You may have heard about recent activity in the stock market that some are calling “the great rotation”. If you’re wondering what that means or what’s causing it, you’ve come to the right place. We’ll explain market rotations, take a look at the current market movements and their causes, and discuss points of particular interest when investing in the small cap space.
So, what is a market rotation? Fairly simply, it is when investors rotate out of some stocks into others. This can happen at the level of individual stocks or on more general levels such as market cap size, growth/value characteristics, or industry sectors. Sector rotation is part of the normal business cycle as investors move money into sectors that typically thrive under the anticipated part of the economic cycle. Funds moved in market rotations usually come from stocks that have been the biggest movers recently.
For the current rotation, large cap tech/AI has most certainly been the area with the largest movers recently. For the first half of 2024, the magnificent 7 tech stocks accounted for 59.5% of the S&P 500’s gains. As such, this is where we are now seeing funds rotating out of to other areas of the market. Much of this is being moved into the small cap space but we’ve also seen some other areas benefit such as the Dow hitting a new record. The Russell 2000, an index for small cap US stocks, jumped 6% in the week this rotation began while the S&P 500 and NASDAQ were each only up a fraction of a percent. This still leaves the Russell behind the large cap S&P 500 and NASDAQ for the year but has helped close the gap after small caps had not seen much movement in 1H24.
So why is all of this happening now? As mentioned above, the large cap tech space has seen tremendous growth this year and has become a highly concentrated portion of the market. With that as the backdrop, the most recent CPI inflation reading came in not only showing that inflation had continued to ease, but it fell by more than expected. After a bit of a hiccup early in the year, this report added to the trend of the last several months of declining inflation and gave investors more confidence that we will see a rate cut from the Fed this year. Declining interest rates have a larger beneficial effect on small cap companies and can help increase their profit margins by lowering the cost of capital. While we probably won’t see a rate cut until perhaps September, the forward-looking market began the rotation to small cap.
While this rotation is coming out of large cap tech, it does not appear to be a dumping of large cap or tech/AI in a broad sense. This makes sense as the extreme growth in that space has been generally backed by earnings and real growth potential. This rotation instead appears to be a healthy reduction in the overconcentration of large cap tech and breadth expansion into previously under-invested areas of the market. However, while there could be great opportunities in small cap stocks, quality is particularly important in this area of the market. At DWM, the securities we utilize for exposure to the small cap space have a high-quality characteristic with almost all the companies being profitable whereas in the Russell 2000 40% of companies have no earnings.
While this “great rotation” has been garnering lots of attention in the news lately, market rotations in general are not uncommon. These events are part of why it is important to have a broadly diversified investment portfolio so you can capture the upside of these events without trying the impossible task of timing the market. Working with a trusted wealth manager like DWM is a great way to make sure your investments are ready for the next great rotation!