Is it too late to play catch-up?

Much of 2023 has been a “good news, bad news” story for equity investors. The good news: until a tough September, major equity indexes largely defied the odds and delivered strong returns despite widespread predictions of recession. The bad news: unless they were invested in the “Magnificent Seven” (the new FAANGs), investors likely missed out on the good news. Most of my conversations at Kaufmann these days are with clients who missed the boat and are left trying to play catch-up. Here’s what I tell them:

• Invest in tomorrow’s growth rather than chasing yesterday’s growth. Despite the great growth rally of 2023, there are still plenty of growth-y pockets of the market like biotech that have underperformed and stand to benefit from simple mean reversion. Health care is another area where investors may want to consider buying the bad news. Some names that sold off due to the success of a popular weight-loss drug arguably have a lot of standalone value. The key takeaway is to act fast. If the deceleration in inflation continues to take hold and we eventually enter a deflationary environment, equity market leadership potentially could change very quickly.
• Don’t underestimate the investment potential of artificial intelligence. AI is here to stay, and it will cause tons of money to be spent—chiefly on data centers. One essential requirement to maintaining a data center is the temperature control for the vast racks of servers operating 24/7. Many companies that perform this work have a 24- to 36-month backlog to supply the units for such facilities. These units require vast amounts of energy and complex large-scale transformers, which come with a hefty price tag (as well as another waiting period). Moreover, “green” units to be green require yet another set of logistical demands. Add all that up, and for companies supporting the AI buildout, a decade of predictable revenue streams could lie ahead.
• Look to the IPO market for fresh new ideas. Back in August, we mentioned that we may be in the early stages of an IPO market recovery. We’ve now seen 77 IPOs year-to-date, including some potentially high-impact names in AI and software, and we don’t see the well drying up anytime soon. Also, don’t shy away from fallen star IPOs. The most recent IPO cohort has been one of the most disappointing crops in recent memory relative to the hype. But a lot of them are still solid under the hood and were mostly victims of their own early success. Don’t be afraid to buy into them on the secondary markets at a steep discount.

While investors seem to be pricing a “soft landing,” history is not on their side. The Fed has raised rates at the fastest pace in modern history, and the market is still trying to absorb the impact. This likely will create higher dispersion between companies and asset classes alike, with the volatility offering investors the potential to find companies that are positioned well but negatively impacted by near-term macro events. As rates have spiked, so too have long-term yields. What does that mean for equity leadership if the market hasn’t caved? Going back to 1990, sectors such as Health Care and biotech historically led the market the next three, six and 12 months after a spike in the 10-year Treasury yield, according to Strategic Research. Yield spreads also bear monitoring. The spread, or difference, between 2-year and 10-year Treasury yields has been negative all year, i.e., an inverted yield curve, but has narrowed from a record -110 basis-point inversion in March to -53 basis points today—not positive, but progress. Again dating back to 1990, when an inverted yield curve has gone positive by about 125 basis points, it signaled a bottom and subsequent move up in equity markets. That was the case in 1991, 2002, 2009 and 2020. Might history repeat itself?