The recent surge in the stock market, driven by the major technology and AI companies, has started to lose momentum. With the Federal Reserve possibly on the brink of its initial interest rate reduction, if you find yourself with $10,000 to invest at this juncture, the question arises: where should you direct your funds?
The current financial landscape is fraught with uncertainty and increasing market volatility. The S&P 500, which is composed of large-cap stocks, is experiencing a retreat from its record highs. Technology shares, notably those of AI chip frontrunner Nvidia (NVDA), are also witnessing a decline in their recent gains. Moreover, stock valuations have reached a point where they are considered to be on the higher side.
Consequently, financial managers are not aggressively advocating for stock purchases—at least not for the recent high-performing stocks. Instead, they are focusing on overlooked segments of the market, such as small-cap and value stocks.
Experts in the field are also advising a shift from cash holdings to short-term bonds, which can secure higher returns for a more extended period. They emphasize the importance of a broad diversification strategy to capitalize on a potential market shift away from the dominant tech giants and towards smaller-cap companies and value stocks.
Small-Cap Stocks
While the world's largest companies and those at the forefront of AI technology have been the stars of the market, there is now a significant opportunity to invest in smaller companies. "At present, they are historically undervalued," according to Ryan Detrick, Chief Market Strategist at Carson Group.
How undervalued are they? "The last time small-cap stocks were this inexpensive relative to large-cap stocks was in 1999, during the dot-com bubble, which initiated a 13-year period of superior performance," Detrick elaborates.
The rationale for investing in small-cap stocks is not solely based on their valuation. Historically, these smaller companies have often relied on borrowed funds for expansion, making them favorable candidates for rate cuts. With inflation on the decline and expectations of the first Fed rate cut in September, followed by three quarter-point reductions by year-end, small-cap stocks stand to benefit.
"Even a slight reduction in rates could provide a significant boost to small-cap stocks," Detrick notes.
Ryan Rosegarten, a Senior Wealth Strategy Associate at UBS Global Wealth Management, suggests that if rates decrease, small-cap earnings could potentially surpass those of large-cap stocks for the remainder of the year.
Total U.S. Stock Market Index Funds
If the dominance of the so-called "Magnificent Seven" wanes, the remaining 493 stocks in the S&P 500 could experience a resurgence. As uncertainty grows regarding the source of future returns, the argument for diversification becomes more compelling, rather than concentrating investments on a select few winners.
"Broad diversification is crucial," says Chris Tidmore, a Senior Manager at Vanguard's Investment Advisory Research Center. "Investors are always searching for the hidden gem. However, the surest way to possess the gem is to own the entire stack."
Investing in a total U.S. stock market index fund means that you would own virtually every publicly traded domestic stock. "Choose a name," Tidmore advises, adding that the optimal stock to own is the small-cap company that matures into a large-cap powerhouse.
When faced with the decision of whether to invest the entire $10,000 at once or to dollar-cost average the investment over time, Tidmore recommends the lump sum approach. "All academic research indicates that you should invest the entire amount immediately," he asserts.
Pick-and-Shovel Plays
While AI chip manufacturers like Nvidia are currently popular stocks, it is not mandatory to own companies that produce semiconductors. Instead, one can participate in the AI and digitalization trend by investing in the manufacturing companies that supply the equipment necessary for creating high-performance computer chips, as suggested by Erin Kolo, Manager of PWM Equity and Fixed Income Research at Baird.
Although chip equipment manufacturers have faced pressure in recent weeks due to signals that the U.S. may restrict chip sales to China, the ongoing demand for chips required for AI development ensures that these stocks will remain a viable investment over the long term, according to Kolo.
"The demand for chips will undoubtedly continue to increase," Kolo states.
ETFs such as the iShares PHLX Semiconductor ETF (SOXX) include chip equipment companies like Applied Materials (AMAT), Taiwan Semiconductor (TSM), and KLA (KLAC), as reported by Morningstar. The VanEck Semiconductor ETF (SMH) holds significant positions in Netherlands-based ASML Holdings (ASML) and Lam Research (LRCX).
Short-Term Bonds vs. The Stock Market
Money market funds are currently offering yields of 5%. However, these rates will likely decrease rapidly once the Fed begins to cut rates as inflation eases, significantly reducing the income of savers. Daniel Siluk, Manager of the Short Duration Income ETF (VNLA) at Janus Henderson Investors, believes that there is a strong case for reallocating from money markets to shorter-dated bonds.
Siluk argues that by "indolently parking" funds in cash, investors may miss out on potential capital appreciation in the bond market that could result from falling rates.
Siluk considers short-term Treasurys and investment-grade credit to be a "highly attractive destination." Investing in bonds with one to five-year maturities allows not only for capturing additional yield but also for capital appreciation as the Fed lowers rates. This strategy, however, does not imply that investors will have to sacrifice liquidity or quality. "These are extremely liquid asset classes," Siluk emphasizes.
Siluk suggests that now is the time for investors to make this move, before the Fed initiates its rate-cutting cycle.
Justin Winters, Managing Director and Partner at the financial advisory firm Treasury Partners, agrees that for investors who are uncertain about whether to buy stocks now, purchasing one- or two-year Treasurys offers the opportunity to secure an attractive yield while they wait to invest the cash into so-called risk assets.
"It provides the most flexibility," Winters explains. "You lock in that rate for a longer period. Not only is your money safeguarded, but if the markets retract, you can capitalize on that and reallocate back into equities at lower levels."
Value in the Stock Market
The market has been dominated by growth stocks for some time, but value stocks present an opportunity. Fed rate cuts will likely benefit value stocks, which tend to perform better when the economy accelerates, according to Rosegarten of UBS. "We anticipate that stocks whose performance is linked to the economy's direction and that are highly sensitive to interest rates will gain as we approach a lower rate environment," Rosegarten predicts.
Foreign Stocks
Investors often focus their investments within the U.S., but opportunities exist beyond American borders. With interest rates on the decline and the strength of the dollar expected to moderate, the outlook for emerging markets is improving.
"Investing in emerging markets, excluding China, is one of the most compelling opportunities for long-term investors at present," says Wylie Tollette, Chief Investment Officer at Franklin Templeton Investment Solutions. His company anticipates annual returns of 9.6% in emerging markets over the next decade. "We believe that many emerging market countries and stocks will deliver robust relative returns due to higher economic growth rates, improved demographic profiles, and enhanced corporate management and governance."
Angus Shillington, Deputy Portfolio Manager for the emerging markets equity strategy at VanEck, is particularly optimistic about Indian stocks. Over the long term, he notes that the Indian stock market has delivered growth of 7% on top of the country's GDP, which is second only to the U.S. in this regard. Shillington also points out that India is currently undergoing transformative changes.
So, what are you waiting for? It's time to put that $10,000 to work.
