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When you think of growth and market leaders, you most likely think of tech stocks or the FAANG names.

This week was a reminder that the face of growth is changing. News of a $1.2 trillion infrastructure deal has renewed hope for a solid few years of economic growth and re-ignited the momentum trade into cyclical stocks.

Believe it or not, the market’s most economically sensitive companies have commanded the market’s momentum for most of this year, with stocks like financials and industrials leading the pack. And after a summer break, cyclicals look poised for the momentum to shift in their favor.

Graph titled Tech Has Dominated the Momentum Trade Until This Year tracks the S&P 500 tech stocks against the S&P 500 excluding tech stocks since 2011. They were relatively equal until 2016, when tech stocks started to pull away and rise. Since 2011, S&P 500 tech stocks have risen about 560%, while the S&P 500 excluding tech stocks has risen about 200%. Source: Ally Invest, Bloomberg

Momentum Trading

Watching market momentum isn’t a new concept. There’s actually a trading strategy called momentum in which investors buy stocks that are leading the market higher (and sell when those stocks turn).

But the momentum trade rarely looks like it has lately. Tech has dominated market gains for most of the past decade, so as you can imagine, momentum and tech tend to be synonymous in investors’ minds. Until this year.

Now, cyclicals have proven to be the new momentum trade. This shift has been propelled by a rush into reopening stocks and a historically strong second quarter for the U.S. economy. Check the scoreboard and you’ll see what we mean. From October 2020 to April 2021, financials climbed more than 50%, their strongest six months since late 2009. Industrials jumped over 30% in the same period, their best six months in over a decade. Companies like Wells Fargo, Capital One and American Airlines nearly doubled.

Growth Driving Momentum

Stocks that lead the market typically have impressive growth prospects. It’s no wonder tech has been the captain of momentum: The sector has a stellar earnings reputation. After all, the S&P 500 tech sector’s profit has grown quicker than the index in nine out of the past 10 years.

In the year ahead, outsized growth is expected to come from a different part of the market. Cyclical sectors have historically been the beneficiaries of growth at the start of a new business cycle.

Chart titled Above-Average Growth Ahead Favors Cyclicals tracks year-over-year change in real gross domestic product from 2011 through 2020 with projections through 2023. The 10-year average until now has been 1.6%, but projections are showing 6.5%, 4.2% and 2.3% for 2021, 2022 and 2023 respectively. Source: Ally Invest, Bloomberg

We’ve seen that play out over the past year, and we believe that trend can continue. Industrials are expected to lead the pack in profit growth among S&P 500 sectors this year and next, according to S&P Capital IQ estimates.

Further, a boost could come from the pending infrastructure deal. If passed in its current state, infrastructure spending on roads, bridges and power grids could start as early as 2022 and be dispersed over five years. The incoming glut in spending could hit just as recovery tailwinds wear off.

To be fair, the infrastructure bill is still far from reaching President Biden’s desk. But investors are already trying to get ahead of the game. Material, financial and industrial stocks have led the market this week as the bill makes its way through Congress.

It’s not just infrastructure, either. Financials’ prospects could improve even more if long-term yields move up with growth. Industrials could stand to benefit as supply chains come back online and raw material prices normalize.

The Risks

At first glance, investing in what’s leading the market seems like a no-brainer. Over the long-run, momentum has historically outperformed the market. However, momentum can be an impressive strategy in rising markets and a stressful one in falling markets. That’s because momentum can cut both ways: big up moves, but typically big down moves as well. Momentum isn’t immune to downside.

Plus, there are still risks to the growth story, too. If the Delta variant or the Fed’s plans cut into growth prospects, investors could turn on cyclical stocks quickly. Interest rates present another challenge. If yields stay put while growth increases, investors may flock back into riskier stocks like tech for the chance at higher returns.

Know What You Own

Many people invest in momentum through one of the most popular exchange-traded momentum funds, the iShares MSCI Momentum Factor ETF. Peel back the onion and you could be in for a surprise. Instead of tech, you’d see that 31% of the fund is financial stocks and 13% is industrials. Of course, there’s a good bit of tech (18%), but the fact that the momentum trade has tilted toward cyclicals so quickly shows the importance of staying nimble and alert in this market environment.

It’s always important to know the strategies you’re investing in, because in a case like this, cyclicals could be impacting your investments even if you’ve never explicitly bought or sold a cyclical stock.

The Bottom Line

The definition of momentum has been flipped on its head. And the new look of momentum could stick. Cyclical stocks like financials and industrials could be poised for growth as investors look to 2022 prospects and beyond.

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Callie Cox, senior investment strategist, contributed to this article.

 
Speech bubble icon next to text "Expert Take"

Headshot of Lindsey BellLindsey Bell is Ally’s Chief Investment Strategist, responsible for shaping the company’s point of view on investing and the global markets. Lindsey has a broad background in finance, with experience on the buy-side and sell-side, in research and in investment banking and has held roles at JPMorgan, Deutsche Bank, Jefferies, and CFRA Research.

Lindsey holds a passion for teaching individuals how to become successful long-term investors. She is a contributor at CNBC, and frequently shares her insights with various publications including the Wall Street Journal, Barron’s, MarketWatch, BusinessInsider, etc. She also serves on the board of Better Investing, a non-profit organization focused on investment education.

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