The recent turbulence in U.S. equities underscores a notable shift from large-cap tech stocks to small-cap and value stocks, a phenomenon that has garnered the nickname “Great Rotation.” Over the past week, major tech stocks such as Nvidia Corp. and Meta Platforms Inc. have experienced significant declines, leading to a broader market correction. This correction has notably impacted indices like the S&P 500 and Nasdaq Composite, both of which are heavily weighted towards technology stocks.
In stark contrast, the Russell 2000 index, which tracks small-cap stocks, has shown impressive gains. Over the past 12 trading days, the Russell 2000 surged 10.2%, significantly outperforming the S&P 500 by 13.3% and the Nasdaq Composite by 17.1%. This outperformance reflects a broader market trend as investors reallocate their portfolios, moving away from high-valuation tech stocks towards smaller, more value-oriented companies.
Market strategists, such as Dave Sekera, Chief U.S. Market Strategist at Morningstar, view this correction as a healthy adjustment. Sekera notes that the recent selloff in tech stocks is indicative of a broader rotation under the surface, with capital flowing from AI and large-cap growth stocks to small-cap and value stocks. This shift was anticipated, given the spectacular gains in the so-called “Magnificent Seven” stocks earlier this year. For instance, Nvidia’s shares were up almost 150% in the first six months of 2024, and Meta Platforms saw a rise of over 42%. Their meteoric rise contributed to the lifting of major stock indexes but also led to unusually narrow market breadth.
As valuations for megacap stocks soared, it became increasingly challenging for investors to justify their high prices, especially when companies like Alphabet reported earnings beats but still saw stock declines. Emily Roland, co-chief investment strategist at John Hancock Investment Management, points out that while earnings weren’t necessarily bad, they needed to be exceptionally strong to justify the high valuations.
The upcoming Federal Open Market Committee (FOMC) meeting on July 30 and 31 is a key event that could further influence market dynamics. Investors are keen to discern the Fed’s stance on future interest rate cuts. While rate cuts are not expected at this meeting, any hints about the timing of future cuts could significantly impact market sentiment, particularly for small-cap stocks that are more sensitive to changes in interest rates.
Lower interest rates generally benefit small-cap companies by reducing their borrowing costs, potentially boosting their earnings and operational efficiency. Thomas Martin, senior portfolio manager at GLOBALT Investments, explains that rate cuts can be advantageous for small-cap companies in multiple ways. These companies are more sensitive to variable-rate financing, floating rates, and shorter-term rates. Cheaper loans can lower operating expenses, improving earnings. Additionally, lower rates can stimulate the economy, increasing customer spending capacity.
However, the Fed’s actions are a double-edged sword. While rate cuts can stimulate the economy, they also signal that the economy might need stimulation, raising concerns about underlying economic weaknesses. Investors will be paying close attention to how Fed Chair Jerome Powell addresses these issues. If the Fed indicates that the economy is slowing too quickly, the risk of a recession grows, which could negatively impact small-cap companies that are less insulated from economic downturns compared to large-cap companies.
Economic indicators in the coming week, such as job openings, ADP employment numbers, and the U.S. unemployment rate, will also be closely watched to gauge the labor market’s health and the economy’s overall strength. These data points, coupled with the Fed’s commentary, will provide crucial insights into the likelihood of a soft landing for the economy, a scenario where inflation is controlled without triggering a recession.
The recent market movements underscore the importance of diversification. While the Great Rotation highlights a significant market shift, maintaining a balanced portfolio with exposure to various market segments is advisable to manage risks and capitalize on opportunities across different sectors. The Dow ended the week on a high note, advancing 1.6% on Friday and about 0.8% over the course of the week. In contrast, the S&P 500 and Nasdaq Composite both suffered weekly losses, down 0.8% and 2.1%, respectively, marking their second consecutive week of declines. The Dow, however, finished a consecutive four-week winning streak.
As Wall Street closely monitors the Fed’s assessment of the economy during the FOMC meeting, investors will be trying to gauge the likelihood of a soft landing. This balancing act by the Fed is crucial as they attempt to manage inflation without pushing the economy into a recession. The coming weeks will be pivotal in determining the direction of the market and the broader economy.