Fortunes for mega- and small-cap stocks poised to flip, Bank of America says

The wind is about to shift for the US stock market, if history is any guide, says Bank of America Corp.

With equities in the “recovery” phase of the business cycle, this year’s laggards — including value and small-capitalisation stocks — are primed to outperform, upending the growth, large-cap leadership that has dominated 2023’s bull run, according to strategists led by Savita Subramanian.

“Admittedly, the last few years have not felt well-defined from a ‘cycle’ perspective, with asynchronous upturns and downturns during and after Covid-19,” Subramanian wrote in a research note dated September 10. “But our US Regime Indicator has remained relevant in capturing factor trends,” she said of the firm’s quantitative model, adding that January to June marked a downturn phase where investors flocked to safety in growth and quality names.

Historically, such phases of the cycle have favored financials, industrials, and materials, while utilities, health care and staples have tended to underperform, BofA said. The firm’s model tracks inputs including inflation, gross domestic product forecasts, the 10-year Treasury yield and various manufacturing data.

This year’s rally in US equities stalled in August as economic strength thwarted investor optimism that the Federal Reserve is nearing an end to its rate-hiking campaign. September also kicked off on a down note, though the S&P 500 Index remains up more than 16% year-to-date.

Bank of America’s view contrasts with that of Morgan Stanley, whose bearish chief US equity strategist Mike Wilson said earlier Monday that investors should focus on a “late-cycle portfolio” of defensive stocks, including industrials, health care and energy. Wilson’s pessimistic view has so far failed to materialise this year after he correctly called 2022’s stock market rout.

Wall Street has been debating the staying power of this year’s US stock rally. Strategists including Oppenheimer & Co.’s John Stoltzfus and Deutsche Bank AG’s Binky Chadha have said recent weakness is expected, with modest pullbacks a normal part of market cycles, while Wilson has said recent price action is a sign that markets are catching up to poor macroeconomic fundamentals.

The next big hurdle for investors is the monthly consumer-price index report due Wednesday, which will offer clues on how much further the Federal Reserve will need to raise interest rates to reach its inflation goals.