It’s easy to see why so much attention has been focused on the more dramatic pre-election developments than usual. Vice President Kamala Harris is the presumptive Democratic nominee, as President Joe Biden’s disastrous debate defeat confirmed what many already knew: Biden is too old for a second term. And with Harris’ rise making the election less certain, no one can blame the stock market for having a rough week. Many see the recent rally as partly attributable to the growing likelihood of a “red wave” of Republican control of the House and Senate.
There you have it. Nearly everything attributed to Trump or Harris can be explained by economic data, assumptions about the Federal Reserve, or mundane business activity. Why did the small-cap Russell 2000 outperform the S&P 500 and Nasdaq Composite? It started with the June Consumer Price Index, which was weak enough that investors were pricing in a near 100% chance of a September rate cut. It continued after Alphabet and Tesla reported earnings as investors worried that the artificial intelligence trade had gotten too ahead of itself.
The selloff in solar stocks is also likely linked to President Trump as well as problems at SunPower, a major installer of residential solar panels.
“On the surface, it appears that the intense political climate has caused a notable shift in the market, moving away from leading tech stocks and towards cyclicals, defense and small caps,” wrote Jeff O’Connor, head of market structure at Liquidnet. “But it’s difficult to attribute this shift solely to political events. Historically, the impact of presidential elections on markets has not been as pronounced as perceived.”
What really matters is the impact of interest rate cuts, the strength of the economy, and the direction of earnings. Interest rate cuts, in particular, are most beneficial for companies that are cyclical, heavily indebted, or simply small. This is reflected in the performance of small and large caps, with the Russell 2000 outperforming the S&P 500 by 12.7 percentage points in the 12 days ended July 24, the largest gap on record for that period. The rally was so strong, and the S&P 500 was so weak, that the Russell, which was up 1 percent year to date at the start of July, is now up 11 percent, just 3 percentage points behind the large cap index’s 14 percent gain.
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The rotation won’t be easy to maintain: Much of the tailwind from the rate cuts is already priced into the iShares Russell 2000 exchange-traded fund, which is trading at a steeper premium to the SPDR S&P 500 ETF than it was at the end of June.
Expectations of rate cuts and a widening valuation gap mean further gains for small-cap stocks are likely to be smaller and more slow, said Dennis Debusschere, a strategist at 22V Research.
Whether the rotation will last may depend on both interest rates and the economy. Ohsung Kwon of Bank of America looked at when the equal-weighted S&P 500, another indicator of rotation trading, outperformed its market-cap-weighted counterpart. He concluded that it outperformed 90% of the time when the 10-year Treasury yield fell one percentage point from its 12-month high and when the Institute for Supply Management’s (ISM) manufacturing purchasing managers’ index rose more than four points from its low. For those two things to happen now, the 10-year Treasury yield would need to fall to 3.99% from a recent 4.21% and the PMI would need to reach 50.5 from 48.5 in June. That seems like a big ask.
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Tech stocks have their own problems: Part of what’s weighing on their stock prices is huge spending on AI and whether those investments will ultimately pay off.
Investors will get more information this week when Microsoft Corp., Apple Inc., Amazon.com Inc. and Meta Platforms Inc. report earnings. John Higgins, chief market economist at Capital Economics, is optimistic about Big Tech’s ability to keep Wall Street happy through the end of 2025.
“Even if the Magnificent Seven only meet EPS growth expectations through the end of next year, we expect their total market value to continue to rise as their combined stock price/next 12 month earnings ratio expands further,” he wrote.
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But the overall stock market may still be trending lower. August and September have historically been the worst-performing months of the year for the S&P 500. Rich Ross, head of technical analysis at Evercore ISI, expects the index to fall at least 5,250, or 8% from its recent high, before starting to rise again. He also worries that small caps and other stocks that benefit from the rotation are showing signs of “fatigue,” putting investors in a bind.
For now, it may be best to just be patient. Don’t give up on tech stocks, hold a little cash, and make sure you have exposure to names beyond the Mag 7. This is one of those times where it’s better to find a middle ground than to choose sides.
Contact Ben Levisohn at Ben.Levisohn@barrons.com.
