A weeklong decline in megacap technology stocks broadened Thursday to encompass smaller firms and financial shares as signs of economic weakness overwhelmed optimism over rate cuts.

Almost every major group in the S&P 500 fell, with the US equity benchmark down nearly 1%. A rally that drove the gauge to almost 40 record highs this year spurred expectations of a pullback or at least consolidation. And those calls have grown after a wide array of companies soared in just a few days, outperforming the leaders of the bull market — the cohort of big techs.

Conviction the central bank is poised to ease back on its battle to subdue inflation has prompted a retreat from megacap stocks, which emerged during the Federal Reserve's tightening cycle as a de-facto safety trade due to their steady profits and pristine balance sheets. Money had previously been flowing in turn to a broader swath of industrial and staples firms, though those joined the selloff as well.

While signals the Fed is a step closer to cutting rates would theoretically bolster that trade, it wasn't the case on Thursday. Wall Street's "rotation" took a breather even after jobless claims showed labor-market cooling.

"Investors have quickly moved from 'over-crowded' megacap leaders and put money to work in 'down-cap' opportunities," said Craig Johnson at Piper Sandler. "While this makes the case for a broadening bull market, prudence favors pullbacks at confirmed support levels amid improved breadth signals."

The S&P 500 fell to around 5,545. Megacaps were mixed, with Nvidia Corp. up and Apple Inc. down. The Russell 2000 retreated about 2% after recently hitting its most-overbought level since 2017. The Dow Jones Industrial Average halted a six-day winning streak.

In late hours, Netflix Inc. said it added over 8 million customers in the second quarter, but gave a cautious forecast. Broadcom Inc. closed higher on a news report it has discussed making an artificial-intelligence chip for OpenAI. Domino's Pizza Inc. sank after suspending its store growth target. D.R. Horton Inc. jumped on solid profit margins.

Treasury 10-year yields rose four basis points to 4.20%. The euro dropped on bets the European Central Bank will cut rates in September.

In just a few days, the Russell 2000 rose more than 10%. Yet most of the rally in smaller companies took place after last Thursday's cooler inflation data bolstered speculation on Fed policy easing.

Small caps notched the best-ever performance over their larger peers in a five-day period, Jim Bianco, founder of his namesake research firm, said in a recent X post. He tracked the difference between the Russell 2000 and Russell 1000 since 1978.

To Dan Wantrobski at Janney Montgomery Scott, the recent "rotation" pushed the broader markets into some moderately overbought territory on a short-term basis. This alongside ongoing extended conditions in leadership areas renders them vulnerable to potential consolidation over the short run, he noted.

"As pundits start to jump on the 'rotation is real' bandwagon, we are cognizant of the threat of potential bull traps ahead," Wantrobski said. "As we noted last week when the change in trend first began, this rotation is in its very early stages, and cannot yet be confirmed as a longer-term investment theme in our opinion. So while we are encouraged by the broadening out of US equity markets most recently, we want to be mindful of any false signals."

To Lori Calvasina at RBC Capital Markets, there have been indeed several false starts — even as valuations and positioning have set the stage for an eventual shift to a new leadership. The earnings season will be a "key test" for the rotation trade, she recently noted.

"Certainly, some digestion of the rotation is required after the massive moves of the past trading week," said Tom Essaye at The Sevens Report. "But whether the rotation can continue will be determined by economic data and earnings."

While Essaye says data remains mostly "Goldilocks" and tech is still "over owned," he's not really in favor of aggressive allocations to cyclicals for anything other than tactical capital.

"While the market is convinced lower rates will prevent a slowdown, corporate earnings and Fed commentary continue to imply investors are too complacent when it comes to slowdown risks," Essaye concluded.

As the Fed embarks on a rate-cutting cycle, markets tend to cheer it initially and even for a short period after the cuts begin, according to Liz Young Thomas at SoFi.

"But if that cutting cycle occurs in concert with slowing economic data, disappointing earnings, or a quick compression in multiples, small-caps would likely lose steam quickly," she said. "Not to mention, the Fed typically cuts rates late in the economic cycle, not early in the cycle when small-caps tend to have their moment in the spotlight."

Stock-market returns following the initial Fed rate cut are largely dependent on whether the economy avoids recession, according to Keith Lerner at Truist Advisory Services.

When stocks avoided recession, such as in 1989, 1995, and 1998, stocks rose over the next year, he said. Conversely, equities were down over the next year following the initial rate cuts in 2001 and 2007, which were not enough to avoid an economic contraction.

The most recent occurrence in 2019 was an outlier since it was followed by the pandemic and then massive fiscal and monetary stimulus. – Bloomberg