The stock market is going through turbulent times, especially within the large technology stocks segment. Nevertheless, a soft landing seems to be in the offing. Investors are already anticipating a possible rebound, especially among US cyclical stocks and smallcaps.
“Smallcaps and cyclical stocks in particular have been craving this moment for a long time,” said Kristina Hooper, chief strategist at Invesco, referring to the interest rate cut to be announced by the Federal Reserve on Wednesday. “This corner of the market will now finally be able to benefit for an extended period, unless new economic data rekindle fears of recession.”
The modest outperformance of small-cap and cyclical stocks that Invesco expects is actually already in the making. US small-cap stocks outperformed the S&P 500 this third quarter, despite a recent decline in September. The Russell 2000 index recorded an 8.8 percent rise over the last three months, even after gains fell to 4 percent in the first week of September.
Cyclical stocks
Cyclical stocks are also taking off. This can be seen in part from the performance of the smallest 493 stocks in the S&P 500 index against the largest so-called Magnificent Seven. The iShares S&P 500 Equal Weight Ucits ETF reports a gain of 7.1 percent over the past 30 days, double that of the standard index.
The attractiveness of sectors such as real estate, utilities and consumer staples is increasing as the Federal Reserve prepares to cut interest rates. The price performance of the Consumer Discretionary Select Sector SPDR Fund, which rose more than 7 per cent over the past 90 days, illustrates this trend.
The positive effect of interest rate cuts on cyclical stocks and small caps is easy to explain. Lower interest rates usually boost economic growth and consumer spending, which can be beneficial for cyclical sectors.
Small-cap companies in particular, which often include many cyclical stocks, can get a bigger boost from interest rate cuts. Smaller companies tend to have more debt on their balance sheets, making them more sensitive to interest rate changes.
In the period following the last interest rate cut of each cycle, the Russell 2000 rises an average of 36 percent over the next 12 months, with a cumulative return of 42 percent over the next 24 months, data from Global X ETFs show.
Six interest rate cuts are priced in by the end of 2025, according to data from the CME FedWatchTool. Traders cannot agree on the size of the interest rate cuts.
Historically attractive
Cyclical sectors, such as consumer goods and industrial companies, often benefit disproportionately from the economic acceleration caused by interest rate cuts.
However, those market dynamics depend more on the speed at which the Fed cuts interest rates, says Lizz Ann Sonders on chief strategist at Charles Schwab. She refers to analysis by Ned Davis Research, which shows that cyclical sectors often do best when the Fed enters a period of gradual interest rate cuts-as expected in this cycle. “Over time, however, the definitions of defensive and cyclical sectors have shifted,” said Sonders.
“For example, technology has historically been classified in the cyclical group, but in this Fed tightening cycle, large technology companies have taken on many characteristics of defensive companies. They have outperformed the market because of huge cash reserves that have protected them from higher borrowing costs,” said Sommers.
‘Stick to quality’
Still, there has been recent distrust among investors about the valuations of major US tech companies. Despite the current downturn, price-earnings ratios remain high. Microsoft is currently trading at 32 times its expected earnings for the next 12 months, down from its high of 35 in July, but still well above its average of 25 over the past decade.
According to Michael Mullaney, director of global market research at Boston Partners, the lower valuation of other market segments will therefore continue to attract investors in the time ahead. However, this does not mean that the tech sector will not continue to perform well, despite the boom in AI-related stocks such as Nvidia, which some compare to the dot-com bubble.
“The other 493 companies in the S&P 500 are significantly cheaper and are likely to attract investor interest. Incidentally, that does not mean we should throw out the baby with the bathwater,” said Mullaney. “The biggest stocks continue to generate money in a big way. That was different at the turn of the century.”
Investors looking to rotate into smallcaps are warned by Sonders that the universe of small stocks is vast, and not always top-quality. She advises investors to focus on high-quality companies, with the S&P Small Cap 600 index offering a better starting point than the Russell 2000.