Market rotation
U.S. stocks experienced a notable decline yesterday, with the Nasdaq Composite Index suffering a loss of 2.8%, its most significant loss since December 2022. This downturn was primarily driven by weakness in big tech stocks, particularly in the semiconductor sector, due to concerns about potential stricter U.S. trade restrictions on China. Since its peak on July 10, the Nasdaq is down 7.1% and 2.6% relative to the Equal-Weighted S&P 500 and the S&P 500 Indices, respectively.
The selloff extended to small caps and cyclical stocks, which had, until yesterday, seen substantial gains amidst optimism about disinflation and a potential Fed easing. In fact, the Russell 2000 Small Cap Index was up almost 11.5% over the previous five trading sessions, before yesterday’s selloff. Despite this, defensive stocks such as consumer staples and healthcare generally performed well. This rotation out of growth and into value stocks is a notable shift in market sentiment.
Expectations of lower interest rates and political developments are the main drivers for the abrupt shift. The initial catalyst was last week’s surprise -0.1% change in June’s CPI data which elevated expectations for a September rate cut to near 100%. Because small-cap companies have an estimated 30% of their debt linked to variable interest rates, it makes sense that their earnings will be positively impacted by a cut in rates. On the political front, the market rotation reflects increased odds for a Trump 2.0 administration.
Fed commentary, economic data, and consumer trends
Recent economic data showed positive signs, with June housing starts, building permits, and industrial production all exceeding expectations. Fed officials have suggested a rate cut might be warranted in the coming months, but ruled out immediate easing in July. The Fed’s Beige Book indicated a mixed economic picture, with some regions experiencing flat or declining activity. Interestingly, the Beige Book reported numerous quotes from the individual Federal Reserve Bank districts that echoed a consistent theme: the labor market is rebalancing with labor supply improving and wage pressures diminishing. These reports support the Fed’s expectation that inflation will continue to moderate towards its 2% target.
While a decline in inflation is a positive development, U.S. consumer sentiment unexpectedly declined in early July according to a preliminary reading of the University of Michigan’s survey, reaching its lowest point in eight months. This decline is attributed to the persistent burden of high prices, which continue to erode consumers’ living standards. Despite rising wages and forecasts of easing inflation, many consumers express frustration over the sustained cost of living. This sentiment is reflected in the deterioration of both current conditions and future expectations gauges, which fell to eight-month lows. Moreover, unemployment rose in June, potentially dampening consumer sentiment further.
Additionally, the upcoming presidential election may be contributing to uncertainty and negatively impacting consumer expectations for the economy. Rising credit card delinquencies are also a source of concern. Credit card balances are now about $1.1 trillion. Since reaching a low of 1.5% in 2021, credit card delinquencies have doubled to more than 3.2% which is the highest since 2011. Low-income consumers have exhausted their cash savings and are now making more value-based purchasing decisions. We have heard from many retailers that they see “trade down” buying trends, even among more affluent customers. The Fed realizes that this trend has the potential to worsen, particularly if labor market weakening accelerates.
The worst months for the market
Since 1980, September has delivered the worst monthly returns for the S&P 500 with an average of -1.1%. August hasn’t fared much better at -0.1%. These are the only two months of the year with negative average returns. There are theories about why this occurs, but we will not analyze this at the moment. Given the relatively strong stock market returns YTD, it would not be surprising if the market follows its historical pattern.
The outperformance of the S&P 500 as compared to its Equal Weighted peer index may have reached a breaking point based on this past week’s rotation. We have to go back to the year of the internet boom in 2000 to find a similar divergence of greater than 13%. A broadening out of the performance beyond AI theme stocks would be healthy and normal for the markets and the economy. Following last week’s surprising lower inflation report, the yields on U.S. Treasury bonds declined with the 10-year yield now near 4.2%. A lower 10-year U.S. Treasury yield will support valuations of stocks so long as corporate earnings are strong and the economy doesn’t sink into a recession.
We are in the midst of earning season. Results so far have been mixed, but we will learn more in the coming weeks. The rotation we are seeing from growth to value is a rational reaction to the incoming economic data and supports the time-tested investment strategy of maintaining a diversified portfolio.
Entrepreneur Richard Branson turns 74 today, publisher and businessman Steve Forbes turns 77 and actress Kristen Bell is 44.
Christopher Gildea 610-260-2235