Ketu Desai
By Ketu Desai
The stock market turned upside down in July. There was a violent rotation in which investors aggressively sold secular winners (large cap tech, semiconductors, AI, weight-loss companies) in favor of the underperformers (small caps, regional banks, biotech, and real estate). It was a historic rotation. Small caps beat large caps over a seven-day period by the widest margin since 1986. By many metrics it was a 99th percentile move. The rotation began when we got a weaker than expected CPI. The cooler inflation data increased the likelihood that the Fed would cut rates.
The market has priced in over a 95% chance that the Fed will cut rates in September. The underperformers not only benefited from lower rates, but also from the shift in Presidential odds. Positioning among the secular winners was stretched. The Nasdaq relative to the Russell 2000 reached record levels, higher than the dot.com bust. Much of the rotation had to do with technical and positioning factors. Unwind of the Yen carry trade was an important contributor. Hedge funds de-grossed to levels similar to many market bottoms.
The question over the coming weeks will be what the stock market leadership will be. We have three potential options. The first option is what it has been for the better part of the last two-years, large cap tech, semiconductors, AI related names, and weight-loss companies. These are the best companies in the world. They are at the heart of major secular themes, they have the best balance sheets, highest cash flow generation, the best margins, are not sensitive to rates, and have the largest buybacks. They will benefit the most from the trillions that will come into the market as FOMO starts to hit those sitting in cash. With significant geopolitical and election uncertainty around the globe, money will flow for the best.
The counter to this is that they are full in terms of valuation and positioning. While they will continue to have strong earnings growth, the growth will decelerate. Sentiment has also turned on these names. In previous quarters, the market was excited about investments related to AI, now it is questioning the return. It is likely that this will be an overhang for the time being. After a huge run, decelerating growth, and full positioning, they might be in for a period of consolidation.
Another option is the continued revival of the laggards. This includes small caps, biotech, regional banks, and real estate. Sentiment and positioning in these areas is very low. Short positioning in the Russell 2000 is higher than it was during the COVID lows. Small caps trade at nearly 30% discount to large caps. Not only are they cheap, their earnings are also expected to increase. By the fourth quarter, small caps will outgrow large caps, growing north of 20%. These are also the areas that are most likely to benefit from rate cuts. Nearly 50% of small cap debt is either floating rate or short-term. Nearly 75% of large cap debt is long-term fixed. This allows small caps to disproportionately benefit from rate cuts. The combination of rate cuts, accelerating earnings, and high short positioning will likely lead to at least short-term outperformance from the laggards.
The final option is large-cap value stocks. This includes financials, industrials, healthcare, and utilities. These sectors make up a large part of the S&P 493. Among these, financials are particularly attractive. With the Fed on the verge of cutting, we are seeing the yield curve dis-invert. A positively sloped yield curve will mean that net interest income (NII) has bottomed out for banks. Lower rates should also start to open up capital markets. A softer regulatory environment, including modifications to Basel III Endgame is a further catalyst. The combination of higher NII, de-regulation, and the return of capital markets will drive upward earnings revisions. They trade at just 12.2x cash flow, a 32% discount to the S&P. It is likely that we are in the process of re-rating banks, leading to multiple expansion.
Financials are the third best performing sector for the year, despite negative flows. From a technical perspective, financials appear to be breaking out of a multi-year base. The charts show a bullish cup-and-handle formation. With positive earnings revisions, low positioning, and bullish technicals, financials appear to be taking on a leadership role.
Looking forward, the market will focus on earnings, the economic data, the election, and the Fed’s Jackson Hole meeting.
Ketu Desai is the Principal of i-squared Wealth Management Inc. (www.isquaredwealth.com), an investment management firm based in New Jersey. ketu@isquaredwealth.com
