Jefferies: Fed cuts could cause 'significant' rotation from large tech to small caps

U.S. stocks may soon be approaching a paradigm shift, as investors begin rotating out of the largest tech names and into cheaper segments of the market, such as small caps and value stocks. The catalyst for this shift could be an interest rate cut by the Fed. Similar rotations have occurred in past easing cycles and could repeat now, investment bank Jefferies warned.

"We aren’t trying to argue for a significant downturn, or a massive selloff in tech, but a dovish Fed has tended to provoke regime change whether the overall benchmark is higher or lower," according to Andrew Greenebaum, senior vice president of equity research product management at Jefferies, who was quoted by Bloomberg. "So, if Friday’s payrolls told us anything, it’s that the time to start rotating out of large cap tech may finally be upon us." 

In the view of Greenebaum, it’s less of a tactical call and more of a longer-term view that value and smaller-cap stocks tend to outperform for multiple years. The data going back to 1990 shows: the S&P 500 Equal Weighted Index outperformed the traditional market-cap weighted version of the benchmark when the Fed is reducing interest rates, the Jefferies strategist calculated. 

An additional argument in favor of small-cap outperformance is that small caps are less crowded and cheaper. The most expensive decile of S&P 500 constituents is currently trading at 36 times projected profits in the next two years, compared with a median valuation multiple of 10 for the cheapest cohort. The spread between the two has reached 26, hovering in the 87th percentile of observations going back to 2009. "It’s fair that there are more downside risks for crowded tech stocks," Greenebaum said.

BCA Research backs Jefferies' assessment, having yesterday downgraded technology stocks to "neutral" so as to take profit. "Time to trim winners after a strong run and protect the downside," Irene Tunkel, chief U.S. equity strategist at BCA, wrote to clients. Current prices are based on a "perfection" scenario, so bad news could have a "disproportionate impact" on performance, she said.

So far, it has been a year of tech outperformance, Bloomberg notes, with the IT group in the S&P 500 gaining 13% year to date on optimism around AI. The broader S&P 500 has posted a 7.6% gain, beating the equal-weighted gauge’s 4.9% rise.

According to Bloomberg data, fed funds futures are pricing in a 95% probability of a quarter-percentage point reduction at the next Fed meeting in September, with the chance of three such cuts by the end of January almost fully priced in.

BofA warned yesterday that expectations of an imminent Fed rate cut are premature: despite a slowdown in hiring, the labor market remains robust, unemployment is low, and consumer spending is rising. Inflation is still elevated, and Trump's tariffs may increase price pressures. According to BofA, "markets are conflating recession with stagflation" and interest rates are likely to be held steady until 2026, MarketWatch reports.

The AI translation of this story was reviewed by a human editor.