SA Asks: What sort of sector rotations are we seeing right now in equities?

What sort of sector rotations are we seeing right now in equities?

Seeking Alpha analysts Eugenio Catone and Luca Socci share their perspectives.

Eugenio Catone: The market's reaction to Meta's (META) quarterly report leaves little room for doubt: investors want some constraints on CapEx. A negative free cash flow combined with the intention to dilute shareholders is too risky a strategy, even if we are talking about the most revolutionary technology ever.

I expect the pressure on Mag 7 to increase over the next few months, and above all, I expect major headwinds for all the pick-and-shovel companies. I am talking about neocloud companies like Nebius (NBIS) and CoreWeave (CRWV), as well as giants like Micron (MU) and Nvidia (NVDA).

Investors could rotate from risk-on sectors like AI to risk-off sectors like consumer staples; I am bullish on McDonald’s (MCD). Also, I think many investors are taking Treasuries into account: the real return hasn't been this high in years.

Luca Socci: This year, the cap-weighted index has often been misleading in showing what is truly happening in the market. It is still hovering near its highs, but this is because of one trade only; we actually are seeing two markets.

Until early October, we saw investors rotate back and forth from AI suppliers to AI capex controllers. The second week of the month marked an interesting shift, with technology (XLK) losing almost 8% while staples (XLP) and energy (XLE) went up roughly 5% each, and health care (XLV) reached record highs. A rotation out of AI names ahead of the earnings season could even be healthy and doesn't necessarily mean the AI trade is over.

Meta's (META) earnings were interesting to this extent: no 2027 guidance was provided, but the company talked about aggressive investments. On that day, both the hyperscalers and AI suppliers fell. Since Treasuries were rallying in the meantime, tech should have done well, because it is the sector that benefits when yields go down. Therefore, the cause of the rotation out of tech still seems to me to be fears about capex returns.

We can say the same thing from another perspective: apparently, October has been a month when breadth has once again taken the lead, and the equal-weighted index outperformed the cap-weighted one. It is the trade I called at the beginning of the year, which I, however, exited as I expect interest rates to rise further.

At the risk of being biased, I don't think we are going to see a shift to equal-weight that will last. The 10Y above 5% is too great a gravity force, and with the Fed expected to hike at least once by the end of the year, defensive sectors such as health care could keep winning.

This rotation is thus driven by two forces: AI-capex doubts and interest rates. But there is a third leg: energy. It is not only a geopolitical leg, but also linked to AI and interest rates because of AI demand for power and oil fueling inflation.

It is surely not a time for small-cap and unprofitable companies, but it is also a market turn that goes against cyclical stocks. Investors want stability. Defensive stocks that generate steady cash flows or offer protection from inflation could be the trade into the holiday season.

(Luca Socci also provides analysis for the SA investment research service iREIT®+HOYA Capital.)