Wall Street's Great Rotation Ushers Out Tech in Favor of New Sectors

The rotation trade, marked by a significant shift from tech stocks to small-cap and value plays, underscores a changing market sentiment. Investors are rebalancing portfolios, moving out of the tech titans that have dominated for much of the past decade. This recalibration is seen as a necessary step for the rally to sustain its momentum. However, the Federal Reserve's stance on interest rates looms large over the market. Traders and analysts alike are keenly watching Fed Chair Jerome Powell's upcoming statements for any hints of a rate cut in September, a move that could further fuel the ongoing equities rally.

Since July 11th, when CPI data indicated signs of cooling inflation, traders have intensified their sell-off of large tech stocks and shifted to buying a variety of stocks ranging from small caps to value stocks. According to Bloomberg Intelligence data, investors have poured nearly $6 billion into U.S. exchange-traded funds (ETFs) focused on non-tech sectors, while inflows to tech ETFs have amounted to only $1.4 billion.

Market breadth is a critical factor in assessing the health and sustainability of a rally. A rally driven by a narrow group of stocks, typically in a single sector like technology, is often viewed as fragile. In contrast, a rally with broad participation across various sectors is seen as more robust and enduring. The recent rotation into small-cap and value stocks suggests a broadening of market participation, which is encouraging for long-term growth.

Historical data supports this view, showing that the S&P 500 Index has risen an average of 5% in the year following the first rate cut after a hiking cycle. The gains have also broadened, with the small-cap Russell 2000 Index climbing 3.2% 12 months later, according to CFRA.

Buying stocks at the end of hiking cycles is a winning strategy in relatively low-inflationary environments, like the 1990s. But when monetary easing comes in the wake of inflationary pressures, like the 1970s, stocks fall in the three months after the last hike, according to Bank of America Corp.

For the current trend to sustain, the Federal Reserve's policy decisions are crucial. Traders are betting on a rate reduction cycle to begin soon, with the belief that such a move would support further gains across a broader range of stocks. However, the timing is critical. The average time from the final rate hike to the first cut has historically been 9.2 months, and with 12 months having passed since the last hike in July 2023, the market is in a precarious position.

"Rate cuts would need to be aggressive for those smaller companies to benefit," said Nancy Tengler, CEO at Laffer Tengler Investments. "And we just don't see that happening with the economy strong."

In conclusion, while history shows that buying stocks at the end of hiking cycles is a winning strategy in relatively low-inflationary environments, the current market narrative is more complex. Powell's commentary this week will be critical in determining whether the broadening rally can maintain its course or if the market will face renewed volatility. As Eric Beiley, executive managing director of wealth management at Steward Partners Global Advisory, puts it, "It's important officials act, or else stocks will be vulnerable in a seasonally weak and volatile time."