Market breadth may expand with broadening profitability

2024 equity market performance has been predominantly driven by companies and sectors associated with artificial intelligence (AI).

As of mid-June, the Information Technology (IT) and Communication Services sectors have surged over 20%, and the Bloomberg Magnificent 7 Index has risen by more than 30%, accounting for 71% of the S&P 500 Index’s year-to-date return. In contrast, the other nine sectors have underperformed relative to the broader .

According to Wells Fargo strategists, this tech-driven rally is partly fueled by optimism around AI’s future potential. However, earnings have also been a significant factor, with the Communication Services and Information Technology sectors growing 44% and 25%, respectively, year-over-year in the first quarter. The Bloomberg Magnificent 7 Index earnings grew by 60% over the same period.

“While valuations have expanded, fundamentals are at least partially supporting the rise in prices,” analysts wrote in a note.

Looking forward, Bloomberg consensus data suggests a broadening in profitability starting in the fourth quarter. Wells Fargo said its four favored sectors—Energy, Health Care, Industrials, and Materials—are expected to see higher earnings growth rates than the S&P 500 Index later this year and into 2025.

“Greater balance in profitability could lead to broader market participation in the coming quarters,” analysts added.

Given the year-to-date surge in the Information Technology and Communication Services sectors, the strategists recommend trimming gains and bringing weightings back to neutral.

“We would take advantage of recent weakness in our favorable sectors (Energy, Health Care, Industrials, and Materials), where we see improving earnings growth, durable demand prospects, and attractive risk-reward profiles,” they concluded.

Wells Fargo noted that upcoming events, such as the November elections and potential delays in disinflation, may cause episodes of market volatility in the months ahead.

However, they believe that if the Federal Reserve pivots to rate cuts and the economy transitions to a sustained growth phase, market pullbacks could offer opportunities to diversify sector exposure within U.S. large-cap equities.

“U.S. Large Caps continue to be our only favored equity asset class. However, market pullbacks may open opportunities to broaden exposure to other equity asset classes,” the note states.