The US equity rotation

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We have now seen the first signs of a rotation in US equities.

A trend of soft inflation prints has brought forward US rate cut expectations and the market is reacting. In the week following US June CPI print we saw:

• The Magnificent 7 down 7.3%,
• the S&P 500 Equal Weight Index outperform the S&P 500 Index by 4.2%, and
• the small cap Russell 2000 Index return 7.2%.

Counter to conventional wisdom, the higher rate environment acted as a tailwind for the US Tech mega caps who issued long-term debt at low interest rates in 2020/21 and benefitted from growing interest on their huge cash balances. It was US cyclicals, small/mid-caps, and value that were hardest hit by rising rates (due to shorter term debt on average and more reliance on debt financing in their capital structures).

In addition, the Fed easing increases the probability of a soft landing, which should favour cyclicals as the market – being forward looking – starts to price in what comes after the “landing” – the next cyclical acceleration.

Investors and active managers have generally upweighted their US allocation to Mega Caps since 2022 due to their growing index weights and, sometimes, performance chasing. Now may be the time for investors to revisit these allocations.

Source: Bloomberg. Since Bloomberg data available: March 2010 to July 2024. Past performance is not indicative of future performance of any index or ETF. You cannot invest directly in an index.

While the initial rally most favoured smaller sized indices (i.e. the Russell 2000) the market will likely turn its attention to the upcoming US earnings season and underlying fundamentals for the sustainability of any rotation. As a group, small caps are failing these tests, with lower capacity to service debt about 42% of the Russell 2000 posted a loss over the last 12 months¹. The Russell 2000 is currently trading at a 12 month forward P/E of 32.2x².

The Equal Weight Index stands well placed to benefit from a size rotation. The S&P 500 Equal Weight Index maintains the quality of the companies on the S&P 500, with expected earnings growth of close to 10% expected over the next year³, while its weighting mechanism favours cyclicals, smaller caps, and value.

We believe, with the US earning season on the horizon, its quality should be a key consideration when seeking an exposure to smaller stocks. All this while the S&P 500 Equal Weight Index’s fwd P/E is trading at close to a historical discount to the S&P 500’s.

Finally, we know that the S&P 500 Equal Weight Index has historically had its greatest periods of relative outperformance when concentration in the market capitalisation weighted S&P 500 Index is high and subsiding. For example, from August 2020 to December 2022 when the top 5 concentration in the S&P 500 fell by 5%, the S&P 500 Equal Weight Index outperformed the S&P 500 Index by 16%⁴.

Betashares offers the

For more information on the case for equal weighting US stocks please read our investment brochure here.

References:

1. Source: Bloomberg. “A $600 Billion Wall of Debt Looms Over Market’s Riskiest Stocks” ↑

2. Source: Bloomberg. As at 18 July 2024. ↑

3. Source: Bloomberg consensus estimates. As at 18 July 2024. ↑

4. Past performance is not an indicator of future performance. ↑