Shift to fundamentals in your equity portfolio strategy this year

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By Bhawana Chhabra

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The investment backdrop is more challenging now than at any other time in the past two years, with valuations trading in the top decile, stalled-out earnings revision momentum, weak earnings breadth and heightened policy uncertainty.

While momentum and sentiment can run for longer than commonly appreciated (the main story in 2024), the current environment necessitates a focus back on fundamentals in order to generate alpha (outperform) in a market that is frothy to say the least.

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A complicated backdrop

Expectations of a broadening out in equity markets in 2024 did not pan out as anticipated, though there was a small hint of it in the immediate aftermath of the November election in the United States. While the price action attempted to do so in fits and starts, fundamentals never ratified this move.

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Indeed, 2025 earnings estimates for the Magnificent Seven went up by 27 per cent during the year, but the rest of the 493 names had a four per cent downgrade, keeping headline S&P 500 expectations flat for the year. For the past six months, however, headline estimates for this year experienced a two per cent downward revision, driven by weakness outside the Magnificent Seven.

Looking through the monthly wiggles, however, the equal-weight S&P 500 delivered an 11 per cent advance for the second consecutive year (less than half the cap-weight index). Yet the downdraft in earnings-per-share estimates caused valuations to further expand into what can be described as a very expensive backdrop. Sentiment embedded in prices sits just below the record highs of the dot-com bubble, and a forward P/E ratio beyond 22x is more than one standard deviation above trend.

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Adding to this is Donald Trump’s re-election to the White House, amping up deregulation and tax-rate-cut bets, leading to even further multiple expansion. What’s worth noting is that Trump 2.0 is not expected to be like his first term, with the fiscal deficit-to-GDP ratio upwards of minus six per cent compared to roughly minus three per cent in his prior term and a razor-thin majority in Congress to boot. In short, Trump may not be able to deliver what equity markets are hoping for.

Layer on a United States Federal Reserve that has pivoted once again to a more “hawkish” footing, signalling a total of two rate cuts in 2025 instead of four earlier. A more uncertain monetary, fiscal and trade policy environment generally means more risk aversion and an associated lower valuation premium, presenting a headwind to currently optimistic valuations.

Focus on earnings momentum

With so many moving parts, it has become even more important to stick to earnings fundamentals as the macro backdrop remains volatile and uncertain. Hence, we continue to recommend a focus on earnings momentum (revision/growth/guidance), not price momentum, which was what worked last year.

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This allows us to navigate the current environment, providing an outperformance of 2.2 percentage points on an equal-weight basis and one percentage point on a cap-weighted basis in our what’s-priced in-based portfolios relative to the headline index.

On a sector and industry basis, we are adding a tactical underweight position on select rate-sensitives like real estate in the near term, with better buying opportunities ahead when the Fed inevitably pivots as it adjusts to the reality that inflation dynamics are less hawkish than they are signalling. Telecommunications fits this bill as well.

This adds to other underweight areas where earnings revisions/growth are weak, and the risk-reward profile is unfavourable. Hence, industrials (earnings downgrades and yet high valuations) and materials (consistent earnings downgrades, a weak global economy and a strong U.S. dollar implying near-term challenges) are additional sectors to steer clear of.

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In terms of our key overweight recommendations, they are: communication services (strong earnings momentum and a comfortable industry composition to the sector), financials (strong capital markets, domestic orientation of the sector, and sustained earnings revisions) and utilities (rate-sensitive, but structurally positive on electricity demand) are our favourites.

Bhawana Chhabra is a senior market strategist at independent research firm Rosenberg Research & Associates Inc., founded by David Rosenberg. To receive more of David Rosenberg’s insights and analysis, you can sign up for a complimentary, one-month trial on the Rosenberg Research website.

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