The stock market is undergoing a 'rare reversal' that's historically signaled double-digit returns to come, says one Wall Street chief strategist

• Investors recently started moving cash out of crowded mega-cap stocks and into cyclicals.
• The shift makes for a "rare reversal" that's previously led to outsize gains, James Paulsen, chief investment strategist at The Leuthold Group, said in a recent note.
• Market-cap-weighted indexes of large-cap stocks outperformed their equal-weighted peers over the past four years, leading to historic concentration in a select few tech stocks.
• Only seven previous instances of equal-weighted underperformance have taken place since 1927. Six of them led to reversals that drove double-digit annualized returns over the next 24 months, Paulsen said.
• "Once the equal-weighted index turned around and began to outperform meaningfully, as it has today, it proved to be a wonderful entry point for stock investors," he added.
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The stock market's narrow leadership signals investors will enjoy double-digit yearly returns over the next two years, James Paulsen, chief investment strategist at The Leuthold Group, said in a recent note to clients.

Market-cap-weighted indexes of large-cap stocks outperformed their equal-weighted peers over the last four years, but recent progress in rolling out a coronavirus vaccine kicked off a shift into long-neglected names. Cyclicals and value stocks began to rebound starting in September, and equal-weighted indexes rallied as investors moved cash out of growth favorites to riskier names.

The shift is a "rare reversal" from the heavy concentration in a select few stocks, Paulsen said. Only seven other periods since 1927 have seen such levels of underperformance from equal-weighted indexes before turning around. Six of those seven reversals gave way to healthy returns over the next 24 months, signaling the market's current trend will perform similarly, the strategist added.

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"Once the equal-weighted index turned around and began to outperform meaningfully, as it has today, it proved to be a wonderful entry point for stock investors," Paulsen said.

Such reversals most frequently take place during recessions. The economic downturns in 1932, 1957, 1974, 1990, and 2008 all saw equal-weight indexes lag before sharply catching up to market-weighted baskets.

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The current shift in market leadership isn't simply a rally among cyclical and value stocks, Paulsen said. It instead signals a rare changing of the guard that allows smaller stocks to catch up to the market after years of "substantial outperformance concentrated among a very small number of large-cap names."

The reversal taking place today is only the eighth time in nearly a century "investors could take advantage of an indicator that proved to be profitable" in six of the seven previous instances, the strategist added.

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