A shift in market leadership

We’re in a new market regime.

Post-pandemic reopening and the Federal Reserve’s aggressive rate hiking cycle have catalyzed a dramatic shift in equity market leadership. The fastest-growing companies — the ones that thrived during the post-global-financial-crisis era of exceptionally low interest rates, and through the more recent period of social distancing — have suffered. Meanwhile, companies that derive their revenues from the “real economy,” and return a larger share of profits to investors, have outperformed.

We believe the outperformance of real economy stocks over digital growth stocks could last for several years, or even through the next decade, if history serves as a guide.

In many ways, this new regime recalls the investing environment of the early 1980s. A spike in interest rates to fight double-digit inflation, known as the “Volcker shock” for Federal Reserve Chair Paul Volcker, marked the beginning of a multi-year stretch of growth stock underperformance. The rate shock led companies to profoundly change how they allocated capital and structured their operations. It also triggered the deep recession of 1981–1982.

We see parallels with, and some notable differences from, the current juncture. Today, inflation is cooling, and if the U.S. economy were to slip into recession in 2023 it would likely not be as deep as the recession of 1981-82. But the past year’s interest rate shock, sparked by economic reopening and surging inflation, will have far-reaching effects. We think it will influence both corporate decision making — management teams will prioritize profits over growth — and investor preferences.

It’s the beginning of a multi-year transition back toward the real economy, we believe, with at least four important implications for investors:

Mega-cap tech stocks will no longer dominate as market leaders

• The energy transition needs capital
• Manufacturing companies could outperform
• Active managers can find ample opportunity to pick secular winners

Lessons of history: When equity market leadership has shifted

Today’s market shift in focus from growth to the real economy echoes earlier market transitions. They were catalyzed by wars, new technologies and energy supply shocks, among other forces.

The chart below, which covers nearly 100 years of data, tells the story. Boom cycles occur when new growth opportunities offer high prospective returns (the dark blue sections of the line). As capital flows toward those opportunities, funds become relatively scarce for out-of-favor sectors of the real economy. Eventually, the high-growth areas become oversaturated, and prospective returns move higher in the areas that have been ignored. The cycle then restarts (the teal sections of the line).

Interestingly, while certain economic sectors tend to outperform during growth cycles (notably technology and healthcare), we find no clear pattern of sector outperformance during real economy cycles. Rather, investors tend to favor the dividend factor and generally prefer value to growth equities.

Real economy cycles may include periods of strong growth stock performance. For example, year-to-date, the information technology sector of the S&P 500 is up about 9.5%. This is a notable gain, but in our view, no harbinger of a new growth cycle.

The 2010s: Digital asset bullishness, manufacturing shortages

The roots of the recent market shift can be found in the 2010s. Over the decade, investment in physical capital stagnated, even as expected returns to physical capital remained high. To some extent, this made sense. Investment choices reflected the growing value of nonphysical, digital assets such as software.

But in some cases, the gap between investment in physical and nonphysical assets looked extreme. As investors saw nearly unlimited promise in electric vehicles, videoconferencing, cryptocurrencies and the metaverse (among other new endeavors), their perception created an unprecedented gap between the total enterprise value of the corporate sector and its stock of physical assets.

This ratio is known as Tobin’s q (chart below). In the 2010s, investors essentially dismissed the gap between Tobin’s q and investment in physical assets. Instead, they emphasized the value of intangibles. Capital pricing was reasonable, the argument went, because in the digital age, physical capital should make up less of a firm’s overall value.

Then came the COVID-19 pandemic. For various reasons (including supply chain issues), shortages of physical items — cars, houses, furniture, energy — emerged or intensified. Yet investors continued to pour capital into speculative assets such as young unprofitable companies (YUCs), special purpose acquisition companies (SPACs) and cryptocurrencies.

In many ways the state of the U.S. economy in 2021 resembled the late 1970s period that set off the Volcker shock: Too much demand against limited supply in the real economy.

Like the Fed of the early 1980s, the Fed in 2022 responded with an aggressive tightening cycle. It aimed to force demand back into balance with limited supply, and thus bring inflation to heel.¹ Indeed, the 2022 spike in real interest rates ranks as the most dramatic since the Volcker shock.

Real rates are still low historically

What’s next? As we consider how the U.S. economy and markets might evolve in the 2020s, we think it’s useful to look back at the 1980s.

IBM and the demise of the 1980s tech stars

The IBM story and the underperformance of tech stocks in the 1980s offer instructive parallels to the current shift in market regime. Then as now, higher interest rates played a critical role as investors turned away from growth stocks and especially the tech stars of the earlier regime.

IBM was the tech darling of the so-called “Nifty 50,” blue-chip stocks (including Avon Products, Coca-Cola and General Electric) that significantly outperformed the broader market in the decades following World War II.² Investors thought these stocks could be “bought and held forever” and that “no price was too high for them.”³ Sound familiar?

IBM shares delivered a 5x outperformance relative to overall market through the 1950s and 1960s, with the stock peaking at 6x in 1973. IBM shares then collapsed precipitously relative to the market, continuing to fall through most of the 1980s.

IBM’s stock underperformed through the 1980s even as the company commercialized new and innovative products. In 1981, IBM debuted its first personal computer, the IBM PC Model 5150. Notably, it was among the first open architecture PCs: Other companies could produce hardware and software compatible with the PC5150.

Yet, as the chart below shows, the debut of IBM’s PC came in the midst of IBM’s secular underperformance.

To be sure, various factors contributed to that underperformance. IBM, weighed down by a hidebound bureaucracy, made a series of missteps, ceding the computer operating system business to Microsoft (Windows) and the microprocessor business to Intel.

In addition, IBM found itself bogged down in a 13-year Department of Justice antitrust case that began in 1969. The legal battle may have prevented IBM from stifling younger competitors (Apple and Microsoft) in the PC and software industry.⁴

IBM’s post-1980s evolution is equally instructive. In 1993, a new CEO (Louis Gerstner) took the reins, keeping IBM intact amid calls for a breakup, and by the mid-1990s, IBM stock once again outperformed during the dot-com boom. Over the subsequent decades, through various corporate strategies and business environments, IBM essentially evolved into a stable, cash-flow-generating company.

Today, IBM is categorized as a value stock. Dividends accounted for more than 70% of its total return over the last 20 years (compared with around 20% for the tech sector as a whole).

Might IBM’s trajectory hold lessons for some of the tech darlings of the past decade? We expect so.

Cutting costs and boosting fixed investment in the 1980s

In the early 1980s, dramatically higher interest rates led to sweeping cost cuts, waves of layoffs and what became known as the first “offshoring recession.”

Companies improved efficiencies by shifting production outside the United States (Mexico and China were the main beneficiaries). The recession fell hardest on lower-wage workers. While earlier layoffs were typically temporary furloughs, the 1980s brought the first wave of permanent layoffs. A new term, “displaced worker,” entered the lexicon.

Today, companies are again cutting costs in the context of higher interest rates. But unlike the 1980s, recent layoffs appear to be mainly hitting higher-wage workers (at least so far), mostly in the tech sector. Within this sector, layoffs have typically targeted unprofitable units such as the Alexa unit of Amazon or the blockchain/Libra unit at Meta. 

Even as U.S. companies downsized their payrolls in the 1980s, they boosted their fixed investments. The pressure to cut costs forced companies to invest in automation and other new technologies. In addition, businesses streamlined their supply chain systems by adopting new conceptual frameworks such as Six Sigma data analytics. (Motorola was the first to implement the program in the 1980s.)⁵

Just-in-time production, which Japanese automakers introduced and mastered, aimed to make a company’s manufacturing process leaner and more cost-efficient. In the wake of the 1980s U.S.-Japan trade war, Japanese car companies built U.S. factories—powered by just-in-time production—to avoid tariffs on their auto exports. Their U.S. competitors soon adopted their own iterations of just-in-time production.⁶

Influenced by these shifts, manufacturing productivity growth picked up speed in the 1980s, reflecting the coincident strong fixed investment cycle.

We see clear parallels to today. Amid costs cuts and layoffs, we expect a significant increase in physical investment in the 2020s.

Investor preferences in the 1980s: Shareholder value, dividends, big box retail

As higher rates catalyzed changes in corporate strategy and practice, they also set the table for a shift in investor preferences.

We see the change most clearly in the rise of shareholder value as a new corporate doctrine. CEOs increasingly emphasized boosting shareholder value by making profits and returns the locus of their attention.

Although high interest rates didn’t directly cause the rise of shareholder value, they did force management teams to make their companies’ equity more competitive relative to bonds. Companies thus raised their dividends to make their stock more attractive to investors.⁷ Dividends rose as a share of corporate earnings and of overall market capitalization in the 1980s.⁸

We can see other shifts in investor preferences in the 1980s. Against a backdrop of higher interest rates, investors favored value stocks over growth stocks and sought attractive dividend payouts. High-dividend stocks outperformed both the tech sector (including IBM) and low-dividend stocks in the 1980s (charts below).

New investment themes emerged. Chief among them: big box retail, led by fast-growing Walmart and Home Depot, which benefited from corporate cost-cutting, globalization and automation.

Big box retailers also got a boost from the 1980 Motor Carrier Act that deregulated the U.S. trucking industry. This law slashed the cost of moving goods around the United States by bringing more competition into the sector. Companies that were able to take advantage of the reduction in shipping costs thrived.

So too did their stock prices.

By any measure, Home Depot and Walmart dramatically outperformed. In the 1980s, the tech sector trailed the overall market by about 50%, while Home Depot and Walmart outperformed by 1,200% and 460%, respectively.

Investment implications

What does the shift in market regime mean for your portfolio?

First, if you loaded up on growth stocks during the past decade, your portfolio may not be best positioned to benefit from the change in market regime.

Although it is still in the early days, we think a real economy cycle will give investors the incentive to direct capital into addressing the needs and stresses that have emerged in a wide range of sectors. These include traditional and clean energy, housing, infrastructure and manufacturing.

Investors may continue to prefer companies that deliver consistent real returns to shareholders in the near term, instead of those that prioritize growth at all costs. Management teams will likely renew their focuses on profitability and return to shareholders.

We see four important implications for investors:

1. Mega-cap tech stocks may no longer dominate as market leaders. One corollary: Investors should consider prioritizing cash return.
   
   The addressable markets targeted by the past cycle’s mega-cap tech leaders look increasingly saturated. Certainly, their pre-2022 growth rates seem unsustainable. Investors will likely view these stocks as funding sources for investments in other areas. Companies that made ill-considered capital investments in nascent digital growth initiatives, as opposed to those focused on shareholder return, may be particularly at risk.
   
   On the other hand, we think investors will embrace real economy stocks (industrials, commodities, the energy sectors, and other sectors that have prioritized shareholder return over expansion). Similarly, dividends and dividend growth will likely be valued by investors who increasingly view fixed income as a viable alternative to stocks. At the same time, some contingent of the past cycle’s tech leaders will—like IBM in an earlier era—make the transition into a stable, steady grower and high-dividend stock.
2. The energy transition needs capital. Traditional energy companies have maintained capital discipline and prioritized shareholder return. Going forward, they should still provide investors with attractive dividend and cash flow yields, and relatively undemanding valuations. But the transition to clean energy is very much underway. It will require significant capital in the coming years, and is likely to benefit from government policy support and incentives. The transition offers compelling growth opportunities for long-term investors, we believe.
3. Manufacturing companies could outperform. Even though inflation is normalizing, shortages in the real economy still exist. The companies that produce semiconductors, homes and housing-related materials, battery storage facilities, infrastructure and machinery could enjoy a durable tailwind. Small- and mid-cap companies also tend to do well during periods of elevated capital expenditures.
4. Active managers should find ample opportunity to pick emerging secular winners. Market indices have become more concentrated in recent years, as the largest companies make up a growing share of, say, the S&P 500. As Michael Cembalest has written,⁹ central bank policy in the wake of the 2009 recession led to collapsing risk premia and falling relative valuation spreads in equities and risky credit markets.
   
   We expect increased dispersion within equity markets. One key reason: Real economy cycles feature more variability of top performing sectors compared with growth cycles, when returns historically have been concentrated in technology and healthcare. Greater dispersion could enable active managers to deliver excess returns relative to market-cap-weighted benchmarks.
   
   Finally, as companies and investors redirect and redeploy capital, we think active managers can potentially identify the emerging secular winners of the unfolding real economy cycle (just like those who were able to spot the theme of big box retail in the 1980s). That could be a trend with enduring long-term power.
    

We can help

When market regimes change, it is important to consider a wide array of investment options. Your J.P. Morgan team can help you evaluate what equity strategies may help you achieve your long-term goals.