Is Your Portfolio Built to Withstand a Market Rotation?

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton.

What’s old is new again. Investors are shifting away from AI-leaders like those that make up the “Magnificent Seven” and falling back in love with laggards like value and small-cap stocks. So, how long can this market rotation persist?

Morningstar Indexes strategist and The Long View co-host Dan Lefkovitz has researched the recent market drama. Let’s check out the conversation.

It’s great to see you again, Dan.

Dan Lefkovitz: Great to be with you, Ivanna.

Trends From the Q3 Market Rotation Extending Into Q4

Hampton: We’re talking about the market rotation that started in Q3 as continuing into Q4. You have been tracking the trends. Tell us what you’ve seen.

Lefkovitz: First, to set the scene, if you think about the last 10, closer to 15 years for equity investors, the action has really been in the US market, in that large-cap growth, large-cap core space, over value stocks, over small-cap stocks, over international stocks from the perspective of the US investor. And now, starting in the third quarter, we really saw a change, as you say, a rotation in market leadership. So just looking at the performance of Morningstar Indexes, value beat growth. We saw small cap beat large, and we saw our global ex-US index beat our Morningstar US Market Index. We also saw equal-weight US equity index beat the market-cap-weighted version, which is really interesting.

Hampton: And key moments in the third quarter ignited that market volatility. For example, Nvidia’s earning beat estimates, but the stock still dropped.

Key Moments Sparked Market Volatility

Hampton: Dan, can you talk about why investor sentiment has been fluctuating like that?

Lefkovitz: Yeah, I think “key moments” is a good way to put it. All sorts of triggers, from earnings announcements like Nvidia’s, to inflation prints and job reports, Berkshire Hathaway trimmed its stake in Apple, which kind of spooked the market. I thought it was ironic that both an unexpected interest-rate hike in Japan and an expected interest-rate cut in the US contributed to volatility in the third quarter. Granted, it was a larger cut than many people expected. But I think, you know, the fact that if you think about these moments, some of them were fundamental, some of them were technical, some of them were macro, some of them were micro. Some of them were domestic, and some of them were foreign. And that kind of speaks to what moves markets in the short term and makes markets so hard to predict.

But, taking a step back, I think we saw a real shift in the narrative. If you think about the market over the past 18-plus months, ever since the launch of ChatGPT in late 2022, it’s been all about artificial intelligence and its transformative promise. And AI has been the theme that has really powered markets. In 2023, it was all about the “Mag Seven.” In 2024, we saw more of the same. And I think in the third quarter, we really saw a shift from that enthusiasm to jitters, to fears, to concerns over the economy, over the narrowness of the market and the priciness of the market from a valuation perspective.

Hampton: That was a lot of moments where people had been predicting this is coming, this is coming, and it starts to show its face.

Lefkovitz: Yeah.

Will Value Stocks Make a Comeback?

Hampton: Well, Nvidia and other Magnificent Seven stocks led that almost two-year rally. But value stocks are beating growth right now, like you just said. Is this the start of value’s comeback? Why or why not?

Lefkovitz: Nvidia is a really interesting story. It’s a phenomenal company. Obviously, sort of the poster child of the AI-led market. It’s a wide-moat company in the eyes of Morningstar equity analyst. I encourage people to read our take on Nvidia.

I guess the question there is, how much is already reflected in its share price? How much of its amazing, gravity-defying growth trajectory is already priced in? And fears over the sustainability of its growth, I think, is why the stock price fell even when the company beat earnings estimates. And that’s the thing, that’s the risk with growth stocks is they carry the burden of high expectations. Whereas value stocks, the idea there is that they can underpromise and overdeliver. So yes, we saw value stocks outperform starting in the third quarter. We saw small caps outperform starting in the third quarter.

These are areas that haven’t participated as much. So I think as maybe investors look to the health of the economy, surprising health of the economy, to interest-rate cuts by the Federal Reserve, stereotypically value and small caps are more sensitive to the economy. They have more cyclical exposure. They’re more sensitive to interest rates. So I think the idea that these areas could benefit and the broadening of the market could benefit value stocks and growth stocks.

Now you had a question about whether it’s sustainable. That is anyone’s guess. I guess one note of caution I would sound is we have seen value rallies before that have kind of fizzled out. Most recently in 2022, maybe you wouldn’t call it a rally, but value held up much better than growth in a huge equity market downturn. We saw a big dispersion between the growth side of the market and the value side in 2022. And then of course along came ChatGPT, and growth took off again and some would say it kind of reflated the growth tech stock bubble. So 2016 was another time when value and small caps outperformed, but it ended up being a head fake. So one quarter doesn’t necessarily a lasting rotation make.

Hampton: Something to watch.

Lefkovitz: Yeah.

Value and Small-Cap Stock Outlook

Hampton: And what does Morningstar think about the outlook of value and small-cap stocks?

Lefkovitz: Our colleagues on the equity research side put out their fourth-quarter outlook. I encourage folks to read it. And I want to get this quote right. They said, “the great rotation out of overvalued and overextended large-cap growth has more room to run.” So they certainly see further upside in value, they see further upside in small caps. Our colleagues on the investment management side at Morningstar also like small caps and think that there’s more room to run there. They also like equities outside of the US in certain markets.

What‘s Fueling Dividend Stocks’ Outperformance Against the Broader Market?

Hampton: And income investors are probably liking what’s going on with dividend stocks. What’s fueling their outperformance against the broader market?

Lefkovitz: Yeah, this was really interesting. So we definitely saw a lot of Morningstar dividend indexes perform well amidst this rotation. So if you think about dividend investing, dividend-payers, they tend to have a value bias, especially traditional equity-income portfolios, more so than dividend growth, which is more of a core quality strategy. So as sectors like financials and healthcare and utilities, which benefit from rates coming down stereotypically, that has helped the dividend-paying section of the market. We also saw our Morningstar US Dividend Growth Index outperform during this rotation, thanks to some of those sector biases.

Bond Performance in Q3 and Early Q4

Hampton: Let’s not forget about bonds. How have they performed from Q3 to early Q4?

Lefkovitz: Yeah, bonds, very, very important. Really a positive story there from the perspective of diversification, income investing. So bonds have done really well and have held up well during equity market selloffs and during volatility that we saw starting in the third quarter. Our Morningstar US Core Bond Index was up during really volatile periods first, the beginning of August and the beginning of September, which is important because, in 2022, stocks and bonds both sold off together. So there was a simultaneous selloff in equity and fixed income, which a lot of people called the death of diversification, the end of the 60/40 portfolio, referring to that classic mix of 60% equities and 40% bonds. Now we’ve seen bonds once again act like a diversifier and cushion losses in equities like they did in 2020 and during the financial crisis 2008 or the early 2000s. So the fact that bonds are zigging, while equities are zagging is good news from a diversification perspective. And the fact that yields, even with the interest-rate cuts, bond yields are still high in the context of the past 15 years or so, that gives them a higher starting point than they’ve had from a total return perspective.

What Investors Need to Watch Out for in Q4

Hampton: Inflation is moderating. Recent job data looked strong, and the Federal Reserve is signaling more interest-rate cuts. Q4 looks promising, Dan. Has your research shown anything lurking beneath the surface?

Lefkovitz: First, I’d sound a note of caution about the consensus. The consensus can be wrong. That certainly is the outlook that most people are expecting. But how wrong were we about the economy? How long was that debate raging of soft landing versus hard landing? We still haven’t landed yet. At one point the market was expecting seven interest-rate cuts in 2024, and here we are in the fourth quarter and we’ve only gotten one. So the consensus could be wrong, and there are no shortage of risks lurking beneath the surface. There are always unknowns out there, unknown unknowns that could upend markets. Valuations, I think, are still high from a historic perspective. I’m stating the obvious here, but geopolitical risk is elevated. We have an election coming up. There are all sorts of macro and micro risks. There’s policy and regulation. There was a great article on Morningstar.com recently about regulation that could threaten the tech sector, and we’ve seen antitrust action against Google. So being prepared for all sorts of risks that could threaten the equity market … One of the lessons from Q3 was that volatility just comes with the territory of stock market investing. Even with all of the bumps in the road that we saw, the US market index was still up 6% over the third quarter. It’s still up roughly 20% year to date, which is well above the historic annual average, and we’re only in the third quarter.

Will the Market Rotation Persist?

Hampton: What would you tell investors if they’re wondering if this market rotation will persist?

Lefkovitz: I’d say that market leadership is changeable, and markets are dynamic. If you think about the period from 2000 through 2009, it was a lost decade for US stocks. The market was down over that 10-year period overall. But value outperformed growth and small caps outperformed large, bonds outperformed stocks, international outperformed US. So I think it makes sense to be ready for, you know, I’m not necessarily predicting that that’s going to happen again, but you have to be prepared for a range of outcomes. I think, diversification and having exposure to all different kinds of assets that could perform should market leadership change and should the rotation persist makes a lot of sense. I think a lot of portfolios these days are very heavy on US large-cap growth and large-cap core stocks given their phenomenal run. But like I said, we have seen periods where that segment underperforms, so you want to be ready should that reoccur.

Hampton: Dan, thank you for coming to the table and sharing what trends we should watch for in Q4.

Lefkovitz: Thank you so much, Ivanna.

What’s Coming Up in the Markets?

Hampton: Here’s the markets in brief for the week ahead: Earnings season is picking up speed. Verizon is scheduled to report its third-quarter results on Tuesday, Oct. 22. Tesla is set to unveil its quarterly performance on Wednesday, Oct. 23. And so is Boeing on that day.

Bad news keeps rolling off the jetmaker’s assembly line. It’s navigating through years of turbulence that’s recently intensified. How can it reset and rebound?

Nic Owens is an equity analyst for Morningstar Research Services and covers Boeing. We talked about how the plane maker is trying to pull that off.

All right. Thanks for coming back on the podcast, Nick.

Nicolas Owens: Thanks for having me, Ivanna.

Why Boeing’s New CEO Announced Massive Layoffs

Hampton: Boeing CEO, Kelly Ortberg, has recently announced 17,000 job cuts worldwide. He said the layoffs would affect all levels. How did the company get to this moment?

Owens: Well, as you probably know, starting 2018, 2019, they started having trouble with the 737. A whole series of events grounding the fleet, covid, which disrupted their whole manufacturing process, has led them. And they also, behind the scenes were betting on defense contracts that they lost some money on. Their defense business has had $10 billion of write-offs, and they’ve lost $35 billion since 2018 on making airplanes.

The bottom line is they have to cut costs to stay competitive, and that’s really where they’re at. I think there’s some multiple factors that led to where they’re at.

How Boeing Is Trying to Prevent a Credit Downgrade

Hampton: A follow-up question: Boeing has announced it’s raising money to shore up the finances as it faces a risk of a credit downgrade. Can you give us the details?

Owens: They borrowed a bunch of money in covid, like a lot of companies, but haven’t been making money to pay it back. They issued a filing to issue a combination of equity and debt up to, I think, $25 billion over three years. It looks to me like they have about $15 billion of short-term debt over those three years that they’ll probably refinance. This filing means that they are talking to the banks. The banks are willing to lend them at reasonable rates, and they’ll probably issue about $10 billion of equity sometime soon.

That will probably allow them to keep the investment-grade credit rating, which is a good thing for their costs, and they’ll use that money mostly, I think, for working capital and pay off a little bit more debt.

What Boeing Is Delaying and Eliminating to Move Forward

Hampton: The new CEO has told everyone the company needs to stop spreading itself thin and focus on the core. Can you talk about what Boeing is delaying and possibly eliminating to move forward?

Owens: I don’t have a lot of detail on that. There’s some candidates, so they’ve already been reported to be marketing their share in the United Launch Alliance, which is a joint venture with Lockheed Martin. They won’t make a bunch of money on that, but it will be removing a distraction.

I think there’s a version where they might reorganize their services business, which has been a steady moneymaker, but does some stuff that is un-Boeing-related. They might fold most of that back into the commercial business.

Then, depending on how deep they cut, they might, and depending on what NASA decides, they might shelve the Starliner that had left two astronauts in space for a couple of months. Again, an unprofitable program, over budget, overdue, maybe not something that they would today say is their bread and butter.

Where the Machinists’ Strike Stands at Boeing

Hampton: At the time of this recording that we’re doing right here, the machinist strike is at a stalemate. How far apart are both sides in the contract talks, and what are the sticking points?

Owens: I think they might not be that far apart on money, but their honest stalemate on this issue: The union is asking to reinstate the defined-benefit pension plan, sort of an old-timey pension plan. The company’s basically saying, no way.

On the one hand, that is a classical negotiating strategy where you ask for something that’s hard to give and then you get other things instead. But it takes time in this context for those counter positions and counter proposals to take shape.

The original number in terms of the cumulative raises that the union members were expecting over four years was 40% raises, and the first offer that they voted down was something closer to 33%. A couple more percentage raises and maybe finding a way to make something better about the existing retirement plan is, I think, where they’ll end up. They have to come up with some face-saving proposal.

Hampton: It’s something to watch.

Owens: Yeah.

What to Look for in Boeing’s Q3 Earnings

Hampton: Boeing is scheduled to release its third-quarter earnings on Oct. 23. They have delivered a lot of bad news lately. What are you looking for from management when you hear that call?

Owens: It’ll be the first time the new CEO is on one of these calls from my perspective, and that’ll be interesting in and of itself, just hear their style and so forth. The bread and butter really is the 737, and so I want to hear more about what they’re doing to get that back in shape and being able to consistently produce them, progress on their purchase of Spirit Aero to consolidate the supply chain. That’s really the number-one thing.

There’s other big programs like 777 and others that I’ll want to hear about, and if they have more detail on what they might be shutting down or giving up, that’ll be interesting.

How Investors Should Approach Boeing Stock

Hampton: How should investors approach Boeing stock right now?

Owens: I think there’s long-term value here. Our fair value is over $200, but with the high uncertainty because of all this stuff we’re talking about, we wouldn’t rate it 5 stars until it traded below $120, $121. It’s getting closer to that, and there may yet be other bad headlines, like if the strike extends another month and that sort of thing.

But when they can get the 737, 787 assembly lines back to, let’s call it normal, so consistently pushing the planes through without having to rework, which has been costing them a ton of money. There’s a lot of pent-up demand for the planes. They’ve already sold the planes, but delivering them means a really positive cash flow boost, and getting those assembly lines profitable again will make a huge difference to the company. I’m pretty sure they will get there. It’s just a matter of how long it’ll take.

Hampton: That’s probably on top of the new CEO’s to-do list.

Owens: Yes.

Hampton: Nick, thank you for coming to the table and sharing your insights into Boeing.

Owens: Thanks again for having me.

Hampton: That wraps up this week’s episode. Thanks for watching and making this show part of your day. 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.