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Could small cap stocks join in on the AI-tech rally?

Are small cap stocks the new pain trade or could they cash in on the tech rally stemming from the AI hype bubble? F.L.Putnam Chief Market Strategist Ellen Hazen joins Yahoo Finance Live to detail cautious outlooks on artificial intelligence stocks or investors and the consumer staples the firm is trimming from its portfolio.

Video transcript

JULIE HYMAN: Something else that Jared has been watching-- thanks Jared-- is small caps. In today's Morning Brief, Jared goes deeper into the small cap run up. He mentioned it yesterday. It's part of a wider trend we're seeing of the so-called market melt up broadening beyond big tech and AI-focused businesses.

Our next guest says she's cautious on AI names that have run so fast, this amid the narrowing of market moves in general. She points out only 25% of S&P names have outperformed year-to-date. Joining us now is Ellen Hazen, F.L. Putnam Chief Market strategist. Ellen, it's good to see you.

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It has been interesting lately what we've seen in small caps because even as we still mostly have the domination of the very largest companies and large cap tech in particular, the small caps have also started to bear watching. So how are you thinking about the sort of indicators at the margins of the market?

ELLEN HAZEN: So we're looking at small caps and we've been slowly increasing our exposure to small caps over the last several months. If you look, for example, at price to earnings ratios, small caps are at a 6 point discount to large cap. That's pretty much as large as that discount usually gets. So we think it looks interesting from that perspective.

And then in addition to that, small caps typically do well at the beginning of an economic cycle. And we are clearly slowing down. If we see a slowdown for the next couple of quarters and then the market and the economy reaccelerates after that, small caps could do very well. And you have this valuation support, which really can help. And you've started to see that the last few days. Will that turn out to be a head fake? Unclear. But we do think you have valuation support to own US small caps here.

BRAD SMITH: Additionally here, you're cautious on some AI names, whether they're small cap or even large that have run too fast. Why is that?

ELLEN HAZEN: So I think it's been well discussed that the market has been extraordinarily narrow year-to-date with the top 5 or 10 stocks, accounting for the vast majority of S&P performance. One example is Microsoft. We like Microsoft a lot. But if you look at the stock, it's up almost 40% year-to-date. And that's all been multiple expansion.

Earnings estimates have actually come down just a hair. So this is all excitement. This is all emotion. I think it's a great company. We still own it. But I think it makes sense to trim a name like that here when you've seen the multiple expand by so much on a lot of hype.

And, of course, Nvidia, same thing-- great company, phenomenal leadership in the AI space. But the multiple has expanded so much, that I don't know if it makes sense to chase it here. These stocks when they have these high multiples, they're always at risk of a disappointment and a hiccup. The stocks could be volatile when that happens.

So we may be at peak AI frenzy right now. Don't know. We won't know until hindsight. Certainly, we thought in 1999 and 2000 that oftentimes these things can go much higher and much farther than you ever expect. But we think it makes sense to own some of these high-quality names, but on pullbacks.

JULIE HYMAN: And Ellen, what's interesting to me is maybe you're trimming a little bit from those frothy positions, but you're also trimming some of the staples stocks. Walk us through the rationale for that.

ELLEN HAZEN: It's really the same thing. As we look at the consumer staples stocks, again, really high-quality companies. They have high returns on invested capital. They have high margins. They have high free cash flow. Campbell's Soup, for example, who you were talking to earlier, great company with great cash flow. But they've gotten to be pretty expensive as the market has really bid up some of the staples' names.

So to be honest, we're not finding too many names that look attractive right now either in the AI space or in the staples. There a few areas that have been left for dead. Small caps is one. There are some areas of industrials that look interesting as well. Some of the semi-names have really pulled back recently. So we're looking at those.

But in general, the market has run so fast, particularly in the large cap realm, that we think it makes sense to take some profits and focus on areas that have been left behind like some of the smaller names or even outside the US and Europe.

BRAD SMITH: Ellen, with that in mind, where you're taking profits, are you reinvesting some of those profits into specific names ahead of the next Fed meeting, specifically?

ELLEN HAZEN: So we're looking at inflation just like everybody else. And the Fed going forward we think is going to have to stay here for longer than the market currently expects and may even have to raise again, maybe at June, maybe not till July. So we do think that will continue to contract, the economic, financial conditions. Financial conditions will continue to tighten.

In general, we're not trying to deploy names specifically ahead of the Fed meeting, but we're looking farther out. So what do we think earnings are going to do over the rest of this year, over next year. And we're really deploying client assets based on that rather than trying to make a short-term call ahead of the meeting. But our overall stance on the Fed is that they will have to keep rates higher for longer than the market currently thinks.

JULIE HYMAN: Ellen, you mentioned earnings this year going into next year. And there have been some sort of dramatic forecasts recently from the likes of Morgan Stanley that we're going to see a 16% drop in profits from here in 2023. How are you thinking about what the direction of profits is going to be like?

ELLEN HAZEN: We think profits are probably still too high for 2023, but I don't think we think it's going to be minus 16% from here. So if you look over the last nine months, earnings estimates for 2023 have declined from previously a 10% growth expectation, to now actually a 2% decline expectation. We think the real number is something more like down 5% to 10%. So down a little bit from here. But we're not looking for as bearish a case as what you just described.

The reasons for the decline in earnings in 2023 are that companies are not able to push through the inflation in their costs 100%. So you've seen operating margins decline for three or four straight quarters now. You've seen negative operating leverage. And what that means is that companies don't have the pricing power that maybe the market is expecting. But we don't see the top line slowdown to be enough to prompt a minus 16 in the earnings growth for this year.

BRAD SMITH: Ellen Hazen, who is the F.L. Putnam Chief Market Strategist joining us this morning. Thanks so much for the time, Ellen.

ELLEN HAZEN: Thanks for having me.