Inside Markets — Cyclical Rotation

Cyclical/value stocks edge closer to inclusion in the momentum factor as the RTY/NDX Index ratio signals the potential for a more lasting cyclical rotation. The RTY/NDX ratio has been building a base in the 0.110-0.116 range for most of the year with Monday’s slight break to 0.117 catching our attention. Our conviction in a durable pro-cyclical rally will rise if the ratio can sustain current levels and extend in the days ahead.

The preference to own cyclically sensitive equity groups is partially driven by potential further Fed rate cuts and shift in the US policy dynamic. Most assume new policies will include some amount of tax relief, deregulation and a more business-friendly environment. To some extent, these pro-growth policies are expected to be offset by higher tariffs. Markets are now in the process of pricing in these potential policy changes, but it’s still very early. The impact of pro-growth policy changes could expand the business cycle by unlocking capex/capital deployment, increase deal activity and lead to significant productivity gains. These potential effects are being underpriced in our opinion, but so are the effects of increased tariffs that weigh more on larger US companies with international revenue exposure. The combined impact of these assumed policy changes should benefit cyclically-sensitive, domestically-focused companies that tend to be smaller in market cap. The RTY has underperformed the SPX by ~39 percentage points since mid-2021 and the S&P Midcap 400 (MID) has underperformed by ~19 percentage points. While the opportunity for a catch up trade seems greater for the RTY, we note that the index already trades at ~22x consensus forward EPS estimates (inline with the SPX), while MID trades at a more reasonable ~16x.

A durable lasting cyclical/SMID cap rotation will likely come from the most crowded large-cap stocks. Consider that the top 10 stocks in the SPX by market cap currently account for ~36% of the index and Magnificent 7 stocks account for 31%.