U.S. economic soft landing + easing expectations = style rotation? Mid-small cap returns to market focus, interpreting the main upward wave of the "post-giant era."

According to the Zhitong Finance APP, Wall Street financial giant Bank of America recently released a research report stating that as the market becomes increasingly cautious about investing in the seven major technology giants in the U.S. stock market (the so-called Magnificent Seven) which are at historically high valuations, coupled with recent economic data indicating that a "soft landing" for the U.S. economy is approaching, and that futures market traders are betting on the Federal Reserve possibly cutting interest rates twice starting in September this year, a structural opportunity is emerging for small-cap stocks (especially micro-cap stocks). However, it is necessary to focus on high-quality factors and low-risk factors to hedge against economic downturn risks, while avoiding high-leverage consumer stocks and high-risk technology stocks that have not yet achieved breakeven among small-cap stocks.

Currently, the U.S. capital market presents a pattern of "overvalued large caps and undervalued small companies": a few technology giants have high valuations while most stocks remain not overheated. With the improvement of the macro environment and expectations of a turning point in monetary policy easing, investors are beginning to prepare for a potential style rotation, shifting from the hot seven technology giants to undervalued small-cap stocks with strong fundamentals that have long been overlooked.

The so-called "Magnificent Seven," which occupy a significant weight (about 35%) in the S&P 500 Index and the Nasdaq 100 Index, includes Apple, Microsoft, Google, Tesla, Nvidia, Amazon, and Facebook's parent company Meta Platforms. They are the core driving force behind the S&P 500 Index's continuous record highs.

Looking at the entire U.S. stock market, the seven technology giants have been the strongest engine driving the entire market since 2023. They attract global capital with their strong market advantages, robust fundamentals, consistently strong free cash flow reserves over the years, and expanding stock buyback programs, thanks to the incredibly strong revenue brought by AI. However, the historically high valuations of these seven giants have made Wall Street increasingly cautious—six of the seven technology giants are expected to have price-to-earnings ratios far exceeding 25x, which is the valuation of the S&P 500 Index, while the benchmark for the U.S. stock market—the S&P 500 Index—is also at historically high levels.

Barry Bannister, the chief equity strategist at Stifel who accurately predicted the bull market in U.S. stocks from 2023 to 2024, warns investors not to be overly confident in the current rally. The current U.S. stock valuations are near historical highs, and although the U.S. economy is expected to achieve a "soft landing," the growth rate may significantly slow compared to last year, making a significant correction in the S&P 500 Index highly likely. This strategist predicts that despite the substantial rise in the U.S. stock market since the sharp decline in April, a sell-off may occur in the second half of 2025. Bannister sets the year-end target for the S&P 500 Index at 5,500 points (the lowest target on Wall Street), which implies that the benchmark index will decline by about 15% from current levels. Strategists from Evercore ISI also expect the U.S. stock market may decline by 15% in the second half of the year.

Bannister stated, in the short term, he is most optimistic about defensive value stocks, while from a long-term investment perspective of around 10 years, he prefers value stocks, small-cap stocks, and international stocks. "These diversified trades provide variety for a market concentrated in technology stocks. Currently, the market is overly focused on technology stocks, but it is difficult to rely solely on seven stocks to run an economy," Banister stated in the research report.

Bank of America strategists indicated in their report that the recent rebound led by microcap stocks in the small-cap sector is not coincidental, but rather a prelude to a return to value within the market. Since the second quarter, the U.S. stock market has seen an unexpected leader: microcap stocks within the small-cap sector have performed strongly. According to Bank of America's latest report, the Russell Microcap Index has risen approximately 22% since the beginning of the second quarter of 2025, significantly outperforming large-cap indices (Russell 1000/S&P 500 up +14%/+13% during the same period) and the overall small-cap index (Russell 2000 up about +12%, mid-cap Russell Midcap up about +11%). This reversal was not visible in the first quarter—when microcap stocks significantly lagged—but starting in the second quarter, the style dramatically changed, with small-cap stocks suddenly leading.

Bank of America analysis pointed out that the recent strong rebound of risk-oriented small-cap stocks is mainly driven by "low-quality stocks catching up" and short covering, accompanied by certain extreme style rotation characteristics: high-risk, high-volatility stocks surged, while fundamentally sound quality stocks lagged relatively. This is closely related to the recent market environment—improving economic prospects have increased investor risk appetite, and the nearing end of the Federal Reserve's tightening has triggered bets on interest rate cuts. However, the Bank of America report also warns that this low-quality trend is usually short-lived: as fundamental factors return to dominance, the market focus will shift back to high-quality small-cap value stocks. Looking ahead, in the context of high valuations for the "seven giants" in technology, a soft landing for the economy, and the Federal Reserve likely entering a rate-cutting cycle, high-quality small-cap stocks are expected to become the new focus of the global stock market.

The post-giant era has arrived, presenting historical investment opportunities in small-cap stocks from the perspective of Bank of America strategists.

In short, the Bank of America strategy team believes that small-cap stocks have a stronger "spring effect": the lower they are pressed initially, the greater the rebound potential later. Bank of America's long-term forecast indicates that small-cap stocks are expected to outperform the large-cap stocks dominated by the seven giants in annualized returns over the next decade. If the U.S. economy avoids recession and interest rates enter a downward channel in the next 12-24 months, then as the market enters the "post-giant era" (where the rally of large-cap stocks dominated by the seven giants gradually gives way to high-quality emerging forces in small-cap stocks), small-cap stocks may experience a "double rise" in profits and valuations, with cumulative excess returns expected to significantly exceed those of large-cap stocks.

The low-quality rebound and short-covering driven market: The Bank of America report pointed out that the small-cap sector, especially high-risk sub-sectors, has largely led the market since the second quarter due to a "risk appetite recovery" trend. Specifically, high volatility and high beta risk factors have performed best among small-cap stocks. For example, in June of this year, within the Russell 2000 Index, high-volatility stocks led the pack, while stocks with high operating profit margins surprisingly fell to the bottom; similarly, in mid-cap stocks, the "high beta factor" dominated, while the momentum stocks that had the highest gains over the past 12 months suddenly lost their leading position This indicates a sharp switch in investment styles: previously underperforming low-quality "junk stocks" are experiencing a rebound, while past winners and high-quality stocks are relatively lagging.

Bank of America stated that the drivers behind this extreme rotation include: a decrease in macro uncertainty (with trade agreements between China and the U.S., the U.S. and Japan, and the U.S. and Europe being reached, and fiscal policies becoming clearer), a temporary easing of geopolitical risks in Israel and Palestine, and an increase in investor risk appetite. At the same time, short covering has become a catalyst for soaring stock prices—Bank of America pointed out that the stocks with the highest short ratios among small-cap stocks in the second quarter saw the largest gains. Recently, the market has even seen a resurgence of the meme stock craze similar to that of 2021: some fundamentally problematic stocks have surged due to retail speculation and short covering. This speculative atmosphere has further amplified the short-term performance of low-quality stocks.

Reflecting on the sustainability of the market: Bank of America’s strategist team holds a cautious attitude towards this round of small-cap rebound led by low-quality factors. They emphasize that the low-quality trend within small-cap stocks often proves difficult to sustain. Historically, low-quality companies occasionally lead the market for short periods, but most of these instances are brief, and the market ultimately returns to being driven by fundamentals.

Bank of America’s analysis of data from the past few decades shows that high-quality factors (such as profitability and stable growth) are one of the most important factors for generating excess returns in small-cap stocks over the long term, while the relative performance of low-quality stocks will eventually revert to align with fundamentals. Only in very rare cases (such as during recovery periods after major crises) does the leading advantage of low-quality stocks last slightly longer (about 1 to 1.5 years), as seen after the 2009 financial crisis and the early 2020 pandemic. The current market context is not one of post-disaster reconstruction or recovery waves after a financial crisis, so Bank of America judges that this recent low-quality rebound is more likely to be short-lived.

At the same time, regarding the short covering factor driving the market, Bank of America’s short analysis indicates that the current small-cap short covering trend may be nearing its end: compared to similar short squeezes after the pandemic, the current intensity and duration of short covering are approaching historical averages, and many heavily shorted small-cap stocks will report earnings in the next two weeks, which will cool the speculative heat due to fundamental catalysts. In short, Bank of America expects the "storytelling" phase in the small-cap market to fully give way to the "performance" phase, where high-quality small-cap stocks are likely to usher in historically significant investment opportunities. From the perspective of factors, in the second quarter, the momentum and quality factors in small-cap stocks temporarily failed, while the risk factor stood out. However, this abnormal situation is not expected to last long. As the speculative frenzy subsides, Bank of America expects the quantum factor to refocus on fundamental trends: genuinely performing small and mid-cap stocks are likely to become the new momentum leaders. The quality factor is expected to return to its long-term performance position—once the market regains rationality, the stock prices of financially healthy and stable-earning companies should have stronger upward momentum. In contrast, high-risk factors (such as high leverage and high volatility) are accumulating withdrawal risks after experiencing significant gains. Bank of America strategists anticipate that the small and mid-cap market will shift from a "low-quality leadership" phase to a new stage of "high-quality steady growth," and investors should prepare for this transition in advance.

Comparative Advantages of Small and Mid-Cap vs. Large-Cap Stocks

The Bank of America strategy team states that under current market conditions, small and mid-cap stocks exhibit multiple comparative advantages over large-cap stocks. First, small and mid-cap stocks are undoubtedly more attractive in terms of valuation. After nearly two years of significant adjustments, the expected price-to-earnings ratio of the small-cap benchmark—the Russell 2000 index—has returned to below historical averages at around 15x. In contrast, the expected valuation of the S&P 500 index (especially among its tech giants) remains near historical highs at around 25x. Some super giants like Tesla and Palantir have even reached price-to-earnings ratios of dozens or even hundreds of times, overextending future growth expectations. Lower valuations mean that small and mid-cap stocks have greater upside potential; once fundamentals improve, as long as performance meets expectations, there is ample room for valuation recovery. Conversely, the higher the valuation of large-cap stocks, the more exceptionally bright and far-exceeding expected performance is needed to support their expensive valuations.

Margin of Safety: Since the beginning of this year, funds and attention have been overly concentrated on a few large tech stocks, leading to relatively conservative pricing of small and mid-cap stocks. The Bank of America strategy team notes that many small-cap stock prices are still close to their lows in recent years, and investor sentiment is relatively cold, reflecting a pessimistic outlook. The low expectation threshold itself is an advantage: even a slight positive can drive significant rebounds in stock prices. In contrast, large-cap investors are highly crowded; once there is a disturbance (such as performance not meeting expectations or regulatory tightening), these stocks may experience severe volatility due to concentrated holdings. In comparison, the downside risk of small and mid-cap stocks is relatively limited, as their valuations and holdings are not significantly inflated, providing investors with a certain safety cushion.

Market Attention and Structure: As mentioned earlier, the current U.S. stock market exhibits an "extreme 1-9 polarization"—seven major tech giants dominate, while other stocks are ignored. This imbalance is unsustainable. The Bank of America strategy team states that historical experience shows that the market will ultimately seek breadth improvement. As the valuations of the giants become too high, funds are motivated to seek new areas with high cost-performance ratios, and high-quality small and mid-cap stocks provide such opportunities. Once more investors begin to refocus on small and mid-cap stocks, these stocks are likely to experience a "double rise" in valuation and liquidity. In particular, some overlooked high-quality small-cap companies have the potential to attract incremental funds through fundamental catalysts (such as improved earnings, industry turning points, etc.), leading to a "Davis Double" market trend The restart of the Federal Reserve's interest rate cut cycle is first favorable for small-cap stocks. If the Federal Reserve officially begins its interest rate cut cycle and the U.S. economy demonstrates strong resilience to achieve a "soft landing," the upward momentum of U.S. stocks is likely to continue rotating to those small and mid-cap stocks that have suffered long-term price declines since 2022, which, from an investment theory perspective, are extremely sensitive to interest rate expectations. Even a slight rate cut is expected to improve their battered prices and valuations, especially for high-quality small and mid-cap stocks supported by performance.

Bank of America strategists stated that under the macro backdrop of the Federal Reserve starting to cut interest rates, small-cap stocks may significantly outperform the seven major tech giants in U.S. stocks and the broader large-cap stocks. The main logic is that small-cap stocks are often very sensitive to the benchmark interest rates set by the Federal Reserve; they heavily rely on floating-rate loans. Therefore, in the context of the Federal Reserve's interest rate cuts, this means that their long-standing debt pressure will be greatly reduced, which is expected to enhance profit margins and stock valuations