The Magnificent Seven tech stocks and the AI themes stole the show during recent market rallies. Do other sectors offer just as many promising opportunities to investors as the tech landscape, which some experts consider to be entering "bubble" territory?
Kestra Investment Management CIO Kara Murphy joins Yahoo Finance Live to discuss looking past the major large cap stock narratives and finding value in small cap markets.
"Valuation is a terrible timing tool. It's a pretty good predictor of what returns will be over the medium to long term. But, that does not suggest that small caps will start to outperform relative to large caps," Murphy says. "We're not building for a market for tomorrow, we're looking to expose ourselves to opportunities to help us get to those goals. So what that means is this is probably not the time to be leaning into these rich areas of the market. It's a time to examine your portfolio, make sure you have exposure to some of these other areas."
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- As earnings season begins to wind down, all the focus has been surrounding big tech and AI. But what other areas can investors be turning to that maybe aren't getting as much love as the Magnificent Seven? For more, we welcome in Kara Murphy, Kestra investment Management CIO. Kara, it is good to see you. So listen, we know there's been a ton of excitement and interest in AI. But you argue there are parts of the market beyond AI that are still compelling here?
KARA MURPHY: Absolutely. The type of market that we have had more recently where there are just a handful of names doing really well, particularly those tied to AI, actually creates an opportunity. It's a tough market for stock pickers, right? Because you only have a couple of opportunities to get it right.
But what that means when you have so much attention and so many dollars chasing this one relatively narrow theme, it means that there are huge swaths of the market that nobody's really paying attention to. And so there are a lot of opportunities in there that have been able to grow in time. And so when you think about the mega tech, as you step down in market cap from there, that's where you start to see a lot of those opportunities.
And one of the most stark opportunities that comes when you do that exercise is small caps. So you have small caps relative to large caps that have had one of the widest, you know, years of underperformance. And then when you compare valuations, typically, small caps trade at like a 40% discount to large caps. They're currently trading at half the valuation of what large caps have.
So you have this really massive valuation differential so that even if it's small caps do indeed have greater headwinds relative to their larger peers, a lot of that is already reflected in the valuation. So any time you get out of those really richly valued areas of the market, those opportunities start to percolate up.
- Kara, those opportunities may well exist. But they don't pay off until those stocks go up, right? Valuation-- something being cheap alone is not a reason for it to then rally. So when do we see a pivot-- I mean, if everybody just keeps paying attention to tech, then-- and doesn't pay attention to small caps, you know-- so what's going to give in this market? What's going to change?
KARA MURPHY: Yeah, it's a great question because you're absolutely right. Valuation is a terrible timing tool. It's a pretty good predictor of what returns will be over the medium to long-term. But that does not suggest that, for instance, small caps are suddenly going to start to outperform relative to large caps.
But, you know, I'm in the business of building portfolios to help people reach their financial goals. So we're not building for a market for tomorrow. We're looking to, you know, expose ourselves to opportunities that help us get to those goals.
So what that means is that this is probably not the time to be leaning into these really rich areas of the market. It's a time to examine your portfolio, make sure that you have exposure to some of these other areas. You don't want to short these names necessarily, but you don't want to go whole hog into them.
- And, Kara, another theme you mentioned is you think investors right now would be smart to focus on quality names. What do you mean by that, Kara? How do you-- how do you define quality as an investor?
KARA MURPHY: Well-- so we can do it in a number of different ways. And again, one obvious area to look at is high-yield versus high-grade corporates in the fixed income side. So high yield is a good example. These are companies who, you know, need to pay a lot in terms of debt in order to keep managing their business. They've been able to manage through this high-interest rate environment by shortening the duration of their debt, kind of hoping that interest rates are going to come down so that then they can re-up in a lower interest rate environment.
Well, now, we've had fed interest rates start to be cut-- pushed out again. But then when you look at spreads in that space, high-yield spreads have actually declined despite this more difficult operating environment. So we think that's a good opportunity to be able to trade up in quality, move out of some of those high-yield names into higher grade corporates on the idea that the fed is maybe not going to be cutting as aggressively as what we had hoped earlier this year.
- And what are this other-- sort of other types of opportunities you're seeing as a result of pushing out those fed rate cut expectations?
KARA MURPHY: So I think in some other sectors, we see things like energy that have been unloved. We think some areas of the consumer are actually pretty attractive. And then again, in the equity side, if you start to look for companies that have higher quality balance sheets, more steady earnings, there too, I think the market has underpriced those opportunities.
- Kara, switching gears a bit, I want to ask, we are staring down the barrel here of another potential government shutdown, Kara. I'm just interested as an investor, how are you thinking about that, Kara? Or are you not thinking about it? Does it sound like just kind of noise to you at this point?
KARA MURPHY: So it is important. So what we've seen are a lot of different-- a lot of different occasions over the last bunch of decades where we've come very close to a government shutdown or actually had a government shutdown. Often, during those instances, we've seen some market volatility heading into it. But then fairly quickly, the market will recover.
So what that tells us is that from a sort of medium term fundamental perspective, these shutdowns don't really have that much of an impact on the broad market. Now that said, every time we go through it, the credibility of the US government gets dinged a little bit. And that, in turn, makes it a little bit more expensive for us to raise debt, hurts Treasury yields. And so it does over time kind of build up. But we would argue that, you know, on any one given occasion, it's not going to have a lasting impact on the price of the S&P, for instance.