The recent market dynamics have been quite perplexing, with small-cap stocks making a comeback while mega-cap tech stocks seem to be faltering. This shift in performance has led many to believe that a rotation trade is underway, signaling potential gains for the S & P 500 as the market diversifies beyond the artificial intelligence sector.
However, according to Sam Stovall, chief investment strategist at CFRA Research, this rotation trade may not be enough to prevent a double-digit correction in the S & P 500. Stovall’s skepticism stems from the overbought nature of large-cap tech stocks, which are trading at a significant premium compared to arrived at by the S & P 500 average price-to-earnings ratio.
Stovall pointed out that while the S & P 500 is already trading at a 37% premium, tech stocks are trading at a whopping 75% premium. This suggests that large-cap tech stocks are significantly overvalued, posing a risk to the overall market stability. Additionally, the relative strength of cap-weighted tech stocks compared to the equal-weighted sector has reached levels not seen since 2000, indicating an unsustainable situation.
Moreover, Stovall expressed doubts that small- and mid-cap stocks would have the capacity to offset the potential losses from a decline in large-cap tech stocks. Given that large caps make up over 92% of the total U.S. stock market value, while small- and mid-caps represent a mere 8%, a significant downturn in large caps could have severe repercussions on the market as a whole.
In light of these concerns, Stovall advised investors to tread carefully. While the ideal scenario would involve small- and mid-cap stocks outperforming large caps, investors should be prepared for a possible market correction. Stovall recommended selling overvalued large-cap stocks and reallocating investments into attractive mid- and small-cap stocks or ETFs. However, he cautioned against going all in, as a declining market environment typically leaves no safe haven for investors.
While a rotation trade may seem promising on the surface, it is important to consider the underlying risks and vulnerabilities in the current market. Investors should exercise caution and be mindful of the potential for a significant correction, particularly in the overvalued large-cap tech sector. By adopting a prudent investment strategy and diversifying their portfolios, investors can better position themselves to weather any potential market turbulence.