JF: Fed Rate Cut May Reshape US Stock Market Small-Cap Stocks Have Potential to Outperform Large Tech Stocks

Investment bank Jefferies said that as the Federal Reserve approaches a rate cut, the US stock market may see a shift in the pattern with small-cap stocks outperforming large-cap tech stocks. Jefferies' Senior Vice President of Stock Research Product Management, Andrew Greenebaum, pointed out that data since 1990 shows that during periods of Federal Reserve rate cuts, the performance of the S&P 500 equal-weighted index outperforms the market-cap-weighted S&P 500 index. Specifically, data compiled by Jefferies shows that in the past four rate-cut cycles, the S&P 500 equal-weighted index has outperformed the S&P 500 index by an average of 0.6% over a one-year period, about 4% over a two-year period, and an average of 12.5% over a four-year period. Andrew Greenebaum stated that the potential rate cut by the Federal Reserve comes after a period of "overcrowded" trading which has driven the weight of tech stocks in the S&P 500 to new highs. He added, "We are not suggesting that tech stocks will see a significant decline or experience sharp sell-offs, but dovish moves by the Fed often lead to changes in market dynamics, regardless of whether the overall index is high or low. Therefore, if the nonfarm payroll data from last Friday tells us anything, it's that now might be the time to start pulling money out of large-cap tech stocks." According to Andrew Greenebaum, this is less of a tactical judgment and more of a long-term view that value stocks and small-cap stocks usually outperform the market over the course of several years. Data shows that so far this year, tech stocks have continued to outperform, with the information technology sector of the S&P 500 rising by 13% driven by optimism in artificial intelligence. In comparison, the overall S&P 500 has risen by 7.6%, while the S&P 500 equal-weighted index has only risen by 4.9%. However, this market pattern may change due to the employment data released last Friday. The data shows that the US added only 73,000 nonfarm jobs in July, far below market expectations, and the job gains for May and June were also revised downward significantly. Signs of softening in the job market have led to an increase in expectations for a Federal Reserve rate cut. Fed funds rate futures indicate a 95% probability of a 25 basis point rate cut at the September policy meeting, and the market has almost fully priced in the possibility of three rate cuts by the Fed by the end of January next year. The reaction of the US stock market to this data and the resulting change in interest rate expectations indicates that even in a market downturn, small-cap stocks may perform better. Last Friday, the Nasdaq 100 index fell by 2%, while the S&P 500 index fell by 1.6%. In comparison, the S&P 500 equal-weighted index fell by 1%. Jefferies' strategists also pointed out that another reason for small-cap stocks outperforming large-caps is that their trading is less crowded and their valuations are lower compared to large companies. The median price-to-earnings ratio of the top 10% of stocks in the S&P 500 index is currently 36 times, while the bottom 10% has a median PE ratio of 10 times. The difference of 26 times between these two levels is at the 87th percentile level since 2009. Andrew Greenebaum stated, "For overcrowded tech stocks, there is indeed more downside risk." BCA Research echoed Jefferies' views on Monday by downgrading their rating on tech stocks to "neutral." Irene Tunkel, the company's Chief Equity Strategist, said in a report, "It is time to trim profit positions and control downside risk after a strong rally." She added that the current market is priced based on "perfect expectations," and any bad news may disproportionately impact performance. Of course, the fundamentals of large-cap tech stocks remain strong. Data shows that the communication and tech sectors currently have the strongest earnings growth performance, and have achieved the most significant earnings beats in this earnings season.