It’s been a volatile month for the stock market. Nobody likes volatility, but recent moves have helped straighten out a badly turbulent stock market. The market’s new, more stable stance could lay the foundation for investors to make further gains later this year.
Stocks have seemed to be surging in 2024. After rising nearly 19% to a record high on July 16, the S&P 500 hit a wall this month and posted its biggest drop in more than a year last week. On Monday, the index rose 0.06%, or 3 points, to 5,462.
One factor is the turbulent U.S. presidential election, in which one candidate escaped an assassination attempt on July 13 and another withdrew just a week later. But perhaps more important is concern that tech companies’ ultimate AI gains may not be worth their soaring stock prices. The so-called “Magnificent Seven” tech stocks that have driven the market for the past few years are down nearly 12% from their mid-July peak.
Fortunately for investors, this big drop hasn’t led to talk of a bear market or correction. Rather, the word that’s getting people talking on Wall Street is “rotation.”
While tech stocks have taken a beating, small-cap stocks, long out of fashion, have surged dramatically, propelling the Russell 2000 Index up 12% since the start of the month. Large-cap sectors that had previously struggled, including real estate, materials and utilities, have also thrived. “A full-blown bear market is unlikely,” Bank of America Securities concluded in a research note on Monday. “What’s in play is a rotation.”
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The overall market resilience isn’t necessarily surprising. The U.S. economy released surprisingly strong GDP numbers last week. More than three-quarters of companies reporting second-quarter profits beat analysts’ expectations. Also, inflation appears to be stabilizing, giving investors more confidence that the Fed will cut interest rates at least once starting in September.
Investors should view this rotation as a blessing and hope it continues, allowing the market’s dangerously inflated tech sector to right-size without triggering a broader market collapse like the one that followed the dot-com bubble of the 1990s.
We’re already seeing signs of this: This month alone, the Magnificent Seven’s share of the S&P 500’s market capitalization has fallen from 34.4% to 31.6%, according to independent market researcher Jim Paulsen. While still high, that’s much closer to the more sustainable 30% level it was hovering around before it spiked this year, he says.
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A mirror image of this movement appears to be playing out among small-cap stocks. Earlier this year, small caps’ share of the overall Russell 3000 index fell to 5.2%, a 20-year low, from a high of 9% in 2006. As of Friday, small caps’ share had rebounded to about 6%, according to FactSet.
So how should you position going forward? One easy step is to look at index funds. Over the past month, the Vanguard Total Stock Market ETF returned 0.7%, nearly a full percentage point higher than the Vanguard S&P 500 ETF, which was down 0.2%. Eight percent of the broad fund’s assets are invested in small-cap stocks, compared with less than 1% in S&P 500 options.
This lesson may seem obvious, but many investors don’t seem to have learned it. According to data firm VettaFi, the $409 billion Vanguard Total Stock Market ETF is the fourth-largest exchange-traded fund on the market. The top three are all S&P 500 funds, with a combined total of more than $1.5 trillion. (To be fair, some, but not all, of the investors who hold S&P 500 funds are institutional investors or likely combine them with another small-cap ETF.)
Investors who want to make a bigger, more aggressive bet on rotation can opt for equal-weight ETFs such as the Invesco S&P 500 Equal Weight ETF, which downplays the role of technology in the market by giving every company in the portfolio the same weighting. And, of course, there are small-cap funds like the Vanguard Russell 2000 ETF and iShares Core S&P Small-Cap ETF.
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Still, chasing returns comes with risks. Small caps have already risen 10% in recent weeks, and even if the economy continues to thrive, they’re unlikely to repeat the feat. As long as you’re not biased toward tech and have at least some exposure to small caps, the best way to rebalance your portfolio for the rest of the year may be to wait for it to rebalance naturally.
