Tech Stocks and Small-Caps Could Suffer From the Fed's Next Moves

A significant market force could soon impact the swiftly moving stock market. U.S. equities experienced heightened volatility last week as investors navigated a sharp selloff in big-tech stocks and a rotation into small-cap and value stocks. This movement from large to small stocks has emerged as a prominent market trend in July, earning the moniker “the Great Rotation.”

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This shift was somewhat expected. The so-called Magnificent Seven stocks had a remarkable start to the year, with Nvidia Corp. shares soaring nearly 150% and Meta Platforms Inc. rising over 42% in the first six months of 2024. Their performance significantly boosted major stock indexes, but also resulted in unusually narrow market breadth.

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The recent selloff in tech stocks marks a swing in the opposite direction. Magnificent Seven stocks have fallen, some even entering correction territory, pulling down indexes like the S&P 500 and Nasdaq Composite, which are heavily weighted in technology stocks.

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In contrast, the Russell 2000, which tracks small-cap stocks, gained 10.2% over the past 12 trading days as of July 26. This performance outpaced the S&P 500 by 13.3%, the largest 12-day outperformance in history, and outperformed the Nasdaq Composite by 17.1%, the second-largest 12-day outperformance ever, according to Dow Jones Market Data. On Friday, the Russell 2000 posted a 3.5% weekly gain, surpassing the performance of the major equity indexes.

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Dave Sekera, chief U.S. market strategist at Morningstar, told MarketWatch, “I think this correction over the past week or two has actually been very healthy.” He noted a significant rotation from AI and large-cap growth stocks into value stocks and smaller capitalizations.

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Despite the unsettling days with significant drops, it has become increasingly difficult for investors to justify the high valuations of megacap stocks. Alphabet’s earnings beat on Wednesday, followed by a 5% drop in its stock, highlighted this challenge. Emily Roland, co-chief investment strategist at John Hancock Investment Management, remarked, “The earnings weren’t bad, but they had to be amazing to justify the run-up in prices.”

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Next week’s Federal Open Market Committee (FOMC) meeting could be a pivotal moment for this trend. While the Fed is not expected to cut rates at the meeting, investors will closely watch for hints on when rate cuts might begin. Interest rate changes significantly impact different sectors of the economy, with small-cap companies being more sensitive to variable-rate financing and floating rates.

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Thomas Martin, senior portfolio manager at GLOBALT Investments, explained that lower interest rates would benefit small-cap companies by reducing their operating expenses and potentially stimulating the economy, allowing customers to spend more. Investors have already started moving from megacap to small-cap stocks ahead of potential rate cuts, suggesting that small-caps could gain even more momentum when the Fed begins lowering rates.

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Martin sees the Great Rotation as a recalibration, bringing market relationships back to more reasonable levels. He advises maintaining diversification and exposure to various market sectors rather than shifting entirely from growth to value stocks.

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The dual-edged nature of rate cuts adds complexity. While lower rates could stimulate the economy, they might also signal underlying economic weaknesses. Investors will closely listen to Fed Chair Powell’s commentary to discern whether rate cuts indicate successful inflation control or economic distress.

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Jeffrey Roach, chief economist for LPL Financial, noted that signs of economic slowing could be good for controlling inflation but risky if the slowdown becomes too rapid. Small-cap companies, less insulated from economic downturns, are particularly vulnerable.

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Emily Roland at John Hancock emphasized the Fed's delicate task of engineering a soft landing for the economy, balancing inflation control without triggering a recession. Investors will be keenly observing if economic "cracks" widen, potentially impacting small-cap stocks and overall market stability.

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The Dow ended the week positively, advancing 1.6% on Friday and 0.8% for the week, marking a four-week winning streak. The S&P 500 and Nasdaq Composite also gained on Friday but ended the week with losses. The S&P 500 fell 0.8%, and the Nasdaq dropped 2.1%, each experiencing two consecutive down weeks.

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In addition to the FOMC meeting, traders will monitor job openings, ADP employment numbers, and the U.S. unemployment rate next week to gauge the labor market and overall economic strength.

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