Will investors keep shifting from US mega caps to value, small caps and everything else?

As US reporting season heats up, some are seeing it as a key test for rotation trade — investors switching from mega-caps to everything else.

Will US investors keep moving from mega-caps? Picture: Spencer Platt/Getty Images via AFP

Will investors keep shifting from US mega-caps to value, small caps and everything else?

US tech giants linked to the AI boom account for most of the rise in the US stock market this year.

But, after benign US inflation data sparked a significant repositioning in stocks more leveraged to interest rate cuts and economic growth, investors are wondering how long it will last.

As the US quarterly reporting season heats up this week, some see it as a key test for the rotation trade — which also helped lift Australia’s underperforming share market up to a record high of 8037.30 points.

“The thing that we’re most interested to get colour on is whether earnings dynamics will give US equity investors a reason to continue the rotation that appeared to begin yet again last week away from Growth, large, and mega-cap, to value, small cap, and everything else,” says RBC’s head of Global Equity Strategy Research Lori Calvasina.

Valuations and positioning have “set the stage for an eventual rotation to new leadership” but “this has been true for quite some time, and we’ve had several false starts”, she cautions.

Greater confidence around Fed cuts coming soon clearly helps to make the case for moving back into small caps after US disinflation got back on track last week.

But, other fundamentals apart from inflation “need to co-operate”.

Ms Calvasina says a problem the “rotation trade” has had in recent years is where large caps and growth options seem to catch a tailwind when US economic growth is trending below average, small caps and value equities seem to catch a tailwind when growth is trending above average.

“With US economic growth expected to dip into below-average territory in coming quarters, and concerns about the consumer increasing, we’ve been a little wary of the idea that now is the precise time to look for the rotation trade to finally get underway in a sustainable way,” Ms Calvasina says.

But, aside from an economy and consumer in the US which turn out to be more resilient than anticipated — and something commentary from management teams will help investors get a handle on — earnings are another source of potential fuel for the rotation trade.

After reviewing the US earnings-related statistics last week, Calvasina says a few of them were pointing to some emerging support for a rotation back into small caps.

Consensus revenue and net income growth forecasts for the Russell 2000 were “baking in a strong recovery in late 2024, in which the small caps index gets close to catching up to the S&P 500”.

And the rate of upward EPS estimate revisions on the sell-side for the Russell 2000 was “starting to move back to parity with the same stat for the S&P 500”.

This gauge of earnings sentiment was stronger for the S&P 500 for most of 2023, aside from the final few months of the year when the Russell 2000 briefly got back to parity with the S&P 500.

“While small caps are starting to make a case for themselves over large caps from an earnings perspective, it’s just not as clear to us that that is happening in value relative to growth,” Ms Calvasaina adds.

“To be sure, within the S&P 500 the rate of upward revisions for the top 10 names appears to be peaking relative to the rest of the index, suggesting that the earnings dominance of the biggest names by market cap is fading a bit.

The Magnificent Seven has far outpaced — and buoyed — the broader US market. Picture: Chris Delmas/AFP

“When we look at growth and value more broadly, however, we continue to see stronger earnings revision trends in the former than the latter within both the Russell 1000 and the Russell 2000.”

Of course it makes sense from a risk management point of view to take some off the top of the Magnificent Seven.

The group of AI beneficiaries had soared 43 per cent for the year to date and fell 3.9 per cent after US CPI data came in below expectations last week. Nvidia alone was up 177 per cent.

The Magnificent Seven stocks — Amazon, Alphabet, Apple, Meta, Microsoft, Nvidia and Tesla — account for 60 per cent of the 18 per cent year-to-date rise in the S&P 500.

Only 24 per cent of S&P 500 stocks outperformed the index in the first half of the year.

It was the third-narrowest performance in a six-month period since 1986, according to Wilsons Advisory strategist David Cassidy. The equal weighted S&P 500 — a proxy for the average stock — rose only 5 per cent this year.

The tech sector’s strong performance over the past year has undoubtedly been driven by AI momentum and bullishness towards both cyclic and structural growth prospects for large cap tech, but its performance is also grounded in the sector’s robust earnings growth over the past 12 months, which has outpaced the broader market.

In the first quarter, Magnificent Seven earnings rose 51.8 per cent on-year versus just 1.3 per cent for the rest of the S&P 500.

“Rising earnings expectations have enabled markets to continue trending higher despite crowded positioning, especially in tech,” Cassidy says.

“Since tech companies began reporting last quarter, forward-looking earnings expectations have increased materially, with prices moving higher in lock-step. Ultimately, the high expectations leave little room for disappointment. With Q2 earnings season now underway, we need to see these strong earnings growth numbers delivered in order to sustain the current rally.”

RBC’s Calvasina remains worried about a pullback in the S&P 500 given the latest developments on her sentiment and positioning indicators, but concedes the timing “seems a bit more complicated due to last week’s CPI print and surge in optimism on Fed cuts”.

“The one big, general worry that we do have about reporting season is the possibility that last week’s negative June CPI print may be signalling some late-quarter weakness on both revenues and pricing power,” she adds.

“The work we’ve done building our earnings model over the years has indicated to us that S&P 500 revenues and CPI tend to be positively and highly correlated. We will be looking for colour on this issue in the weeks ahead, along with the usual macro topics that we monitor in our reading.”