The recent stock market rally that has been fueled by mega cap tech stocks will shift to small caps, real estates and biotech, experts said.
The Russell 2000, a small cap benchmark index, rose by 5.5% through June 28 while the Nasdaq has rebounded with almost a 30% gain and the S&P 500 surged by 14%.
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The gains made by the Russell 2000, which is up 7.47% year-to-date and 6.47% in the past month, are just the beginning of the rally for small caps.
Investors should expect the Russell 2000 to see additional gains and increase by 14% during the next 12 months, outpacing the returns of the S&P 500, according to Goldman Sachs.
Goldman estimates small caps will beat the returns of large cap stocks as the S&P 500 is expected to rise only by 9% during the same time period, according to a model based on U.S. economic growth and starting valuations.
"While the path of least resistance for the stocks may be to move higher, the market will probably not be able to keep climbing on the shoulders of the tech sector, which by any reasonable metric appears stretched," Anthony Chan, former economist for JPMorgan Chase (JPM), told TheStreet.
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An improvement in market breadth -- or when a larger number of stocks see gains instead of just a few stocks, could result in higher returns, especially in the financial and consumer discretionary sectors, he said.
The consumer discretionary sector could rally, especially if the recession does not occur, Chan said.
"Companies might not pull back so heavily on investment and consumers might not reduce their spending as much because they have prepared so much for rough waters that when it happens and there will be fewer ripples which mean that equity investors will have less fearful outcomes," he said.
Emerging markets, small caps, REITS and biotech will generate outperformance in the "coming quarters," Thomas Hayes, chairman of Great Hill Capital in New York, told TheStreet.
"The magic will be found under the surface in coming quarters as laggards from the first half start to outperform leaders on a relative basis," he said.
The market has rebounded and climbed 25% off the lows in October and up until about a month ago, the rally was driven by the “magnificent 7” tech stocks, but that is starting to shift, Hayes said.
Investors should focus on the next phase or the 93% of stocks that haven’t participated since they will "begin to get bid as managers play catchup," he said.
Even if the stock indices only move up more modestly such as mid to high single digits into the end of the year, expect to see individual “catch-up” stocks under the surface that can move massively by 30%, 40% or 50% or more, Hayes said.
"The magic will happen under the surface," he said. "While the majority of strategists have been looking for a 20% reduction in earnings since October, instead we got a 25% rally in the S&P 500. When everyone is on one side of the boat, it pays to think independently. As for now, people are still preparing for an imminent recession that may not come."
Emerging markets and China will "resume the uptrend they began in October" as China trades inversely with the U.S. dollar and is the heaviest weighting in emerging markets indices, Hayes said.
Biotech will continue its slow recovery from its low last May "as risk comes back into the market," he said.
Sectors that are sensitive to interest rate moves will also "get bid," Hayes said.
Since REITs have been left for dead, "as the long end of the curve gets bid and rates come down, you will see this group begin to recover," he said.
Banks will attract more investors as their portfolio and loan book “mark-to-market” improves, reducing the need to raise capital.
"Funding costs will begin to moderate as deposit rates become more competitive to alternatives," Hayes said.
As the financial sector recovers, small caps, which have been a major laggard, will see more interest from investors, he said.
Investors will rotate towards sectors that have not performed and will begin chasing small caps, value stocks, energy, healthcare and industrial, Art Hogan, chief market strategist at B. Riley Financial, told TheStreet.
Real estate, especially data centers that are in high demand with the boom in artificial intelligence and healthcare REITs with medical offices are all performing well and are in demand, he said.
"The rest of the market will play catch up," Hogan said. "The market had a very productive first half. It caught people by surprise because no one thought the first half would be good and it ended up being great."
The first real test for the market is second quarter earnings as stock prices have outstripped earnings expectations, Steve Sosnick, chief strategist of Interactive Brokers, a brokerage based in Greenwich, Conn., told TheStreet.
"The market got ahead of itself," he said. "The bottom line is right now people are greedy and not at all fearful."
Volatility could spike again -- the VIX or the Cboe Volatility Index, was at 13.5 on June 29, which is close to the lowest levels since February 2020. The VIX is the price of options being used to hedge from declines in the market and gauges fear on Wall Street.
"When you have volatility moving lower, it tends to reverse itself in a hurry," Sosnick said. "People get complacent and they don't feel the need to buy insurance by hedging. It's been so calm for so long that people have begun to underestimate something could disrupt that calm,” Sosnick said.
The Federal Reserve's actions could also drive the returns of the market, Robert Johnson, a professor at the Heider College of Business at Creighton University, told TheStreet.
Market consensus, based on the CME's Fed Watch Tool, is that there will be another 0.25% hike in rates in July since the odds have risen to 89% and 32.8% for a December rate hike.
Since those probabilities are "baked into current market prices, if the actual Fed policy should deviate from these expectations, particularly if the Fed is much more aggressive in raising rates than expected, we could see market declines," Johnson said.
