The 2-Year Treasury yield has dropped 80 basis points after peaking in October. That reflects the market pricing a Fed that’s shifting from fighting inflation to cutting rates to avoid a recession.
Fed pivots tend to be a positive for stocks as investors front run the stimulus from lower interest rates. They often drive big sector rotations as investors make bets on who the winners will be. [1]
In this Investment Radar we look at small-caps, that have broken out in recent weeks as the stock market rally has broadened out. While they could indeed come out on top, we believe that an equally-weighted Tech stock index like RSPT is a better bet.
Fed Pivots are a Catalyst for Attractive Valuations
We studied 16 episodes of Fed pivots going back to the 1960s, where the Fed either paused or cut interest rates following rate hikes:
- Stocks posted an average return of 7.3% in the following 6 months, outperforming the historical average of 4.4%
- Low valuations stocks outperformed, generating gains of 12% on average and outperforming the market by 3 pp.
We should take those results with a grain of salt, as it doesn’t mean that we should go buy everything that looks cheap:
- Some sectors stay “value traps” and never really recover [2]
- Value stocks have been consistently underperforming since the financial crisis
Instead, we think reasonable valuations but strong fundamentals are the way to go.
Small-Cap Stocks are Cheap, But for a Reason
With small-caps rising by 23% since end-October, outperforming the S&P 500, we’ve received questions from many members asking whether this move has legs.
After all, small-caps seem to be attempting to break out above the trading range they’ve been in for the last year-and-a-half.
Small-caps seem to be shifting their behavior:
- Between 2010 and 2020, small-caps’ performance was correlated to interest rates. As the economy showed strength, investors expected this to benefit smaller companies
- This changed post-Covid. Rising interest rates have been a headwind for small-caps as they’ve increased their cost of funding in a tougher economic environment
Today, it seems that small-caps are benefiting from falling interest rates, that’s allowing their valuations to expand once again.
Given that this move lower in yields could have room to run, it’s reasonable to ask whether small caps are due for a catch-up play. Let’s look at how they’re priced:
- Small-caps are now priced at a hefty 25% discount to the S&P 500 on a forward-P/E basis
- However, 40% of small-cap stocks are unprofitable companies
That means that small-cap stocks are cheap, but they’re cheap for a good reason.
When we compare small-cap stocks’ earnings against large-cap stocks’, we understand why they’re so much cheaper:
- Small-caps’ valuations could be due for a small catch-up today if rates continue moving lower. This could allow small-caps to outperform without a big improvement in fundamentals
- However, it’s hard for us to make a big bullish bet on small-caps without a catalyst driving an improvement in fundamentals. An example of one would be a sustained economic boom
- Small-caps would remain a “value trap” if we see the economy deteriorating
The technicals of small-cap stocks don’t look too favorable:
- The Russell 2000/S&P 500 ratio has rebounded in recent weeks as the market rally has broadened out, but it’s now reached downtrend resistance
- In the last 6 weeks we’ve seen one of the biggest surges in the ratio of the last nearly 25 years, that historically has marked tops in the Russell 2000/S&P 500 ratio
Chasing the rally in small-cap stocks today requires conviction that the macro backdrop will significantly improve next year for these mainly cyclical companies. [3] Cyclicals are particularly vulnerable to a deterioration of the economic environment.
Equal-Weighted S&P 500 Tech ETF (RSPT): An Easier Bet?
On the other hand, the Equal-Weighted S&P 500 Tech Stocks ETF (RSPT) looks like an easier bet to get right. For starters, the technical setup looks more favorable:
- RSPT has outperformed the S&P 500 significantly on the recent market rally, proving it could be a winner in the Fed pivot trade
- A basing head-and-shoulders pattern relative to the S&P 500 was recently broken
- The indicated target is hinting at RSPT gaining another 9% relative to the S&P 500
One advantage of betting on RSPT relates to its superior profitability. Operating profit margins for the average Tech company are nearly 2x as high as those of the small-cap index.
The higher margins of RSPT don’t come cheap. It trades at a 22x forward-P/E ratio. But that’s more reasonable than the regular S&P 500 tech index P/E of 27x. RSPT isn’t a value trade. It’s a calculated bet for us to have exposure to a broadening out of the stock market rally that could have more legs in this Fed pivot:
- Since the rally started in late-October, RSPT (23.4%) has outperformed the S&P 500 (15.8%), XLK (19.5%) and matched the Russell 2000’s performance (23.5%)
- That tells us that the market is rewarding ultra-value plays like the Russell 2000 as much as it’s rewarding more reasonably-priced quality plays like RSPT
Conclusion: Adding Equally-Weighted Tech Stocks (RSPT ETF) to Our Ratings
We’ll be adding RSPT to our asset ratings with a neutral score (5):
- We’re constructive on RSPT but acknowledge that price has already broken out relative to the S&P 500
- If the RSPT/S&P 500 ratio were to retest and hold at trendline support, we’d likely upgrade our rating to a 6 or 7
- A break below trendline support in that ratio would see us lose interest in this trade given the false breakout
- On a nominal basis, RSPT looks overextended in the near-term and it’s near key resistance like some of the major indices
- A rating of 5 makes us more favorable on RSPT than on regular Tech stocks like XLK, where we have a rating of 4
We’ll monitor how RSPT behaves at this resistance level and wait for a more favorable tactical entry, where we’d upgrade our rating.
While we see potential for RSPT to outperform in a continued broadening of a stock market rally, we remain generally cautious on stocks today given that their risk reward isn’t great:
- Since the October peak in 2-year Treasury yields, the S&P 500’s return has already exceeded the historical average seen in the 6 months following Fed pivots
- The opposite is true for Treasury bonds, that in our view offer more runway to the Fed pivot as they’re not vulnerable to a recession emerging in coming months
As we pointed in our last asset ratings post, the S&P 500/TLT ratio is reversing from a well-respected channel resistance level.
Footnotes:
[1] Sector rotations occur when investors shift their investment allocations in anticipation of a change in the economic regime. In this example, investors are betting on a broadening out of the stock market rally into other sectors that stand to benefit the most from the Fed cutting interest rates, as opposed to hiking them or leaving them at a high level.
[2] Value traps are stocks that are priced at relatively-low valuations due to poor fundamentals or a disadvantageous macro environment. However, they never see a positive catalyst that drives their valuations higher. As a result, they stay cheap forever, trapping many investors whose investment strategy relies on betting on low-valuation opportunities.
[3] Close to 50% of the small-caps’ universe is made up of traditional cyclicals like Financials, Industrials and Consumer Discretionary stocks.