Investors are increasingly convinced that the cyclical and Great Rotation trade is very real and long-lasting (see Everything you need to know about the Great Rotation but were afraid to ask). That should be bullish for the S&P 500, right?
Well, sort of.
Despite the cyclical and reflationary tailwinds for stocks, the S&P 500 has a weighting problem. About 44% of its weight is concentrated in Big Tech (technology, communication services, and Amazon). The top five sectors comprise nearly 70% of index weight, and it would be difficult for the index to meaningfully advance without the participation of a majority of these sectors. However, an analysis of the relative performance of the top five sectors does not exactly inspire confidence as to the sustainability of an advance. Technology relative strength, which is the biggest sector, is rolling over. Healthcare is weak. Neither consumer discretionary nor communication services are showing any signs of leadership. Only financial stocks, which represent the smallest of the top five sectors, is exhibiting some emerging relative strength.
There are better investment opportunities, and investors can potentially outperform by a cumulative 50-250% over the next 2-3 years.
The Great Rotation Risk-On trade is very real
I believe the cyclical rebound and Great Rotation is long-lasting. First, there is ample evidence that the global economy is reflating. The copper/gold ratio and the more broadly based base metals/gold ratio are both surging, indicating cyclical strength.
Earnings sentiment is improving in every region of the world.
Over in Asia, the closely watched and highly timely 20-day South Korean export figure jumped in November, indicating an acceleration in global strength.
An analysis of fast-money positioning shows that hedge funds went into the November election underweight equity market exposure. When the dire forecasts of a contested election and riots in the streets didn’t materialize, they reversed course and bought equities. Current positioning is not excessive. Institutional fund flows, which is glacial but enormous, is only beginning to buy into the cyclical and reflation theme.
This Great Rotation rally has legs.
What’s the upside potential?
What are the potential gains from the Great Rotation trade?
An analysis of the trade setup indicates that upside potential is significant. Historically, relative style performance such as value/growth is long-lasting and the magnitude of gains significant when the dispersion in style returns are large and begin to mean revert.
A similar reversal effect can be seen for the size effect, or the small vs. large-cap relationship.
Marketwatch reported that Jim Paulsen of Leuthold and Ed Yardeni believe that small and mid-cap stocks are relatively cheap, and exhibit superior fundamental momentum compared to large caps.
Smidcaps are relatively cheap
This reflects the fact that they’ve been persistently unpopular, despite the recent gains. “Their price action has not kept up with earnings performance,” says Paulsen. Since the end of October, forward one-year estimates for the S&P 600 small-caps have gone up almost 8%, compared to 1.5% for the S&P 500.
In other words, earnings estimates have gone up over four times as much, but stock prices have only gone up twice as much.
From their lows during May-June, the forward earnings of the S&P 500 grew 17%, compared to 35% for the S&P 400 smidcap stocks and 57% for S&P 600 small-caps, according to Ed Yardeni of Yardeni Research.
As of Nov. 24, large-cap S&P 500 stocks had a forward price earnings ratio of 22 compared to 19.7 for S&P 400 midcap stocks and 19.9 for S&P 600 small-cap stocks, says Yardeni. But the gap is effectively wider, given the greater potential for earnings growth among smidcaps going forward.
The bottom line: small-cap stocks have additional catch-up potential.
Here are the main takeaways from this analysis.
- Relative Return Magnitude Potential: The dot-com experience saw the DJIA/NASDAQ 100 plunge and mean revert to a level just above the spot when the ratio began to accelerate downwards, indicating the start of an investing mania. The magnitude of the current episode of downward acceleration was not as severe, and therefore the snapback should be less than the dot-com era.
- Cyclical trade: One rough measure of the cyclical trade is the Dow (old economy) to NASDAQ 100 (new economy) ratio. The aforementioned estimate technique of upside relative performance potential is 50-60%. If history is any guide, that relative return potential should be achieved within a 2-3 year time frame.
- Size Effect, or Small Caps: Large caps have been beating small caps for much of the last market cycle. Based on the same evidence, the upside potential is 60-70% over 2-3 years.
- Non-US stocks: US stocks have led the market upward since the GFC. There is ample evidence that global leadership is changing. However, it is difficult to estimate the magnitude of the potential relative rebound as there were two plateaus and subsequent downward declines in this cycle. If US to non-US stock relative performance were to recover to the first target level, it would translate to a relative gain of 100%. If it were to bounce back to the higher target, the potential relative gain can be as much as 250%.