The rotation trading of US stocks restarts, defensive dividend stocks become a safe haven, how should investors position themselves?

According to the Wisdom Financial APP, last week, due to concerns that the Federal Reserve might miss the opportunity to rescue the U.S. economy, the stock market experienced a severe sell-off, ending not only a rotation trade but also possibly heralding the beginning of another rotation trade. Investors are full of speculation about the next direction of the stock market.

The Federal Reserve decided to keep interest rates unchanged at the end of the two-day meeting last Wednesday, followed by a sharp drop in the stock market. Although Federal Reserve Chairman Jerome Powell seemed to hint at a possible rate cut at the next meeting in September, the market reacted strongly. The tech-heavy NASDAQ 100 index fell into a correction zone, and the S&P 500 index fell by 3.2% in two days, marking its worst two-day performance since March 2023.

However, not all sectors suffered losses. Technology and non-essential consumer stocks were hit hard, but utility and real estate companies, which pay hefty dividends, were sought after by income investors as bond yields fell, becoming the best-performing stocks in the S&P 500 index this week.

With the job market cooling down and interest rates expected to fall, this will drive the so-called "rotation trade" to continue. But in this scenario, which stocks should investors buy? Eric Diton, President and CEO of Wealth Alliance, believes that in the current market environment, choosing companies that can provide stable dividend returns may be a wiser investment strategy, especially for larger companies with more stable financial conditions.

Diton pointed out that large tech companies do not necessarily need rate cuts as they have strong balance sheets and already high valuations. In contrast, small companies hold more debt and may not be a stable and reliable investment choice. The "rotation trade" here may refer to investors moving from one sector to another in search of better returns.

This strategy has begun to show results. Data from Bloomberg Industry Research shows that investors poured nearly $1 billion into U.S. real estate and utility industry exchange-traded funds last week, while funds invested in tech ETFs amounted to only $300 million.

Figure 1

This marks the second stock market rotation that investors have faced recently. The first wave began at the end of June when demand for small-cap stocks started to rise. The price-to-earnings ratio of the Russell 2000 index was almost on par with the S&P 500 index, which is usually seen as a buy signal for small-cap stocks. Investors sold off shares of large tech companies and instead bought shares of riskier small companies.

However, as the valuation gap between the two widened, buying interest in the Russell 2000 index began to dry up. The index, typically seen as a representation of risk appetite, fell by 6.8% since reaching its peak on July 16th

Figure 2

Now, with the expectation of interest rate cuts and the sharp drop in US Treasury yields, investors are turning to dividend-paying, low-volatility stocks such as utilities and real estate investment trusts. Last week, both the 10-year and 2-year US Treasury yields fell below 4%, with the 2-year US Treasury yield dropping to its lowest level since May 2023 last Friday.

As August and September approach, these two months have historically been the worst-performing months in the US stock market. Apart from dividend-driven stocks, the stock market may face more challenges.

At the same time, market volatility is on the rise. The Chicago Board Options Exchange Volatility Index (VIX) surged to 29.66 on Friday, a level not seen since March 2023. The VVIX index, which measures VIX volatility, is hovering near its highest level since the start of the Fed's rate hike cycle in March 2022.

Figure 3

Traders are finding it increasingly difficult to profit in the market as risk assets had already risen significantly before the Fed's first rate cut. Before the sell-off on Thursday and Friday, the S&P 500 index had risen 34% from its 52-week low over the past nine months, with a 30% increase this week. There is clearly still a risk of over-exuberance in stock prices.

Julie Biel, portfolio manager at Kayne Anderson Rudnick, stated that due to strong expectations of rate cuts in the market, some trades may become "sell-the-news trades." However, she also cautioned investors to be cautious about their expectations, as many are concerned that the Fed's failure to ease policy early enough could be a mistake. If the economy does weaken, small-cap stocks may suffer more severe blows.

Nevertheless, investors have not yet paid enough to hedge against potential sell-offs. Data compiled by Bloomberg shows that in the options market, the cost of contracts protecting against a 10% drop in the largest ETF tracking the S&P 500 in the next 60 days is only 1.9 times the cost of options profiting from a 10% increase.

Chris Murphy, Co-Head of Derivatives Strategy at Susquehanna International Group, believes that this sell-off is more of a reset of the bubble stock market rather than a panic mode. While concerns are growing, the order flow for individual stocks still indicates a significant amount of put option selling, suggesting that investors are willing to buy on further declines