Can the Rally Broaden? Earnings Momentum and Valuation Shifts Signal a Shift to Cyclicals

The stock market's recent rally has been driven largely by a handful of AI-driven megacaps, but can this momentum broaden to other sectors? A closer look at Q2 2025 earnings trends, valuation disparities, and Federal Reserve policy suggests that a rotation toward cyclicals and smaller-cap equities could sustain the rally—provided investors focus on undervalued opportunities with improving fundamentals.

Earnings Momentum: A Sector Divide

The S&P 500's Q2 2025 earnings growth is projected to rise by 4.9% year-over-year, but this masks stark sector divergence. While aerospace (+15.1%), tech (+11.8%), and consumer discretionary (+105.6%) are leading the charge, seven sectors—including energy (-24.9%), autos (-30.2%), and construction (-14.4%)—are contracting.

The so-called “Magnificent 7” AI stocks—NVIDIA, Microsoft, Alphabet, Amazon, and others—have been the primary drivers of the rally, but their growth is now facing headwinds. Q2 earnings revisions for tech stabilized, but the sector's 11.8% growth trails its historical potential. Meanwhile, sectors like consumer discretionary and aerospace are showing resilience, with the latter benefiting from defense spending and global supply chain stabilization.

Valuation Gaps: Growth Overvalued, Cyclicals Undervalued

The valuation divide between growth megacaps and cyclicals is stark. The S&P 500 trades at 24.17x trailing earnings, but the Russell 2000—a proxy for small-caps—carries a higher multiple (31.71x), reflecting its underperformance. However, this masks deeper opportunities.

• Growth Stocks: The AI frenzy has cooled, with the sector's valuation premium narrowing from 24% to 3% since January 瞠目结舌. The “Magnificent 7” now trade at a 7% discount to fair value, but their dominance risks overcrowding.
• Cyclicals: Value stocks (including cyclicals) are trading at a 13% discount to fair value. Infrastructure, regional banks, and energy are particularly attractive. The S&P 600 Small Cap Index, which screens for profitability, trades at 15.9x trailing earnings—far cheaper than the S&P 500.

Fed Policy: A Catalyst for Undervalued Sectors

The Federal Reserve's expected three rate cuts in 2025 could be a game-changer for cyclicals and small-caps. Smaller companies, which rely more on short-term debt, will benefit from lower borrowing costs, while regional banks—already trading at 10-year lows—could see net interest margins expand.

Meanwhile, falling inflation (the Fed's core PCE inflation is projected to drop to 3.2% by year-end) reduces risks for cyclical sectors like industrials and materials. Infrastructure stocks, in particular, are poised to benefit from fiscal stimulus and global energy security investments.

The Case for Rotation: Where to Look

1. Cyclicals:
2. Infrastructure: ETFs like the SPDR® S&P® Global Infrastructure ETF (XINF) offer exposure to utilities, energy storage, and transportation.

3. Regional Banks: The SPDR® S&P® Regional Banking ETF (KRE) targets undervalued lenders with strong loan growth and buyback potential.

4. Small-Caps:

5. The Goldman Sachs Small Cap Value Insights Fund (GSATX) focuses on domestically oriented, profitable small-caps with low tariff exposure.

6. Avoid energy and autos, which remain vulnerable to global demand headwinds.

7. Tech Selectivity:

8. While AI's long-term potential is undeniable, investors should prioritize companies with tangible monetization strategies (e.g., Salesforce's Agentforce) over speculative plays.

Risks and Considerations

• Tariff Uncertainties: Ongoing trade tensions could disrupt supply chains, disproportionately affecting tech and industrials.
• Profit Margins: S&P 500 margins are projected to fall to 8.51% from Q1's 11.84%, but cyclicals could outperform if inflation continues to ease.

Conclusion: Broadening the Rally Requires Focus on Value

The market's reliance on AI-driven megacaps is unsustainable. A rotation to cyclicals and small-caps—backed by improving profit forecasts, falling inflation, and Fed support—could extend the rally. Investors should prioritize sectors like infrastructure, regional banks, and profitable small-caps while remaining selective in tech. The path forward hinges on resolving policy risks and sustaining earnings momentum outside the “Magnificent 7.”

Investment Recommendation: Overweight cyclicals and small-caps via ETFs like XINF and KRE, while underweighting speculative growth stocks. Monitor Fed rate decisions and inflation data for further cues.

This analysis underscores that the rally's longevity depends on broadening beyond a narrow set of winners. Cyclicals and undervalued small-caps are the logical next chapter—if fundamentals and policy align.