Record-Setting Rotation Hits the Market, But Will It Gain Momentum?
Rotation will be a boon to aggressive traders who have long struggled with an extremely narrow market.
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For over a year, the market has incorrectly anticipated that the Federal Reserve would cut interest rates. At the beginning of 2024, it was widely predicted there would be at least six rate cuts this year, but sticky inflation and a strong labor market have kept the Fed on hold.
Surprisingly, the major indexes never really cared about the lack of Fed dovishness. They steadily trended higher and have hit new all-time highs dozens of times.
The main driving force has been a small group of big-cap technology names. These stocks are awash in cash and have little debt, so persistently high interest rates didn’t really matter. Money flowed into these "safe havens" and drove up the market while everything else was ignored.
This dynamic shifted on Thursday.
A lower-than-expected CPI report has made rate cuts in September and December a near certainty. There is still some risk of Fed delay, but with indications that the labor market is cooling fast and the economy is weakening, the Fed is now concerned that it may not act quickly enough to prevent a recession from developing.
The shift in expectations about rate cuts triggered a massive market rotation. Suddenly, the big-cap names that were expensive and technically extended looked less attractive compared to the thousands of stocks that will benefit from lower interest rates and still have attractive valuations.
The rotation was one for the record books, with the Nasdaq 100 QQQ dropping 2.2% while the Russell 2000 IWM jumped 3.6%. There have been a few signs of rotation earlier this year but it never took hold and sputtered out very quickly.
The big issue now is whether the rotational action will gain momentum and close the giant gap in performance between the big-cap, AI-related technology names and the rest of the market.
There are two factors that will impact rotation. The first is upcoming economic news, and the second is second-quarter earnings.
On Friday morning there is a PPI Report and Michigan Consumer Sentiment survey. There are also PCE inflation reports and a Fed interest-rate policy decision at the end of the month. Surprise data could easily upside the rotation action and cause a return to the safety of big-cap technology, but there is a trend now that makes rate cuts look highly likely.
Second-quarter earnings reports begin on Friday morning with several banks. After the big run-up in the indexes, expectations for earnings are quite high, and valuations are aggressive. It is a perfect setup for some sell-the-news action, but the dip on Thursday may have partially reset things. Guidance will be very important, especially if there is talk about economic slowing.
Rotational action will be very beneficial to traders who are able to shift gears and focus on stock-picking among the many small stocks that offer good opportunities. Fans of the Magnificent Seven are not going to go away quickly or easily, but these names may not be as easy to trade with rate cuts looming.
We have a quiet start early on Friday.
At the time of publictaion, Rev Shark had no positions in any securities mentioned.
