A Long-awaited Great Rotation in the Stock Market Must Overcome This Nagging Concern

This week, stock-market investors got a taste of what bulls hope will be the beginning of a long-awaited shift from a narrow band of megacap technology winners to the neglected sectors of the market. The key question, however, remains: Will the consumer join in?

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Stocks and market segments that are highly sensitive to interest rates surged on Thursday after the June consumer-price index (CPI) came in cooler than expected. This data reinforced expectations that the Federal Reserve might initiate the first cut of a new easing cycle in September.

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The June producer-price index released on Friday was hotter than expected, but it did little to alter the improving inflation outlook. The Fed’s preferred inflation measure, the core personal-consumption expenditures index, is anticipated to fall further. Fed-funds futures traders have now priced in a 90% chance of a quarter-point rate cut by the central bank's September meeting.

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However, if the economy is already starting to falter, stocks and sectors sensitive to the economic cycle may not sustain their gains. Some analysts caution that there are reasons to be concerned.

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Larry Adam, chief investment officer at Raymond James, highlighted in a Friday note, “Consumer spending has been a key driver of economic growth in the current expansion. However, recent data suggests that the consumers’ resilience is fading — particularly among the lower-income earners.”

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Early earnings-season results from companies like Nike Inc. (NKE), Walgreens Boots Alliance Inc. (WBA), and General Mills Inc. (GIS) indicate that consumers are beginning to cut back on spending, reinforcing these concerns.

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Helen of Troy Ltd. (HELE), a consumer products company, saw its shares drop by more than 25% this week after a significant earnings miss and a downward revision of its full-year outlook, particularly citing weakness in its beauty and wellness segment. CEO Noel Geoffroy remarked on a post-earnings conference call that mass retail traffic is slower across the country and promotional pressure is increasing, leading retailers to manage inventories more cautiously.

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Peter Boockvar, chief investment officer at Bleakley Advisory Group, reacted to Geoffroy's comments, stating, “This is nothing but consumer recessionary type language.”

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Meanwhile, Thursday’s CPI report led to a historic day in the stock market. The Russell 2000 index, representing small-cap stocks, jumped 3.6%, while the Nasdaq Composite slumped 2%. This was the biggest one-day outperformance for the Russell 2000 over the Nasdaq since 1986, according to Dow Jones Market Data.

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The S&P 500, which has seen an almost 18% year-to-date gain driven by a small group of megacap tech stocks benefiting from a surge in artificial intelligence spending, also saw a shakeup. While the tech-heavyweights declined, much of the rest of the index's components rallied. The equal-weight version of the S&P 500 outperformed the market-cap-weighted S&P 500 by 1.8 percentage points.

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This shift seemed to be exacerbated by hedge funds unwinding profitable trades centered on long positions in big tech stocks and short positions in small-cap stocks and other market areas.

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The broader investor sentiment over the summer has shifted towards greater confidence that inflation is receding. This has turned attention to whether the economy will achieve a soft landing or face more serious issues as the delayed effects of the Fed's aggressive rate hikes become more apparent.

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For the rotation to persist beyond a few weeks, "economic growth must remain resilient and we cannot have a growth scare," said Tom Essaye, founder of Sevens Report Research, in a Friday note. “If we do get a growth scare, then cyclical sectors like energy, industrials, materials, and financials will likely not do well.”

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Investors can adjust their strategies accordingly. Those anticipating a slowdown in growth should overweight megacap tech (TDIV) and defensive sectors like utilities (XLU), healthcare (XLV), and consumer staples (XLP), Essaye wrote. Those expecting resilient growth should focus on value stocks (VTV) and the equal-weight S&P 500 (RSP).

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Essaye himself expressed more concern about growth than the consensus, choosing not to chase value and cyclical stocks. Instead, he prefers defensive sectors and longer-term Treasurys, which will benefit from a sustained decline in yields along with moderating growth.

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