Inside Markets — Rotation

Fund flows should be supportive for equities into year end with a wide open buyback window doing most of the heavy lifting. The certainty of election results on Wednesday resulted in a sharp decline in implied equity volatility, which is still driving multiples higher albeit at a slower pace. The VIX Index has pulled back from elevated levels near 22 last Monday to its YTD average near 15 and the MOVE Index (bond market volatility) fell 27% into Friday’s close. In our opinion, the next phase for equity markets is a pro-cyclical rotation that favors small/mid-sized companies over mega-cap Tech. Coming into the election, we noted how a non-trivial percentage of ISM manufacturing survey respondents cited the event as a reason for deferring capex decisions. Coming out of the election, market participants see pro-cyclical policies adding fuel to a surge in capex and potential M&A activity. In the near-term, we expect the S&P Midcap 400 Index (MID), Rusell 2000 (RTY) and equal weight S&P (SPW) will outperform the SPX and Nasdaq 100 (NDX).

The RTY has underperformed the SPX by ~22 percentage points over the last two years. On the surface, a potential catch-up trade in the RTY offers a compelling investment opportunity but with a significant number of unprofitable companies, the RTY already trades at a ~22.5x forward multiple vs. the SPX at ~21.5x. The S&P Midcap 400 (MID) is a more compelling catch up trade given ~19 percentage points of relative underperformance, has similar cyclical exposure as the RTY and trades at a more reasonable ~15.5x forward estimates.

Financials: The Financials sector should benefit most from: 1) a steepening yield curve; 2) potential M&A and 3) deregulation. Even after last week’s move, valuation levels (P/TBV) in regional banks are still ~20% below levels from the spring of 2023 (pre-SIVB).

The ‘Trump trade’ looks far from exhausted if you use the 2015 experience as a template. But in 2015/2016, ten-year bond yields were below 2% vs. today’s starting point of ~4.30% and the fiscal deficit was less than half what it is now. In the current environment, we’d expect 10-year yields >5% (last year’s high) to become a headwind for the post-election equity outlook. Core CPI on Wednesday and retail sales on Friday will have an impact on bond yields.