Stock Market Before the Election: Rotation or Regrouping?

Stock market participants are once again trying to find high-tech stocks, but it seems that their search for other sectors has once again stalled. The market is about to bet on November's election results, but I think it's far wiser to stick to stocks with strong confidence that are sure to win no matter who sits in the Oval Office.

Since the second half of 2022, the US stock market has been increasingly driven by a small number of stocks - large high-tech companies related to artificial intelligence (AI). During this time, the number of fund managers jumping on AI, led by FOMO (“fear of missing a ride”) increased. As a result, the inflow of investors' funds increased rapidly, and the valuation of large high-tech stocks reached an outstanding level.

Hyperscalers and other large companies' huge spending on AI provided a solid foundation for further profit growth for hardware and software providers in the AI cohort, yet many strategists and money managers feel that stock prices have surpassed fundamentals. Also, the fact that there was a big gap in performance and valuation between the AI leader group and other markets made many market participants uneasy.

This anxiety was first strongly expressed in the first quarter of this year. Expectations for imminent interest rate cuts have been rekindled since some economic data that fell short of expectations came out. Lower interest rates will support businesses struggling with high financing costs. If interest rate cuts are due to a cooling economy (including the job market), companies in many industries will also benefit from a decrease in wage increases. In short, the outlook for monetary easing will reduce the attractiveness of large technology stocks, which functioned as safe harbors for investors in the era of high inflation and high interest rates.

Since soaring high-tech stocks came to be highly appreciated, it was recognized that their relative attractiveness had declined, and investors began to test rotation; in other words, the inflow of investors' funds into small-cap stocks and value stocks increased at the expense of high-tech stock leaders. The problem with these tests is that since the AI rally began, its leaders have risen significantly, and the weight that accounts for the S&P 500 stock price index SPY -1.73% ▼ has never been greater. As a result, the decline in high-tech stocks led to a decline in the overall market, induced full-scale “dip buying,” and shortened rotation.

This is because the results of the latest inflation report announced on 7/11 fell short of expectations. Recent economic data and Jerome Powell's statement that policymakers are deepening their confidence in disinflationary trends convinced investors that the Federal Reserve will begin cutting interest rates in September. As a result, the attractiveness of the business cycle sector, which is expected to benefit most from the Federal Reserve (Fed) interest rate cuts, has further increased.

Additionally, it can be understood that investors' anxiety about the financial results season is palpable. Earnings in the high-tech sector as a whole are expected to grow by double digits compared to the previous year, but there is a possibility that this will be a double-edged sword. On the other hand, if top companies in the high-tech industry once again exceed expectations, there is a possibility that the tailwind will blow into the sluggish high-tech rally. Conversely, especially considering current investor agitation, there is a possibility that many stocks that are soaring will be hit by the “Sell the News” moment.

Furthermore, since past performance appears to be fully factored in, future quarterly guidance may have a greater impact. After the S&P 500 and the Nasdaq Composite Stock Index NDAQ -0.49% ▼ recorded the worst week since April, bets on guidance from tech companies became even higher.

This is because investors have found new reasons to profit from AI rallies. This money has been diverted to sectors that have been lagging behind until now, such as healthcare, real estate, finance, energy, materials, etc., and is driving the outperformance of the Dow Jones Industrial Average (DJIA), which has extremely little exposure to technology compared to the S&P 500. Furthermore, funds flowed into small-cap stocks, leading to a strong outperformance of the Russell 2000 IWM -0.63% ▼ small-cap benchmark in the past 2 weeks.

The small-cap index includes stocks of more domestically oriented companies that are seen as one of the beneficiaries of Donald Trump's victory in the November election. Trump is expected to strengthen trade restriction policies such as import tariffs and support local production. As the possibility of Trump winning increases, other potential beneficiaries (commonly known as “Trump Trade”) are also increasing market interest.

These include energy producers, automobile manufacturers, healthcare companies, and other companies that are expected to benefit from deregulation, a freer M&A environment, import tariffs, and drastic relaxation of environmental policies.

However, one area where the current administration and Republican candidates are on the same page is trade relations with China, and in particular, additional and strict restrictions on exports of semiconductors and chip machines to China. Last week, news that the White House is considering further tightening chip equipment sales to China echoed across the semiconductor sector and spurred worries.

Meanwhile, President Trump is known for his tough stance on China, and in particular, he has proposed imposing tariffs of at least 60% on all imported goods from Asian giants. The view that the trade war with China will intensify no matter who wins the election is bad news not only for the semiconductor industry but also for the technology sector as a whole.

There is still time until the election, and it is too early to predict the outcome and impact on the stock market. However, if you look only at high-tech stocks, there is no need for additional reasons from political headlines due to their drastic rise and rich valuations, and adjustments are easy. Meanwhile, whether this adjustment means a rotation to other sectors or an overall downturn in the market depends on several economic, political, and market forces.

Accordingly, if heightened profit expectations, particularly guidance for further high growth, are not realized, there is a possibility that investor sentiment will be further damaged.

Tesla TSLA -10.48% ▼ and alphabet GOOGL -4.49% ▼ weigh on sentiment despite the fact that Tesla reports were not disastrous, and despite the fact that alphabet reports were generally good. The market just expected more from the “Magnificent Seven” members.

As for the economy, the main driving force behind this year's economic rise was the prediction that the economy was entering a “goldilocks” state.

Monetary easing is widely recognized as positive for the stock market as a whole, but if carried out in the midst of an economic recession, it will be toxic. If the economy decelerates more than expected, it will be disastrous for many stocks that want to ride the wave of stock rotation, such as small-cap stocks, real estate, consumer stocks, etc.

It was not a surprise that Joe Biden announced his withdrawal from the election campaign. However, new unknowns have also been added to the various uncertainties that investors are currently facing, such as the economy, performance, and geopolitics. After this news, the market is taking time to reorganize, and it seems that rotation trading has been put on hold.

The fact that the rotation from high-tech stocks ended in an easy failure may be proof that the main reason for recent sales is the high valuation of these stocks, and not lack of trust in the future. After the worst tech stock crash since April, investors began returning to AI stocks and the larger technology universe. Currently, performance, which is not as big as expected, is drawing back investors, but it is uncertain how long it will last.

The long-term cause of this probably lies in the “AI is the future” scenario, but the more direct cause is that large high-tech stocks should not be adversely affected by the policies of any presidential candidate. The accelerating flow of anxiety and uncertainty won't ease until at least November, so investors who don't want to bet a fortune on any presidential candidate's agenda would be better off holding large tech stocks or other stocks that have stepped foot on both sides.

In other words, American companies involved in technology, industrial production, construction, electricity, and material supply, and financial companies that fund these projects will be winners in the next election.