Be cautious! The US stock market is undergoing a "historic rotation"

In the past few days, the U.S. stock market has suddenly reversed, with laggards in the market suddenly becoming active, while the seemingly invincible "Big Seven" have encountered setbacks.

Currently, investors are paying more attention to corporate earnings than ever before as they try to predict what will happen next.

According to Dow Jones market data, in the seven days leading up to Wednesday, the small-cap Russell 2000 Index (RUT) outperformed the S&P 500 Index (SPX), marking the largest increase in this time period since records began in 1986. At the same time, the Russell 1000 Index (RUI) outperformed its growth stock index, marking the largest increase since the bursting of the internet bubble in April 2001.

Few investors foresaw this shift, and many are puzzled by the reasons behind it: is it a change in expectations for a Fed rate cut? Expectations of Trump returning to the White House? Or has tech trading become overly crowded?

U.S. President Biden's announcement last Sunday that he will not seek re-election has heightened market uncertainty.

Now, investors are scrambling to determine whether the reshuffling of winners and losers is just a minor fluctuation in the era of tech stock dominance, or if a sustainable transformation is underway.

Raheel Siddiqui, Senior Investment Strategist at Neuberger Berman, said, "This is the question everyone is trying to answer."

Small-cap indices rose 1.7% last week, expanding to 7.8% for the year 2024, while the S&P 500 Index fell 2%, reducing its year-to-date gain to 15%.

With the Fed expected to continue raising rates in 2023 to curb inflation and keeping rates high so far this year, investors are flocking to large-cap stocks for a "safe haven," believing these companies can withstand economic uncertainty, with some companies poised to capitalize on the transformative advances that artificial intelligence may bring.

Meanwhile, traders are cautious about stocks of smaller, more cyclical companies, which are often particularly vulnerable to higher financing costs and the risk of the Fed raising rates pushing the economy into a recession.

This trading trend seemed unstoppable earlier. Then, on July 11, an unexpectedly mild inflation report seemed to change everything. While investors had long expected the Fed to start cutting rates, the data almost convinced them that rate cuts would begin in September. As the market increasingly believed that rate cuts were imminent, investors rushed to reduce their bets in the tech sector and turned to parts of the market that could rebound when rate cuts lower borrowing costs and boost the economy.

Siddiqui said, "Who benefits from falling rates? The answer is those stocks that fell sharply when rates rose, i.e., the weaker companies."

When the Fed began raising rates in March 2022, the 10-year U.S. Treasury yield was around 2.2%. Over the following months, as the Fed raised rates, the Treasury yield rose. In October 2023, the 10-year Treasury yield surpassed 5% for the first time in 16 years, hitting a new high As investors begin to anticipate a rate cut by the Federal Reserve, US bond yields have subsequently declined. However, with inflation stubbornly high in 2024, US bond yields remain elevated.

Another factor at play in the market is that more and more people are expecting Donald Trump to return to the White House after the November election, which could increase the likelihood of tax cuts and deregulation.

In order to sustain the rotation of market leadership, many believe that companies with smaller scale and stronger cyclicality are poised to perform well.

Investors this week will focus on the earnings reports of Google's parent company Alphabet (GOOGL) and electric car manufacturer Tesla (TSLA), as well as nearly 300 small companies in the Russell 2000. Next week, Microsoft (MSFT), Meta Platforms (META), Apple (AAPL), and Amazon (AMZN) will release their earnings reports, providing more insights for investors on large tech companies.

The drive into tech stocks is not just fueled by excitement; these companies also dominate in a huge market, shielding them from economic fluctuations.

According to data from Ryan Grabinski, an investment strategist at Strategas, the profits of the "Big Seven" grew by 52% in the first quarter of this year, while the profits of the remaining 493 companies in the S&P 500 index declined by 8.7%. Analysts expect that the profits of these seven companies will grow by 28% in the second quarter, while the profits of other S&P 500 index constituents will decline by 1%.

"Earnings growth will be a key factor in determining whether this trend will continue," said Sumali Sanyal, Senior Portfolio Manager of Systematic Global Equities at Xponance.

Smaller companies are often more susceptible to the impact of high interest rates. According to a study by Goldman Sachs earlier this year, 30% of the debt of companies in the Russell 2000 index is floating rate debt, while only 6% of the debt of S&P 500 index constituents is floating rate debt.

Due to the Federal Reserve maintaining rates at high levels, investors have shown little enthusiasm for small companies, with the Russell 2000 rising only 1% in the first half of this year.

On the other hand, the largest stocks have been driving the rise of the S&P 500 index. According to data from S&P Dow Jones Indices, in the first half of the year, only one company - chip maker NVIDIA (NVDA) - contributed 30% of the total return of 15% of the S&P 500 index. Along with Microsoft, Amazon, Meta Platforms, Alphabet, and Apple, their contributions make up more than half of the index's return.

However, the number of stocks driving the current rise of the S&P 500 index is limited, causing investors to worry about the sustainability of the uptrend. Nancy Curtin, Chief Investment Officer at Alti Tiedemann Global, expressed concerns

On the rotation of sectors: "This does bring risks, but I am glad to see this rotation happening, creating a healthier and more stable market. Frankly, it also gives the bull market more upward momentum."