Under the expectation of interest rate cuts, small-cap stocks in the U.S. are expected to take over the "crowded" trading of technology stocks?

The long-standing market dominance of large American technology stocks may be approaching a turning point. Historical data shows that against the backdrop of the Federal Reserve starting a rate-cutting cycle, market styles may shift, creating opportunities for lower-valued, relatively less traded small-cap stocks to take the lead.

Last Friday's weak U.S. employment data became a key catalyst, significantly raising market expectations for the Federal Reserve to initiate rate cuts. Currently, the market believes there is a 95% probability that the Federal Reserve will cut rates by 25 basis points at the September meeting, and it has almost fully priced in expectations for three rate cuts before January next year.

This shift in expectations was immediately reflected in market performance. Last Friday, as rate cut expectations heated up, the tech-heavy Nasdaq 100 index fell by 2%, while the S&P 500 index dropped by 1.6%. In contrast, the S&P 500 Equal Weight Index, which better reflects the performance of mid- and small-cap companies, only fell by 1%, demonstrating greater resilience.

Jefferies strategists believe that this may signal that the time has come for investors to rotate out of large technology stocks. This view is also supported by institutions like BCA Research, which has downgraded its rating on tech stocks to neutral and advised investors to lock in profits.

History Suggests Rate Cuts Favor Small-Cap Stocks

Jefferies strategist Andrew Greenebaum noted in a client report that the Federal Reserve's dovish turn often triggers a shift in market styles, and this time the backdrop is that the weight of technology stocks in the index has reached a record high.

Data compiled by Jefferies, dating back to 1990, shows that during periods of Federal Reserve rate cuts, the performance of the S&P 500 Equal Weight Index typically outperforms that of the traditional market-cap-weighted S&P 500 Index. In the last four rate-cutting cycles, the equal weight index outperformed the traditional index by an average of 0.6%, about 4%, and 12.5% over one, two, and four-year time frames, respectively.

Greenebaum wrote:

“We are not predicting a severe downturn or massive sell-off in tech stocks, but history shows that regardless of whether the benchmark index is rising or falling, a dovish Federal Reserve often stimulates a change in market style.”

He believes that the market is currently at a point of rotating out of large technology stocks. For him, this is more of a long-term view focused on value stocks and small-cap stocks likely to outperform the market in the coming years, rather than a short-term tactical judgment.

"Crowded" and Valuation Raise Alarm Bells

In addition to historical patterns, the "crowded" nature of trading and high valuations are two other major reasons strategists are bearish on the outlook for large technology stocks. This year, driven by the AI boom, the S&P 500 Information Technology sector has risen by 13%, far exceeding the S&P 500 index's 7.6% and the equal weight index's 4.9% gains, making tech stock trading exceptionally crowded.

Jefferies data shows that the top decile of stocks in the S&P 500 index, which have the highest valuations, has a projected price-to-earnings ratio of 36 times over the next two years, while the bottom decile of stocks, with the lowest valuations, has a median price-to-earnings ratio of only 10 times The valuation gap of up to 26 times between the two has reached the 87th percentile of historical data since 2009.

"Crowded tech stocks undoubtedly face greater downside risks," Greenebaum said.

BCA Research shares a similar view. The firm's Chief U.S. Equity Strategist Irene Tunkel wrote in a report this Monday:

"After a strong rally, it's time to trim winning positions to protect against downside risk."

She added that market pricing has become nearly perfect, and any bad news could disproportionately impact stock prices.

The fundamentals of tech stocks remain resilient

Despite the accumulating rotation risks, it is worth noting that the fundamentals of large tech companies remain strong.

According to media data, the communication and technology sectors have achieved the strongest earnings growth in this earnings season and are among the sectors with the largest earnings surprises.

Jefferies' Greenebaum also emphasized that his view does not predict a "massive sell-off" in tech stocks. This suggests that the potential market shift may manifest more as a style rotation, with funds flowing from overvalued leading sectors to other areas with more attractive valuations, rather than a systemic collapse of the overall market.

Risk Warning and Disclaimer

The market carries risks, and investments should be made cautiously. This article does not constitute personal investment advice and does not take into account the specific investment goals, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article align with their specific circumstances. Investing based on this is at one's own risk