Taking Some Large Growth Gains Off the Table

Additional content provided by Colby Hesson, Analyst, Research.

The growth style within large cap equities has had quite a strong run the last few months, with a nearly 10% gain this year and a 43% advance over the past year, based on the Russell 1000 Growth Index, compared to the S&P 500, which has gained 8% this year and 31.5% over the past 12 months.

Those strong gains and the elevated valuations that come with them are the primary reasons why the LPL Research Strategic and Tactical Asset Allocation Committee (STAAC) has recommended reducing its large cap growth overweight. This move helps lock in some of the relative gains in portfolios and frees up capital to shift to an asset class with a potentially better risk-reward profile now.

The STAAC recommends a shift toward high-quality small cap equities with equal proportions to growth and value. The move is largely an acknowledgement that the outlook for small caps has improved from a technical analysis perspective.

Large Cap Growth Seeing Signs of Slowing Momentum

So why trim the large cap growth allocation? Besides locking in gains, the asset allocation committee has identified some technical indicators that have deteriorated recently. The asset class category recently became overbought (as measured by a relative strength index of over 70) before losing some momentum, and sentiment surrounding artificial intelligence stocks has reached a point where it could be considered overly optimistic.

Valuations have become increasingly stretched as growth stocks have rallied, which adds downside risk should the group suffer from deteriorating fundamentals. Earnings growth for the mega cap technology stocks is far outpacing the rest of the market and may do so for another quarter or two, but at some point, later this year, we would expect that relationship to flip.

Bottom line: while still a favored asset class for its exposure to high-quality companies in a potentially slowing economy, LPL’s STAAC is trimming the size of its large cap growth overweight allocation.

Russell's Large Growth is Starting to Stagnate Compared to the S&P 500

Source: LPL Research, Bloomberg 03/19/24
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested in directly.

Small Cap Stocks Have Made Technical Progress Recently

In looking for an asset class to move to after reducing large cap growth, several options were considered, including international equities and even fixed income. The Committee landed on small caps, going to a neutral stance from underweight, including exposure to both growth and value styles.

Based on the technical progress small caps have made over the last few months, an underweight recommendation may no longer be warranted. Although small caps have not recaptured the leadership reins from large caps, there is growing evidence suggesting they could be due for a catch-up rally over the coming months. Broadening participation in this bull market beyond the mega-caps, including improving relative strength in industrials, materials, and financials, helps support this call.

Based on other quantitative work, small cap equities fall into the top quartile amid improving economic conditions relative to market expectations. The outlook for small caps is also helped by healthy credit markets, low valuations for high-quality (profitable) small caps, and the market’s increasing comfort with risky assets recently, which has helped the lower-quality small caps. Additionally, if the market broadens out, small and mid-caps should get a boost.

Russell 2000 is Close to One Year Lows Compared to S&P 500

Source: LPL Research, Bloomberg 03/19/24
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested in directly.

Conclusion

The LPL Research STAAC recently recommended decreasing its overweight exposure to the growth style within large cap equities and increasing the allocation to small cap equities. This move reflects the STAAC's belief that while large cap growth equities still have strong earnings prospects and have shown resilience even as the U.S. economy has begun to slow, the extremely strong recent outperformance warrants scaling back the size of the overweight. This locks in some of the relative gains experienced since LPL Research recommended an overweight to growth over value at the start of December 2023. Finally, the Committee believes the market environment may become more favorable for small cap equities over the next year, so bringing the allocation closer to benchmark levels makes sense.