Small Caps and Sector Rotation: Is the Stock Market Rally Finally Diversifying?
Since October 2022, the stock market has experienced a significant bull run, primarily driven by artificial intelligence (AI) and the stellar performance of a handful of large tech companies. This narrow focus has led to concerns among investors about the sustainability of the rally. However, recent market movements suggest a potential shift towards a more broad-based rally, which could signal a maturing and potentially more sustainable bull market.
Inflation Data and Fed Rate Cut Expectations
A better-than-expected inflation report released on a recent Thursday has sent ripples through the stock market. This positive economic indicator has prompted investors to rapidly adjust their expectations regarding the Federal Reserve’s monetary policy.
The market is now pricing in a more than 90% chance of an interest rate cut by the Federal Reserve in September, according to the CME FedWatch tool. This dramatic shift in expectations has led to a notable rotation in market leadership.
The Changing Face of Market Leadership
Tech Giants Take a Back Seat
The Roundhill Magnificent Seven ETF, which tracks the group of large tech stocks that dominated the 2023 stock market rally, has seen a decline of more than 1.5% in a five-day period following the inflation report. This underperformance marks a significant departure from the tech-centric rally that has characterised much of the current bull market.
Rise of Interest Rate-Sensitive Sectors
As investors recalibrate their portfolios in anticipation of potential rate cuts, interest rate-sensitive sectors have emerged as new market leaders. Real Estate (XLRE) and Financials (XLF) have been the biggest winners in recent trading sessions, benefiting from the prospect of lower interest rates.
Small-Cap Resurgence
The small-cap Russell 2000 (RUT) index has shown remarkable strength, surging more than 7% and finally breaching its 2022 high for the first time during the current bull market. This performance indicates a broadening of market gains beyond the large-cap tech stocks that have dominated headlines.
Equal-Weight S&P 500 Outperformance
In another sign of broadening market participation, the equal-weight S&P 500 (^SPXEW) has outperformed the traditional market cap-weighted S&P 500. This index, which ranks all stocks equally regardless of size, provides a clearer picture of overall market health by reducing the outsized influence of the largest companies.
Expert Perspectives on Market Broadening
Callie Cox, chief market strategist at Ritholtz Wealth Management, describes the recent market action as “refreshing.” She suggests that this could be a sign of a maturing bull market, where a wider range of stocks contribute to the rally, providing more robust support for stock indexes at record levels.
Ohsung Kwon, senior equity strategist at Bank of America Securities, notes a higher level of conviction in the current broadening trend compared to previous instances. While the overarching narrative of a soft landing and gradual interest rate cuts remains similar to past episodes, Kwon highlights that the earnings backdrop is now more supportive of this rotation.
The Role of Earnings in Sustaining the Broadening Rally
Bank of America’s earnings analysis reveals that the 493 stocks not including the “Magnificent Seven” are expected to grow earnings year-over-year for the first time since 2022 during the current reporting period. This trend is projected to continue in the coming quarters, potentially supporting a more broad-based rally.
As illustrated in a chart from JPMorgan Asset Management’s midyear outlook, earnings growth for non-Big Tech stocks is expected to accelerate, while Big Tech earnings growth is anticipated to slow. This divergence could provide fundamental support for a rotation away from the narrow leadership that has characterised the market in recent years.
Cautionary Notes and Potential Hurdles
Despite the optimism surrounding the recent market action, some strategists emphasise the importance of seeing actual earnings growth across multiple sectors to confirm the narrative currently baked into estimates. Callie Cox stresses the need for earnings growth to come from sectors beyond just tech to solidify the broadening trend.
Kevin Gordon, senior investment strategist at Charles Schwab, cautions that more clarity on the Fed’s cutting cycle and its rationale for initiating cuts remains crucial, particularly for interest rate-sensitive areas of the market like small caps.
Gordon also notes that while recent market action is a positive step, broad rotations typically unfold over extended periods rather than in a matter of days. This suggests that investors should temper their expectations for an overnight transformation in market dynamics.
Implications for Market Performance and Investor Strategy
The recent index performance indicates that a broader rally may result in a different, potentially slower path higher for the S&P 500. The index closed down on the day of the promising June inflation report, despite the positive economic news, as investors rotated out of large tech stocks that hold significant weightings in the index.
Callie Cox suggests that this period of churn, where leadership is passing from tech stocks to other sectors, may result in less rapid price appreciation. However, she argues that this type of movement strengthens the foundation of the bull market, potentially leading to a stronger and more durable rally over time.
The recent shift in market dynamics, triggered by positive inflation data and changing interest rate expectations, has sparked hope for a more broad-based stock market rally. While this broadening trend is still in its early stages and faces several hurdles, it could signal a new phase in the current bull market. Investors and market observers will be closely watching earnings reports, economic data, and Federal Reserve communications for further confirmation of this potentially significant market shift. If sustained, this broadening could lead to a more resilient and long-lasting bull market, benefiting a wider range of investors and sectors.
