Cyclicals ripe for a rally amid record bearishness

Time to read: Minutes
James Dorment

James Dorment, CFA

Co-Head of Fundamental Research and Portfolio Manager

Gareth Shepherd

Gareth Shepherd, PhD, CFA

Co-head of Machine Intelligence, Portfolio Manager

Key Takeaways

The time may be nigh to make a move back into cyclicals and growth, which have been punished as investors flocked to defensive names.

Investor sentiment can’t get much more bearish than it is today — even compared to the pandemic, the financial crisis and the dot-com bust.

Other developments that may signal a cyclicals bounce-back include the possibility for mean reversion in the US Dollar Index and potentially better-than-expected 3Q earnings.

We are cautiously optimistic about cyclical stocks. Their historically low relative value and deeply negative overall investor sentiment could be a recipe for a strong relief rally.

The stage may be set for a rally in cyclicals and growth

For most of this year, as war and inflation rattled nerves, stable value and defensive stocks reigned supreme over growth stocks — the previous market darlings. But as we near the end of the third quarter, we’ve seen sharp moves in one particular area: cyclicals. And now, for the first time in more than a year, we are seeing attractive opportunities in the cohort of cyclical and growth stocks, on both a top-down and bottom-up basis. Indeed, quantitative equity signals, multi-asset indicators, machine intelligence models and our own fundamental analysis all point in this direction.

Multiple market indicators are sending strong signals

Sentiment is at all-time lows. The Investors Intelligence Index is often considered to be the grandaddy of sentiment indicators, with a nearly flawless track record of frontrunning contrarian market moves. The data point to a surge in the spread between bears and bulls, with sentiment approaching a level of bearishness that eclipses even the peak of pandemic hysteria (Exhibit 1). The S&P 500 Index has shown a tendency to bounce back when market sentiment has turned this negative.

Exhibit 1: Historically, the S&P has bounced after a surge in the bear/bull spread
Exhibit 1: Historically, the S&P has bounced after a surge in the bear/bull spread

As of 09/23/22. Source: Voya Investment Management, FactSet, AAII (American Association of Individual Investors).

Similar levels of bearishness have only been observed a handful of times in recent years. Consider the onset of the Covid-19 pandemic in March 2020. The 4Q18 stock market drop. The global financial crisis of 2007–2008. The dot-com shakeout in the early 2000s. The Long-Term Capital Management bailout of 1998. The savings and loan crisis in the 1980s. In each instance, such a sentiment backdrop was followed by an acute resurgence in investor bullishness.

Both the S&P 500 and the Nasdaq are oversold. While any single asset can indeed stay oversold for an extended period (insert mandatory Keynes quote about staying irrational longer than one can stay solvent), indexes rarely remain oversold for long. If history repeats itself, they may be ripe for a rally.

Our proprietary intelligence also points to an opportunity in cyclicals

Let’s not take the Investors Intelligence Index’s word for it. We’ve seen a number of other signals indicating that the time may be nigh to make a move back into cyclicals:

  • Our in-house Voya Sentiment Indicator (from our Multi-Asset and Solutions team) underscores the market’s oversold conditions (Exhibit 2).
  • Our Machine Intelligence team’s AI-powered models, which track and inform portfolio positioning, have moved more into cyclicals and away from defensive names.
  • Our AI models also alerted us to a rare top-down signal in recent days: mean reversion in the US Dollar Index. This suggests a transition to a lower dollar over time, which could be a tailwind for US companies with high foreign earnings and/or unhedged foreign-exchange exposure
Exhibit 2: Proprietary Voya Sentiment Indicator also shows an oversold market
Exhibit 2: Proprietary Voya Sentiment Indicator also shows an oversold market

As of 09/30/22. Source: Voya Investment Management, Bloomberg.

Enough about quants. What do the fundamentals say?

Growth and cyclicals are attractive — particularly cyclicals. Why? Long-duration growth could be in for something of a reprieve, as it seems likely that rates will (at a minimum) take a breather. More likely still, rates will revert a bit. But take a look at cyclicals, particularly vs. their defensive peers (Exhibit 3). We have now eclipsed the peak-pandemic levels of high pricing for perceived safe havens. While we recognize that multiples have likely compressed on perceived cyclical “peak” earnings, this is still a historically aberrant spread, and we believe it is unsustainable.

Exhibit 3: The premium for defensive stocks vs. cyclicals is near all-time highs
Exhibit 3: The premium for defensive stocks vs. cyclicals is near all-time highs

As of 09/29/22. Source: Bloomberg, 22V Research.

What about the macroeconomic view?

We could see inflation relief and the prospect of better-than-expected economic data. In the face of so many factors — sentiment, valuation, our own proprietary models — favoring a constructive view on cyclicals, the economic tea leaves indeed remain challenged. So under what circumstances could broader macro and/ or micro news ignite a semblance of animal spirits, if only for a time? Let’s look at the lagged effect of interest rates on purchasing managers’ indexes (PMIs). As we all pretend to know, interest rate sensitivity works in a decidedly lagged manner: Conventional wisdom says that rates take 18 months to have an economic impact. So by comparing PMI data with Treasury yields (but inverted and shifted 18 months), we can see that last year’s short-term decline in rates could lead to surprisingly constructive PMI — if only for a window of time (Exhibit 4).

Exhibit 4: Could last year’s drop in yields boost PMIs in 4Q22?
ISM manufacturing index vs. 20-year Treasury yields (inverted and shifted 18 months)
Exhibit 4: Could last year’s drop in yields boost PMIs in 4Q22?

As of 08/31/22. Source: Voya Investment Management, Trahan Macro Research LLC.

Bottom line: Company fundamentals could prove better than feared in the very near term

At the end of the day, we continue to focus on fundamentals, and we are cautiously optimistic. In the current environment, our analysts see greater stability in the third quarter, and we believe it’s highly likely that companies will produce better results than investors generally fear. This all comes against a backdrop of generationally depressed cyclicals and sentiment that is rubbing against its lower bound.

To be clear, we think it’s likely that we won’t ultimately see a bottoming-out of the market until 2023 — perhaps in one event, or perhaps it will be a process. But between now and then, the stage seems well set for what could be a rather meaningful near-term relief rally, with cyclical stocks leading the charge.

At times like these, it’s a good idea for investors to make sure their asset mix fits their risk appetite and circumstances. Equally important, however, is to remember that adversity breeds opportunity. We’re keeping the big picture in sight and using all the signals at our disposal to make well-informed decisions.


Past performance does not guarantee future results. This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities.