Now’s the Time to Diversify Beyond the ‘Magnificent Seven’ Stocks

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. A chain reaction in the markets rippled around the world. Did you look at your portfolio this week? I don’t blame you if you didn’t! August has gotten off to a rocky start. This week’s Investing Insights features three Morningstar specialists who cover the markets and the economy. You’ll hear about what caused the market madness, why it’s a good time to diversify beyond the “Magnificent Seven” stocks, and why the Fed should not panic. Let’s begin with my conversation with Morningstar Inc. markets reporter Sarah Hansen.

What Caused the Stock Market Selloff?

Global markets are rebounding following a wild swing. A sharp selloff closed out trading on Monday, Aug. 5. Just a few weeks ago, stocks were at new highs, but a worldwide wipeout knocked back gains for popular trades and Big Tech. Morningstar, Inc. markets reporter, Sarah Hansen, has investigated the turmoil. Thanks for being here, Sarah.

Sarah Hansen: Thanks so much for having me.

Hampton: Well, let’s get into it. The stock market has stabilized after a couple of bad days, especially Monday. What happened out there?

Hansen: You’re right. Yesterday, Monday, was a wild day in the markets, and it wasn’t just one thing that triggered all those losses. A big part of the story this time around has to do with the economy, interest rates, and the Federal Reserve. So last week on Friday, we saw a weaker-than-expected June jobs report. We saw the unemployment rate rise to 4.3%, and we saw a lot fewer jobs added compared to what economists were expecting. That report started to fuel worries among investors that the Fed has actually left interest rates too high for too long in its fight against inflation and has, in doing so, damaged the labor market, which would leave the door open for a recession.

Now, that’s not the consensus view, by any means. Here at Morningstar, our economists say that while the jobs report was certainly bearish, there aren’t yet those super-worrying signs that we’re headed for a recession, but nonetheless, investors and markets reacted pretty strongly to that data. And on top of that, we had some serious tumult coming out of markets in Japan, and we had some more fundamental issues surrounding American tech stocks that finally came home to roost.

US Tech Stocks, and Bank of Japan Raising Interest Rates

Hampton: Let’s focus on the Bank of Japan. It recently raised its interest rate. Talk about how that move was a one-two punch for the so-called carry trade and for US tech stocks.

Hansen: This is a really interesting part of the story, and it has to do with the Japanese yen and interest rates in Japan. And I’ll say as a caveat that this is really a professional investor story, this angle. Over the past couple of years, Japanese interest rates have been extremely low, and as a result, the yen has been extremely cheap compared to the dollar and compared to other global currencies. So professional investors like hedge funds have been borrowing this yen at a discount and using it to fund the purchase of other higher-yielding assets like other global currencies like US stocks, including US tech stocks, which have just seen some incredible momentum over the past year or two and make for a really attractive trade for those professional investors. That’s what’s known as the carry trade.

The problem started when the yen started to strengthen, which made the carry trade a lot less profitable, and it forced those professional investors to start unwinding their positions and start exiting out of riskier assets in order to cover their losses. And then last week, to make matters even worse, a larger-than-expected interest-rate hike from the Bank of Japan only accelerated that unwinding of the trade. And when everyone started to exit their carry trades all at once, it created this ripple effect across global markets and it caused even more selling, kind of like a snowball, and that’s why we saw a lot of losses accelerate starting yesterday.

Global Selloff and Big Tech

Hampton: And the global selloff bruised Big Tech, yet some market watchers have warned that this was coming for a while. What have strategists told you?

Hansen: You’re absolutely right. In a lot of ways, the losses in Big Tech weren’t all that surprising to analysts, and that’s for two reasons. The first is that we’ve had an extremely concentrated stock market over the past year or two, and that means that just a handful of stocks like Nvidia, Microsoft, Google, and Amazon have been driving a large, large portion of the entire stock market’s returns because they’re weighted so heavily in the major indexes. When the AI trade was at its peak when these companies were reporting quarter after quarter of blockbuster earnings, those stocks really pulled the entire market up with them.

But the other side of the coin is that it is just as easy for those names to pull the market down when they struggle and when investors fall out of love with them. And that’s what we’ve been seeing over the past few weeks and on Monday in a more extreme way.

And then the second element is that these stocks have been very expensive. They’re trading at a premium to what analysts think they’re intrinsically worth. And some strategists have said that a reset was in order to bring prices back in line with what they’re intrinsically worth. So that reset happened yesterday and over the past couple of weeks, and it wasn’t super surprising to analysts who have been looking for it.

Hampton: Sarah, thank you for reporting on this and telling us what you found out.

Hansen: Thanks for having me. A pleasure.

Should You Shift Your Portfolio Away from the Magnificent Seven Stocks?

Hampton: You heard Sarah say that Big Tech’s losses really didn’t surprise analysts. And the cover story from the July edition of Morningstar ETFInvestor newsletter rang the alarm bell about these mega-cap growth stocks. I sat down with the author to discuss why he believes it’s time to make some tweaks to your portfolio and put your money to work elsewhere.

Several technology companies may come to mind when you think about the US market’s bull run. These stocks belong to a club known as the Magnificent Seven. Their outperformance is raising concerns about overconcentration in some index funds. How can you shift your portfolio, if it’s heavy in Magnificent Seven stocks? Bryan Armour is the director of passive strategies research for North America for Morningstar Research Services. He’s also the editor of Morningstar’s ETFInvestor newsletter. Thanks for being here, Bryan.

Bryan Armour: Yeah, thanks for having me.

How the Magnificent Seven’s Outperformance Affects the US and Global Markets

Hampton: Let me grab this. I want to show everyone. Bryan, you’ve recently written about why the Magnificent Seven stocks’ performance against the rest of the market is not normal. And it was in this ETFInvestor newsletter. Why do you believe that? And how has it affected the US and global markets?

Armour: Yeah, well, it starts with the Magnificent Seven and the incredible run they’ve been on over the past few years. And what that’s led to is a concentration in those stocks but also large caps, more specifically, and US large caps to be most specific. So, this time it’s different because the US has taken on a huge market share of the global stock market, and it’s up to about 65% of stocks globally in terms of market cap. And then on top of that, the concentration within the US has really not existed to this extent before when you look at the top couple stocks. So, Microsoft, Apple, Nvidia, for example, make up a very significant portion of the US stock market. And when the US stock market has become such a big part of the global stock market, it just means that so much is riding on a few companies.

Apple and Nvidia: Why Their Products Are a Double-Edged Sword

Hampton: So, let’s focus on two names from the Magnificent Seven: Apple and Nvidia. How could their well-known products be a double-edged sword?

Armour: Well, the iPhone, for example, hugely successful. It has incredible moat built around it, which is why investors love Apple as a stock for such a long period of time. If you think about your iPhone, the App Store, all the apps that you have, watches, integration across various products and platforms, it’s really hard to switch if you own an iPhone right now. And so that’s one of the things that has built its lead. At the same time, half of Apple’s revenue comes from the iPhone. And so when you have something that’s 7% of the US market, or such a substantial portion of the global stock market, riding on a single product, that becomes a concern as an investor because you don’t know what could go wrong. We talk about knowable risks and unknowable risks. And knowable, great positioning, that’s why it’s done so well, but we don’t know what we don’t know. And for Nvidia, it’s a similar story where they have really risen up through their GPUs and some of their data center products that have helped crypto miners, that have helped in the AI boom. So that’s like 80% of their revenue. And so, a lot’s riding on just a couple of products.

What Areas of the Market Are Poised for a Rebound?

Hampton: Now, since the article came out, the market rally was broadening. I would just ask what areas could make a comeback?

Armour: Small caps turned things around for the first time in a long time, and then risk has ticked up as of recently, and so that’s faltered a little bit more recently. But in general, we see value, small caps, and some of these out-of-favor areas of the market as being poised for a rebound because it’s just been such a long stretch where they’ve underperformed the broader market and, more specifically, those Magnificent Seven stocks. So, we expect, if you look at Dave Sekera’s monthly letter, value stocks are much cheaper than growth stocks right now, and then small-cap stocks much cheaper than large cap. And then international stocks as well. We talk about the US representing 65% of the global market cap. It’s been a long time, but there’s a good opportunity for developed-markets or even emerging-market stocks to have their day in the sun.

How Diversification Can Help Investors Stop Chasing the Magnificent Seven

Hampton: And we’ll put a link in the show notes for Dave Sekera’s article that you just mentioned. Now Bryan, it may be hard for some listeners to break away and stop chasing Magnificent Seven stocks. Why should they, and how can they do it?

Armour: It’s an opportunity to put more bets into your portfolio and not be as reliant on a few different products or a few different companies. Some of the ways you can do that is you can go all-in contrarian into like what hasn’t worked, go small value, go heavily international. You could also just make small tweaks, move from the S&P 500 to total market, which means peeling back some of those large-cap exposure and putting it into small- and micro-cap stocks. But overall, there’s a lot of different ways, and I would recommend smaller moves. I think of it as like steering a cargo ship rather than a speedboat. Make tweaks, move some of that risk out to some other assets that haven’t been as favorable, and cash in on what’s worked well.

Hampton: It seems like there’s different options based on what your stomach can take.

Armour: Yeah, exactly.

Top ETF Picks for Portfolio Diversification

Hampton: Can you name some top ETFs that could help folks diversify their portfolio?

Armour: Yeah. So, if you want to go all-in on small value, which you don’t have to go 100%, but maybe you add a 5% allocation to just more specifically obtain small-value exposure, Vanguard Small-Cap Value ETF is always a good option and then Dimensional US Targeted Value ETF is another great one. And that sort of tilts into value but keeps a lid on profitability and makes sure that you’re not holding the companies that are about to fall off the small-cap ladder or go under. Likewise, Vanguard Total Stock Market ETF is a good example of a pivot from S&P 500 or something like QQQ. Dimensional US Core Equity 2 ETF is another one where they use some of the value, small size, and profitability characteristics that are very popular in academic literature and sort of put it in ETF format at a low price. And then if you want to go international, Avantis International Equity ETF is a great option for managing some of those risks internationally, some of the idiosyncrasies that don’t exist domestically, that having an active manager could be helpful. And then Schwab Fundamental International Equity ETF is another good option where you can have more of a value tilt and go international at the same time.

Hampton: Bryan, thank you for coming to this table today and explaining how we can tweak our portfolios.

Armour: Absolutely. Happy to be here.

When Will the Fed Cut Interest Rates?

Hampton: The current market volatility is intensifying calls for interest-rate cuts. The Federal Reserve has signaled a rate cut could happen at its September meeting. But some market watchers believe that’s not soon enough and want an emergency rate cut before then. Check out why Morningstar’s senior US economist Preston Caldwell thinks the Fed should not panic.

There is now this talk of a half-point interest-rate cut by the Fed in September. That would be an aggressive first stop. Is that likely? And what do you think the Fed will be doing when it comes to cutting interest rates?

Caldwell: I’ve said previously over the last several months that I do think the Fed will start cutting in September, and that’s become now the market conventional wisdom. And then with this last jobs report on Friday, now the market is expecting a 50-basis-point rate cut in September and even another 50-basis-point cut in either the November or December meeting. So, the market’s now expecting 125 basis points of rate cuts just by the end of this year, which is an astonishing shift from just expecting maybe one or two rate cuts as of several months ago. I do think the market now has gotten a little bit too aggressive. I would say I expect maybe something more like three rate cuts of 25 basis points each or 75 basis points of total rate-cutting by the end of this year. I don’t think the Fed is going to panic in response to this one data point.

Now, if the unemployment rate remains elevated where it’s at or even increases a bit and we also see deterioration in other economic indicators, then yes, absolutely a 50-basis-point rate cut could become our base case in that scenario. But if we see every other part of the economy still looking quite strong, then I don’t think the Fed is going to start off with a 50-basis-point rate cut. We’ll just have to see based on the data, but it’s not a foregone conclusion, which is kind of what the market is pricing in as of this morning with a 90% probability of a 50-basis-point cut in the September meeting.

Will There Be an Emergency Interest-Rate Cut Before the Fed’s Next Meeting?

Hampton: And a quick follow-up: Is there any scenario where you think that the Fed could roll out an emergency rate cut between now and when they meet in September?

Caldwell: There is a scenario. It would not be in response to just the data that we got on Friday, but if we were to see in terms of the economic data, if we were to see an abrupt slowdown in consumer spending or another measure of economic activity, then I do think the Fed could do that. Because the Fed is so close already to achieving its goals on inflation, and it’s clear that if the economy slows down further, then victory over high inflation is a foregone conclusion. It will happen very quickly. It’s just a matter of time. So there’s really no reason for the Fed to keep rates at restrictive levels given those facts. But the Fed also doesn’t want to be seen as panicking unless there really is something that’s screaming emergency in the data. I think we’d have to see another data point in a more adverse direction for the Fed to call an emergency meeting.

Also, keep in mind, just given how much bond yields have already fallen, that already is kind of transmitting expectations of greater Fed easing into the economy because we’ve already seen, for example, mortgage rates fall in response to falling bond yields, and that reaction will continue to play out. And so borrowing rates across the economy are now easing because of the shift in market expectations for monetary policy. And that actually will already start to stimulate the economy a bit and kind of front-load the impact of this monetary easing. That means the Fed doesn’t necessarily have to change the federal-funds rate right now through an emergency meeting in order to already start having an accommodative impact on the economy.

Hampton: Preston, thank you for your time today and your insights.

Caldwell: Thanks for having me, Ivanna.

Hampton: That wraps up this week’s episode. Thanks for watching and making this show part of your day. The Investing Insights team asks that you give our podcast 5 stars to help others find the work we’re producing for you. And subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to Senior Video Producer Jake VanKersen and Associate Multimedia Editor Jessica Bebel. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.