The Stock Market Could Experience a Rally Similar to 2021. It Might Be Best to Play This Way

By now, you've likely come across countless headlines about the "Magnificent Seven," the group of tech giants that collectively make up nearly a third of the S&P 500. Since the index is weighted by market capitalization, its structure inherently favors companies that perform well. However, for investors seeking simple and cost-effective diversification through an index fund, this weighting can lead to significant exposure to just a few stocks, which often move in tandem.

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Jefferies analysts, in a note to clients on Saturday, described the earnings growth outlook for the S&P 500 as "deep-seated" and highlighted favorable conditions for "the other 493 stocks" in the index. They pointed to similarities with past periods that preceded broad market rallies in 2013, 2017, and 2021.

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Before diving into earnings forecasts and historical market trends, it’s essential to consider the valuation of the U.S. large-cap index.

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A key concern for investors over the past year has been the S&P 500’s expensive valuation. The most common metric used to assess this is the forward price-to-earnings (P/E) ratio, which divides the index’s weighted stock prices by analysts' earnings estimates for the next 12 months. Historically, this ratio has fluctuated significantly, with a notable peak during the dot-com bubble in 1999-2000.

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Currently, the S&P 500 trades at a forward P/E of 22, above its 10-year average of 18.5. In contrast, the S&P 500 Equal Weight Index has a forward P/E of 17, compared to its 10-year average of 16.5.

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In their report, Jefferies analysts maintained a positive outlook on equities, arguing that stocks remain "eminently investible." They acknowledged concerns over high interest rates, rising valuations, and strong recent performance but emphasized that these factors alone do not prevent continued market growth.

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However, they cautioned that investors could experience volatility if corporate fundamentals weaken or an unexpected policy shift disrupts the market.

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Looking ahead, FactSet's consensus projections estimate that the S&P 500's weighted earnings per share (EPS) will grow at a compound annual rate of 13.9% from 2024 through 2026. Over the next 12 months, Jefferies expects the information technology sector to drive 40% of the index’s EPS growth. Still, they noted that earnings forecasts for the "other 493 stocks" are becoming increasingly attractive compared to recent years.

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Despite the anticipated growth in tech, Jefferies believes that better investment opportunities may exist outside of the Magnificent Seven, as expectations for these tech giants remain high.

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The analysts forecast a 9% EPS growth rate for the S&P 500 Equal Weight Index, surpassing its historical long-term average of 8%. Given that the equal-weighted index is currently performing at multi-decade lows relative to the cap-weighted index, they see conditions resembling those before major market rallies in 2013, 2017, and 2021.

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The $628 billion SPDR S&P 500 ETF Trust (SPY) tracks the S&P 500 by holding all its stocks. As of Friday, the Magnificent Seven—Apple, Microsoft, Nvidia, Amazon, Alphabet, Meta, and Tesla—comprised 32.5% of SPY’s portfolio. Meanwhile, the $76 billion Invesco S&P 500 Equal Weight ETF (RSP), launched in 2003, distributes its holdings evenly across all 500 stocks in the index.

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During the past market rallies referenced by Jefferies, the equal-weighted approach outperformed the cap-weighted strategy in two out of three years. While both strategies tend to perform well during broad market upswings, investors concerned about overexposure to the Magnificent Seven may find the equal-weighted S&P 500 a compelling alternative.

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Among the Magnificent Seven, Alphabet currently has the lowest forward P/E ratio, though its EPS growth is projected to trail the overall cap-weighted S&P 500. Meanwhile, Apple has the slowest projected revenue growth in the group, but its EPS growth is expected to surpass that of the broader index.

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Apple’s aggressive stock buybacks over the past decade have significantly boosted its EPS. However, concerns over high valuations and weak iPhone demand led Jefferies analyst Edison Lee to downgrade Apple to an "underperform" rating last month.

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