruptions such as DeepSeek and the opportunities that can emerge from volatility in a fast-evolving market.
What factors will drive a market broadening?
The Mag 7 have remained leaders of the US stock market in recent years based primarily on the overall strength of their business fundamentals, as well as the opportunities created by AI.
But there are signs that this extreme leadership may be moderating, giving an opportunity for performance rotation into other parts of the market. Several factors may contribute to market breadth expansion.
Mag 7 earnings growth, for example, is expected to decelerate this year, while that of the rest of the 493 companies in the S&P 500 Index is poised to accelerate. Last year, the Mag 7 achieved a 26% growth in earnings, compared to 6% earnings growth for the other 493.
This year, we expect to see more of a convergence as Mag 7 earnings growth is forecast to slow to 17%, while the growth rate for the other 493 is expected to rise to 14%. Strong corporate earnings across the market should contribute to strong performance returns, assuming the economy remains fairly healthy and other major market risks are kept at bay.
We could also see a post-election broadening. Since 1980, regardless of which political party held control in Washington, the stock market has broadened away from concentrated leadership in the 12 months following a presidential election.
While this doesn’t happen with every new administration, it suggests that new, business-friendly policies and regulatory changes can bring benefits to a larger number of companies.
Lower interest rates could also trigger a marketing broadening. The Federal Reserve (Fed) began cutting interest rates last fall and is expected to make at least another cut this year.
Lower interest rates can be positive for companies weighed down by higher borrowing costs. Recent cuts have come not during a recession, but in a relatively strong US economy.
Lower rates could help companies in industries that are already emerging from rolling recessions improve their earnings profiles.
Sectors emerging from rolling recessions
With the rotation into other parts of the market, the broadening could emerge in several areas, namely the industrials, financials and healthcare sectors.
In the industrials sector, companies that manufacture and distribute capital goods have been in a period of contraction. As these markets recover, companies in this sector should capture their fair share of the upside.
In financials, changes to regulation around capital controls could help banks focus on responsible lending and shareholders.
There is also promise in payments and exchanges companies for their wide competitive moats and strong returns on equity. These companies can benefit from a growing economy.
For the healthcare sector, life sciences tools and services companies could see a recovery linked to increased biotech and pharmaceutical investments, and lower interest rates.