Stocks opened mostly unchanged today after the S&P 500 hit yet another record high yesterday. Investors seemed to overlook the sticky inflation data, focusing instead on the upcoming economic updates.
The S&P 500 and the Dow Jones Industrial Average both ticked up slightly at the open, following Tuesday’s broad gains. The Nasdaq Composite, however, saw a small drop of about 0.2%.
Tuesday’s rally was fueled by continued optimism that the Federal Reserve might start reducing interest rates in the coming months, despite February’s core consumer inflation reading exceeding expectations.
This situation might lead Fed policymakers to proceed with caution regarding borrowing cost reductions at next week’s policy meeting. However, with the US economy performing better than Wall Street predictions, investors remain hopeful for the wholesale inflation and retail sales data set for release tomorrow.
Recent market gains have largely benefited the tech sector, but cyclical stocks have also seen favor. Yet, both technical and fundamental warning signs are emerging for stocks linked to the business cycle.
Over the past year, cyclicals have kept pace with growth stocks, with both segments seeing nearly a 25% increase since the market’s low point in late October. This is significantly better than defensive stocks, which have lagged behind. However, reaching overbought levels could spell trouble for cyclicals, historically speaking.
The fundamentals for cyclicals don’t look promising either. Despite the surge driven by improving macroeconomic indicators like PMIs, cyclicals might be overestimating the extent of economic expansion, making them susceptible to potential downturns.
Bank of America strategists suggest it’s premature to count on a sustained economic strength. They recommend an underweight stance on cyclicals compared to defensives, predicting a 15% underperformance as the economy decelerates. Their strategy favors defensive sectors like food and beverages and pharma, while advising caution towards cyclicals like banks and autos.
They argue that much of the positive news is already factored into current prices, and any sustained economic resilience could dampen hopes for rate cuts this year. “Even if the current macro sweet spot were to continue for a while longer, we think equity market upside is capped in the low-to-mid single digits for the year as a whole,” they comment.
Valuation levels, especially against defensives, are becoming stretched. Although analysts have raised estimates for cyclicals based on better economic data, their relative forward price-to-earnings ratio is significantly higher than the 10-year average. On a price-to-book basis, cyclicals are now at their most expensive compared to defensives in over a decade.
JPMorgan strategists also view cyclicals as “outright expensive” against defensives. They caution that the recent uptick and earnings rebound expectations for cyclicals might not materialize, citing potential weaknesses in business surveys over the coming quarters.
Despite some investors being tempted by signs of PMIs bottoming out, JPMorgan’s team views the data as mixed, with cyclicals not necessarily positioned to benefit from any potential improvement.
Industrials, construction, autos, and travel and leisure sectors have all seen significant gains in the past five months, with only technology outperforming them. Banks have matched the broader market’s performance, while commodity sectors are the only cyclicals in the negative.
In the potentially more volatile second quarter, consumer-related and defensive sectors might offer better value to portfolios, whereas cyclicals and sectors with high price-to-earnings ratios could face challenges.
In other words, high-flying tech is going to struggle opposite value names, which should do comparatively better. That changing of the guard might take a while (possibly even a few weeks) but it seems inevitable in the face of rising inflation – something the Fed did not anticipate going into March.
