AI Stocks Lead Q3 with Value Plays Rising for 2024

August 1, 2024

Key points:

• The US equity market increased by 3.20% in Q3 and 13.77% year-to-date, largely driven by AI-related stocks.
• The price-to-fair value ratio of the US stock market rose to 1.03, indicating potential overvaluation.
• Growth stocks are trading at a premium, while value stocks are at a discount, suggesting a strategic shift may be beneficial.

The third quarter of 2024 has seen intriguing developments in the US equities market, with attention on the performance of AI-related stocks.

As we approach the end of the quarter, investors are questioning whether the AI stock trade has reached its peak.

Q3 US Equity Market Boosted by AI-Driven Growth

As of June 24, the Morningstar US Market Index, representing the broad US equity market, increased by 3.20% for the quarter and 13.77% year-to-date.

This rise has been largely fueled by the performance of stocks related to artificial intelligence.

AI Stocks Leading the Charge

The second quarter’s gains were concentrated in a handful of AI-related stocks, including Nvidia (NVDA), Apple (AAPL), Microsoft (MSFT), Alphabet (GOOGL), and Broadcom (AVGO).

An attribution analysis reveals that without these gains, the broad market index would have declined. This trend raises questions about the sustainability of the AI-driven rally.

Market Valuation Concerns

The US stock market’s price-to-fair value ratio rose to 1.03, reflecting a 3% premium over fair value estimates as of June 24.

While this doesn’t yet signal an overvalued market, it places it near the higher end of the fair value range seen since 2010.

Historically, the market has only traded at this premium or higher 10% of the time.

The AI Surge and Its Implications

AI-related stocks continued to surge, heavily influencing the Morningstar US Growth Index and, to a lesser extent, the Morningstar US Core Index. Both indexes outperformed the Morningstar US Value Index.

However, based on current valuations, the outperformance of these AI stocks appears to be waning.

Growth vs. Value Stocks

Growth stocks traded at a 6% premium to Morningstar’s composite valuations, and core stocks at a 7% premium as of June 24. In contrast, value stocks remain attractively priced at a 9% discount.

This disparity suggests that long-term investors may benefit from shifting focus from overextended growth and core stocks to undervalued value stocks.

Sector Analysis and Investment Strategy

Given the current market dynamics, we recommend adjusting your investment strategy.

Growth and core stocks have become overextended due to the AI-driven surge, making it prudent to underweight these stocks. In contrast, value stocks present a better margin of safety and potential for future gains, warranting an overweight position.

Additionally, focusing on small-cap and mid-cap stocks is advisable, as these categories offer attractive valuations compared to the increasingly overvalued large-cap stocks.

Specific Sector Opportunities

While the broad market shows signs of overvaluation, there are specific sectors with promising opportunities:

• Real Estate: Despite negative sentiment, real estate, particularly REITs with defensive characteristics, offers attractive investments.
• Energy: The energy sector, trading at a discount, provides a natural hedge against geopolitical risks and persistent inflation.
• Basic Materials: Select gold miners and agricultural chemical producers offer value, even in a slowing economy.

Shifting Focus to Value Stocks and Small Caps for Better Returns in 2024

The concentrated rally in AI stocks during the third quarter of 2024 has sparked worries about market overvaluation.

As we look forward, shifting focus from overvalued growth and core stocks to undervalued value stocks and smaller-cap opportunities may provide better investment returns. Stay informed and strategic to navigate this evolving market landscape effectively.