Stocks Are Rotating. Where Will It Go Next?

Last week's sharp stock market decline, fueled by concerns that the Federal Reserve missed its opportunity to support a weakening US economy, may have ended one investment trend and started another, leaving investors uncertain about the future of equities.

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After the Fed opted to maintain current interest rates at its two-day meeting concluding on Wednesday, stocks plummeted. Despite Chair Jerome Powell's indication that rate cuts might be possible at the next meeting in September, the Nasdaq 100 Index, heavy with tech stocks, entered a correction, and the S&P 500 Index fell by 3.2% over two days, marking its worst two-day performance since March 2023.

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However, not all sectors were negatively impacted. While technology and consumer discretionary stocks suffered significantly, utilities and real estate companies, known for their high dividends and appeal to income investors during periods of declining bond yields, emerged as the top performers in the S&P 500 for the week.

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“With rates expected to drop due to a cooling job market, the rotation trade is ongoing, but the question is which stocks to buy? Big Tech doesn’t need rate cuts as they have strong balance sheets and high valuations,” said Eric Diton, president and managing director of the Wealth Alliance. “The focus should be on dividend payers because small companies with more debt are not a reliable choice.”

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This trend is already evident. Last week, investors directed nearly $1 billion into real estate and utility sector US exchange-traded funds, compared to just $300 million into tech ETFs, according to Bloomberg Intelligence data.

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This shift marks the second stock market rotation investors have encountered recently.

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The first began gaining traction in late June, driven by increased demand for small-capitalization companies. At that time, the Russell 2000 Index was trading at 23 times projected earnings, closely matching the S&P 500’s multiple of 21.2. This narrow valuation gap is typically a buy signal for small caps, leading investors to abandon Big Tech in favor of riskier smaller companies.

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This trend persisted for a few weeks until the valuation spread widened again, favoring large caps. Consequently, the bid for the Russell 2000 dried up. The index, often viewed as a risk appetite proxy, peaked on July 16 and has since dropped 6.8%.

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Now, with potential rate cuts on the horizon and falling Treasury yields, investors are gravitating towards dividend-paying, lower-volatility stocks, including utilities and real estate investment trusts. Both 10-year and 2-year Treasury yields fell below 4% last week, with the 2-year reaching its lowest point since May 2023 on Friday.

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This shift indicates that more challenges may lie ahead for equities beyond dividend-driven plays, especially as the market approaches August and September, historically the worst months for US stock market returns.

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Meanwhile, market volatility is surging, with the Cboe Volatility Index (VIX) spiking to 29.66 on Friday, a level not seen since March 2023. The VVIX Index, which measures the volatility of the VIX, is also near its highest levels since March 2022, when the Fed's rate hike cycle began.

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The difficulty in predicting market movements stems from the significant degree to which risk assets have anticipated the Fed’s first rate cut. Prior to Thursday and Friday’s selloff, the S&P 500 had rallied 34% over the previous nine months from its 52-week low on Oct. 27, and it still ended the week up 30% since then. There is clearly some excess exuberance left in stock prices.

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“Some of this could be a ‘sell-the-news trade,’ due to high expectations for rate cuts. But be cautious, as many fear the Fed erred by not easing policy sooner,” said Julie Biel, portfolio manager at Kayne Anderson Rudnick. “If there’s economic weakness, it will impact small caps more severely.”

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Despite these concerns, investors are not heavily hedging against a potential selloff. In the options market, contracts protecting against a 10% decline in the largest ETF tracking the S&P 500 over the next 60 days cost just 1.9 times more than options betting on a 10% rally, according to data.

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“This selloff is more of a reset of an overvalued equity market rather than a panic situation,” said Chris Murphy, co-head of derivatives strategy at Susquehanna International Group. “There’s a growing shift in concern, but order flow at the individual stock level still shows significant put selling, indicating a willingness to buy on further weakness.”

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