Cautious Outlook Emerges for Cyclicals as Warning Signs Flash in Markets

Cautious Outlook Emerges for Cyclicals as Warning Signs Flash in Markets 

Recent market gains have primarily favored the tech sector, but cyclicals have also seen a surge in popularity. However, there are now concerning signals emerging, both in technical indicators and underlying fundamentals, for stocks reliant on economic cycles.

Over the past year, cyclicals have kept pace with growth stocks, with both experiencing a remarkable rally since late October, boasting gains of nearly 25%. This outperformance, particularly relative to defensive peers, has raised eyebrows. Additionally, cyclicals have entered overbought territory, a historical red flag.

Fundamentally, the outlook isn't rosy either. While recent market momentum was supported by improving macroeconomic indicators such as PMIs and economic surprises, cyclicals might be overly optimistic about economic expansion, potentially setting them up for setbacks.

Bank of America strategists, led by Sebastian Raedler, maintain a cautious stance on cyclicals versus defensives, anticipating a 15% underperformance as economic momentum wanes. They favor defensive sectors like food, beverages, and pharma, while suggesting underweights on cyclicals like banks and autos.

Valuation metrics paint a concerning picture, especially in comparison to defensive stocks. Forward P/E ratios for cyclicals have surpassed their 10-year average, and price-to-book ratios indicate that cyclicals are the most expensive relative to defensives in over a decade.

JPMorgan strategists echo these concerns, noting that cyclicals, even excluding tech, are now "outright expensive" compared to defensives. They anticipate a potential earnings slowdown in cyclicals, particularly in industries like autos, chemicals, and transportation, which are most sensitive to economic shifts.

Despite some investors eyeing cyclicals as PMIs stabilize, JPMorgan suggests caution, pointing out mixed data flow and recent weakening in the US ISM. They question whether cyclicals will truly benefit from PMI improvements, especially considering their resilience during weak PMI periods last year.

Looking ahead, while certain cyclical sectors like industrials, construction, and travel have seen significant gains, the volatile second quarter could see consumer-related and defensive sectors offering more support due to their comparatively favorable valuations.