Wall Street Revives the Big-to-Small Trade on Fed Expectations

As stock traders anticipate Federal Reserve rate cuts, there's been a noticeable shift towards riskier market segments, particularly small-cap stocks, while tech megacaps, which have fueled much of the recent bull run, are seeing a rotation out.

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The majority of S&P 500 stocks saw gains, signaling a renewed pattern on Wall Street where money is moving from large, safer tech stocks into smaller, riskier ones. This shift comes after Fed Chair Jerome Powell hinted that the central bank might lower borrowing costs in September. Although the main US equity index showed little movement on Monday, the equal-weighted version of the S&P 500, which gives equal importance to companies like Target Corp. and Microsoft Corp., reached an all-time high, driven by optimism that the rally is broadening.

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Craig Johnson of Piper Sandler commented on the situation, noting that Powell's dovish remarks support the narrative that inflation is trending downward, making it likely that the Fed will soon cut rates. This scenario favors small and mid-cap stocks (SMID-caps), and the market's shift towards these stocks suggests a positive outlook for the remainder of the year.

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Monday's market activity echoed a recent trend where capitalization-weighted indexes, which are dominated by large tech firms, underperformed compared to the average stock. The reason lies in the significant influence of megacaps like Apple Inc. and Nvidia Corp., which each represent over 6.5% of the S&P 500. Even when most stocks in the index rise, losses in these heavyweights can drag the overall index down.

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Looking ahead, strong inflows from corporate buybacks, systematic funds, and retail investors are expected to support stock prices in the coming weeks. Scott Rubner of Goldman Sachs Group Inc. estimates that there will be around $17 billion in "unemotional demand" from automated trading systems and corporate buybacks daily this week. He also predicts a "green sweep" for commodity trading advisers (CTAs), meaning these funds are likely to buy stocks regardless of market trends.

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The S&P 500 hovered near 5,620, with most of its sectors advancing. However, trading volume was 25% below the average of the past month. The Russell 2000, an index of smaller companies, rose by 0.5%, while the Nasdaq 100, which is heavy on technology stocks, fell by 1%. A Bloomberg index tracking the "Magnificent Seven" megacaps dropped 1.4%.

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Meanwhile, Treasury yields for the 10-year note remained stable at 3.79%. Oil prices rose following an Israeli strike on Hezbollah targets in southern Lebanon, which escalated tensions in the Middle East, and Libya's eastern government announced a halt in exports.

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Chris Larkin from E*Trade, a division of Morgan Stanley, suggested that for stocks to reach new highs this week, they must avoid any significant earnings disappointments, especially from Nvidia. The chipmaker's earnings report on Wednesday is highly anticipated, with analysts expecting another strong performance that could lead to an upward revision in its profit guidance.

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Nvidia stands to benefit directly from the massive investments companies are making in artificial intelligence (AI) infrastructure. This trend is also likely to be reflected in the upcoming earnings reports of HP Inc. and Dell Technologies Inc.

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Nvidia's earnings report will cap the results for the "Magnificent Seven," a group of companies that are expected to post 34% year-over-year earnings growth for the second quarter, compared to just 6% for the rest of the S&P 500, according to Jason Pride and Michael Reynolds at Glenmede. This comes after nearly a year in which these megacaps achieved earnings growth exceeding 40%, while the rest of the index experienced declines.

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Pride and Reynolds believe that the latter half of this year could mark the beginning of a broader improvement in market fundamentals. As earnings growth becomes more widespread, smaller-cap stocks and investment strategies that avoid the pitfalls of market concentration should benefit.

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Interestingly, despite a strong rebound in the tech sector since early August, hedge funds have been selling technology stocks at the highest rate in two months, according to data from Goldman Sachs Group Inc. Information technology stocks were sold across all regions, with North America accounting for 86% of the total net selling. Global equities experienced net selling for the sixth consecutive week, with the largest amount of selling in two months, driven by both long and short sales.

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