Schwab’s Aguilar: Time to Diversify From Magnificent 7

Overweighting the Magnificent Seven stocks boosted performance going into year-end, but also exposed the rally’s narrowness. 

Consider the 28% gain in the market-cap weighted SPDR S&P 500 ETF Trust (SPY), where the seven tech stocks dominate, versus the 13% gain in the equal-weight Invesco S&P 500 Equal Weight ETF (RSP). 

Omar Aguilar, CEO and chief investment officer at Schwab Asset Management and CEO of Charles Schwab Investment Advisory, says the lack of market breadth caused herding behavior by investors who jumped into many of these names because of the hype around artificial-intelligence and growth stocks in general. 

Companies such as Nvidia Corp. and Microsoft Corp. with heightened exposure to the AI theme have generated high levels of free cash flow and have provided significant amounts of multiple, but he doesn’t see that lasting as the market cycles start to change. That change could come soon, he adds. 

“We’re at a clear inflection point,” he says, adding that the end of the Federal Reserve’s tightening phase will be the catalyst to change market cycles.  

Diversify Away From Magnificent Seven

Aguilar believes the market is positioning ahead of an economic deceleration and potential recession, and preparing for the recovery phase, noting that equity markets are usually six to 12 months ahead of the economic cycle. Investors should also heed that sign.  

“People who have significant exposure to growth, these mega-cap seven stocks, it will probably be good (for them to) start diversifying and try to add to areas that may do better through the early cycle phase,” Aguilar says. 

Small- and mid-caps historically benefit during the recovery phase rally, as do non-cap-weighted strategies. November’s rally might have offered a small peak at what’s to come for market leadership. But he stresses the markets could still stumble before they improve, citing recession risk. Holding high-quality, defensive funds may still be prudent as signs become clearer.  

He expects volatility to continue into 2024, but the biggest question will be if volatility stems from the macroeconomic outlook that drove 2023’s market swings or if it’s driven by fundamentals, such as corporate earnings. If so, that could create a better structure and give active managers a fighting chance to prove their mettle against the indexes.  

Fixed Income vs. Equities 

Even with the volatility and uncertainty, Aguilar says now is “one of the best environments for investing” because fixed income offers yields. Equities will remain important, but “equities are going to be more volatile and less attractive than the other two asset classes,” he says. 

Investors should wean themselves off sizable cash positions and look to take advantage of the opportunities in fixed income.  

Like other market watchers, he sees more compelling valuation in fixed income than in equities. He says high-quality corporate bonds “are very attractive” as corporate balance sheets are solid. Going down in credit quality isn’t worth the risk in the early part of 2024 because the yield spread isn’t wide enough to take excessive risk.  

Aguilar also advocates extending duration a few years. High-quality corporates with an intermediate duration could offer good total return opportunities without excessive risk for those wanting an income boost. 

If investors still want some of their portfolios in cash or shorter-duration funds, they could opt for a barbell approach, keeping some dry powder in cash and adding five-year maturities, depending on their future needs.

There’s no need to extend duration out to the long end of the curve, as has been popular by with fixed-income investors; adding duration through the belly of the curve is fine, he adds, reiterating the need to move out of shorter duration. 

“Money-market fund yields, Treasury bills, are incredibly attractive, but they're not going to stay there,” he says.