Is now the time to rotate large caps out of your portfolio?

Nvidia (NVDA) is rebounding after dipping in Monday's trading session. Northwestern Mutual Wealth Management chief portfolio manager Matt Stucky joins Morning Brief to discuss how investors should navigate the current market and whether investing in large-cap stocks like Nvidia is still worth it.

"Our caution toward US large caps is a function of a little bit of caution toward the economy here. We still are in the camp that the end destination for what's been the fastest hiking cycle from the Federal Reserve in more than 40 years is ultimately some form of a mild recession. And when we're looking at different asset classes on the equity side of our portfolios, US large cap expectations, or what's built into the price, don't give us a lot of compensation for that thesis on the macro side of things," Stucky explains.

He notes that in light of this economic environment, US small caps are a good buying opportunity "given that they're a little bit more economically sensitive." He adds, "US small caps trade at eight times trailing cash flow. That is a recession-level valuation that you just don't see anywhere else across the equity investing side of things today." As a recession is likely to be mild, Stucky believes that small caps will "respond positively" to the Federal Reserve's rate cuts.

As the AI race continues to fuel the growth of large-cap stocks, Stucky asks, "Is the return on investment of all of this AI infrastructure going to keep demand levels in the future to support the stock?" He is cautious about Nvidia and other large-cap AI names, explaining his doubts about whether their valuations are ultimately sustainable.

For more expert insight and the latest market action, click here to watch this full episode of Morning Brief.

This post was written by Melanie Riehl

Video transcript

Let's take a look at the broader market.

We're seeing some pressure across the board as we're just about five minutes into the trading day.

A lot of focus has been on tech.

You've got NVIDIA shares at least here at the open under a bit of pressure off just about 3/10 of a percent giving back some of the gains that we saw yesterday.

Our next guest saying that it might be time to rotate out of some of those larger cop names we wanna bring in Matt Stuckey, he's Northwestern Mutual Wealth Management's Chief Portfolio Manager.

It's great to talk to you.

So let's take a step back, talk to me about what you're seeing here.

Some of the caution maybe uh that you're warning about when it comes to large caps and what investors should be doing today.

Well, really our, our caution towards us large caps is a function of a little bit of caution towards the economy here.

Um You know, we still are in the camp that the end destination for what's been the fastest hiking cycle from the Federal Reserve in more than 40 years is ultimately some form of a mild recession.

And when we're looking at different asset classes on the equity side of our portfolios, us, large cap expectations are what's built into the price.

Don't give us a lot of compensation for that thesis on the macro side of things.

And what I mean by that is if you're looking at 2024 2025 earnings, they're expected to grow double digits and against those double digit growth rates, we're expected to pay 22 times 24 estimates and, and about 20 times 2025 estimates, that's a full valuation, not a lot of compensation for if something does go bad with the economy.

Yeah, and, and that's, you know what we were talking about a little bit earlier on trying to figure out if we did see some volatility or at least uh a worsening economy in the second half of this year, how that would translate through to valuations?

What, what are your anticipations?

Well, usually something has to give if the economy starts to falter and earnings are under pressure, um price tends to follow that as well.

Um You know, looking at, you know, the various macroeconomic indicators that we follow, I just can't stop looking at leading economic indicators and I know they haven't really played out as they have in historical cycles, but just looking at the actual index today, it's down almost 15% from its highs.

You know, typically we've seen recessions historically, if it's off just 10%.

There's only been three other times in the last 80 years where it's been down more than 15% and that was the recessions of 1973 19 82,007.

Um So certainly there's some warning signals here that, you know, we can probably rotate out of asset classes that are expecting continued growth, soft landing and acceleration of the economy and into things that give us a little bit more defensiveness in our portfolios or don't have as egregious expectations built into the price on the equity side.

And what would some of those investment opportunities be?

Well, I think us small caps can make some sense here and, and typically it's a little bit funny to recommend that um you know, given that they're a little bit more economically sensitive, but you know, us small caps trade at eight times three, the cash flow, um that is AAA recession level valuation that you just don't see anywhere else uh across the equity investing side of things today.

Um You know, and given our view that what we're likely to see on the on the recession side of things is more mild in nature that the fed is going to likely be able to cut quite a bit.

Um You know, typically we see us small caps respond positively to those effects.

Um So there's a little bit of catalyst on, on, on the other side of all of this, that we think is attractive and it's overweight in our portfolios because of that, I, I guess boiled down as well though, is that the case for small caps, just that it really hasn't participated in the rally thus far.

And, and that's the area where we could potentially see the, the next, uh you know, upward trajectory or, or a trend higher.

I think that's part of it.

But I also think that um thinking through the next kind of leadership cycle as the economy moves past this economic expansion and and starts another one, usually leadership also changes in the markets.

And us small caps tend to be earlier in, in an economic cycle in terms of demonstrating our performance.

And we want that well represented in our portfolios.

Now when it comes to some of the valuation, uh comparisons that have been made here between a lot of those A I stocks when it comes to maybe the excitement surrounding NVIDIA and comparing that to what we saw uh 20 plus years ago.

Uh with Cisco, you're talking Barry Banister over at steel about this uh at the top of the hour.

I'm curious what you make of those comparisons and whether or not there is some sort of warning sign or signal that you are seeing from the massive run up in some of these A I names.

Well, since you mentioned NVIDIA specifically, I think it's a little bit different than we saw in the late 19 nineties, you know, NVIDIA certainly has the margins, the cash flow of the earnings.

Um And you know, from my perspective, the question is not so much really the valuation today, but you know, more so is the return on investment of all of this A I infrastructure going to keep demand levels into the future to support the stock?

Uh We just don't know the answer to that because we're in kind of more of a test and learn phase across corporate America as it relates to artificial intelligence diligence, really on the product deployment side and return on that all of this investment.

That's when we're going to know whether or not this valuation is sustainable.

Um You know, and, and, and you can probably apply the same kind of logic to a lot of the other A I winners out there.

Now, we're the belief that artificial intelligence is for real, that productivity gains are likely to be uh quite strong from this technology.

We just think it's further out than what we're likely to see in 2024 even the front half of 2025.

And so evaluations are getting ahead of their skis a little bit on that then and then about how long could you expect for the actual benefits of the technology to be realized?

And then uh the companies actually grow into those, those uh those valuations, I guess um over realized kind of appreciation of that technology, IRL I, I think it's more of a, a two plus year out kind of framework that we're thinking about with that.

Um And that's well beyond the window of where we see some macro pressure enter into investor mindsets and, and keep in mind these aren't exactly low beta names.

And so, despite, you know, a, a strong story to tell as it relates to the deployment of this technology, they are volatile stocks.

And so, um you know, just be careful in terms of how much exposure you have in your portfolio to some of these positions because despite a good story that's behind it, uh it wouldn't be surprising to see the move around quite a bit if, if the macro gets a little bit rocky from here.

Great insights, Matt Stuckey Northwestern Mutual Wealth Management, Chief Portfolio Manager of Equities.

Matt, thanks so much for taking the time here today just after the market opened.