Fed rate cuts and the stabilization of business-cycle indicators will drive more balanced growth and performance across the U.S. equity market in 2025, but this balanced growth may be concentrated more in Large Caps than in small caps. Historical experience shows that sustained small-cap outperformance usually occurs in an Early Cycle Environment, alongside the end of the labor cycle and rate cuts of several hundred basis points. The current environment does not have these characteristics.
The pace of earnings growth is an important clue to which stage of the business cycle the economy is in.
S&P 500’s EPS Growth typically bottoms at one of two levels: near 0%, or between -15% and -25%. Small caps fluctuate more, with more pronounced movements in their troughs and peaks.
Chart: The current pickup in Earnings Growth, beginning in 0, is characteristic of a late-cycle extension
The key to determining which kind of bottom forms is whether the labor cycle delivers a shock to the economy.
During labor cycles accompanied by rising unemployment, earnings troughs are usually deeper, as shown by the dashed circles in the chart above. If the labor market has not suffered a material shock (solid circles), the trough is shallower.
The current Inflection Point (the turning point in earnings growth) has rebounded from near the zero line, meaning it has not been weighed down by the unemployment cycle. This indicates that the current economic cycle has not ended but has continued along its expansion path. In other words, This is Growth Acceleration after a “soft landing.”
However, it is worth noting that, because the labor market remains tight, This reacceleration in earnings growth today may be a typical Late Cycle Extension, that is, an extension of the late cycle.
Historically, earnings-growth accelerations of this kind in the late cycle have usually been driven by the distinctive forces of a particular cycle.
Overheating in technology equipment spending in the late 1990s drove earnings growth but failed to persist as growth broadened across the economy; the rebound after the earnings trough in 2015 benefited from a global growth recovery fueled by large-scale fiscal stimulus in China and a boost from U.S. tax reform in 2017.
In the current cycle, the recovery in earnings growth depends more on a small group of Large Cap, Quality Names that benefit from AI capital expenditures, cost reductions, and improved operating efficiency.
Chart: Reposting the chart from yesterday’s Weekly Wrap
The trend is typified by the ratio of the S&P500 equal-weight index to the market-cap-weighted index.This ratio has consistently reflected late-cycle market characteristics over the past few years. Although the market rebounded this summer from the lows of “recession fears,” the ratio has recently started falling again, suggesting that a broadening of earnings growth may be more a story for 2025 than something achievable in the fourth quarter of 2024.
Chart: Equal-weight relative performance has shown no sustained growth
Looking at forward-looking indicators of earnings growth, EPS growth among small caps and lower-quality companies (Lower Qualiy Areas) has also bottomed out, but its rebound is clearly weaker than that of the S&P500. This further confirms that the current environment remains late cycle:
At this stage, profits are harder to come by for lower-quality companies With higher price levels, persistent labor-cost pressures, and rising real interest rates, the key question is whether earnings growth among ordinary companies can reaccelerate.
Probably, but the drivers of earnings growth will still be tilted more toward Large Caps, and this growth may be more ldiosyncratic than the market consensus suggests. This means it is better to focus on Quality Cyclicals than to chase lower-quality cyclical stocks, The latter’s performance often depends on larger adjustments in interest rates and labor costs, and these conditions are not yet fully in place in the current macroeconomic environment.
The broadening of earnings growth across the market (Broadening Eamnings Growth) is still at an early stage. In the near term, the core drivers of the earnings recovery remain concentrated in high-quality names with pricing power, cost control, and efficiency advantages. Beware of the relative disadvantages facing lower-quality names due to structural constraints such as high costs and access to capital. Prioritize companies that can generate excess returns in the current environment through innovation and operating leverage. This divergence is a typical feature of the late cycle.
Last week’s Weekly Wrap, published yesterday (if you haven’t read it, you really should!!),We also wrote about our concerns over current market breadth in last week's Weekly Wrap, published yesterday (if you haven't read it, you definitely should!!). In a late-cycle environment, large caps are bound to benefit first as breadth broadens. If nothing new emerges, the small-cap trade may have run its course after this Trump-driven wave.
2024.12.16