Strategist: Fade small caps, turn to midcaps and industrials

As the market (^DJI,^GSPC, ^IXIC) reacts to the Federal Reserve’s first rate cut in four years, John Hancock investment management co-chief investment strategist Emily Roland joins Brad Smith and Seana Smith on Morning Brief to take a closer look at navigating the market amid changing sentiment. “It's six straight days of gains leading markets higher [and] riskier assets are really celebrating this idea that the Fed can stave off a hard landing, prevent a contraction from happening, do it proactively before we see more weakness here in the labor market,” Roland tells Yahoo Finance. The strategist says there are three key signs that a soft landing can be achieved. “The first one is that you need to see no real further cracks in the labor market.” Secondly, Roland is watching credit market conditions. “The final thing is the fed actually has to deliver on what the bond market is pricing in.” Roland indicates the bond market has priced in another 50 basis points cut this year, and another 100 points cut in 2025, which is consistent with the Fed’s dot plot. “You're seeing the riskiest parts of the market, the most cyclical areas, small caps really being a poster child for that really taking off amidst this dovish turn from the Fed, but at the end of the day, there's not a lot of fundamental support for it.” Roland believes a lot of the upside is already priced into small caps. “When you look at the outperformance of small caps, they're up 8% [to] 9% quarter to date. While the S&P 500 is up about 3%. You're seeing some profit taking in large-cap names and a rotation into small caps. We really see that as a sentiment-driven rally.” “Of [small caps’] 8% return this quarter, it's been entirely driven by multiple expansion, not earnings growth. In fact, in the second quarter, the S&P 500 saw double-digit positive earnings growth. Small cap equities saw 15% negative year-over-year earnings growth for the second quarter,” Roland says, adding that analysts expect this “muted earnings growth” to persist in the third quarter. Believing the upside is already priced into small caps, Roland says “we continue to overweight the quality factor. So these are companies with great balance sheets, tons of cash, good free cash flow, the ability to maintain margins in an environment where margins pressure is happening and playing out right now. So the poster child for high quality is going to be megacap tech.”
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