It isn’t hard to see why the focus is on the run-up to the election, which has been more dramatic than usual. Vice President Kamala Harris is now the presumed Democratic nominee after President Joe Biden’s disastrous debate performance confirmed what many already knew—he’s just too old for a second term. Nor is it hard to find someone who will blame Harris’ ascension for the stock market’s tough week because it made the election’s outcome less certain, just as many credited the rising odds of a Red Wave that would see the Republicans take the House and the Senate for some of the recent gains.
Please. Nearly everything that can be attributed to Trump or Harris can be explained by the economic data, assumptions about the Federal Reserve, or just run-of-the-mill business activity. The outperformance of the small-cap
index relative to the
and
? It began with June’s consumer price index, which was weak enough for investors to price in a nearly 100% chance of a rate cut in September. It continued as investors fretted about whether the artificial-intelligence trade had gotten ahead of itself after
and
reported earnings.
Even the selloff in solar stocks likely had as much to do with problems at
SunPower
,
a large residential installer of solar panels, as anything to do with Trump.
“On the surface, the intense political climate seems to have caused a notable shift in the marketplace, moving from prominent tech stocks to cyclical, defense, and small-caps,” writes Jeff O’Connor, head of market structure at Liquidnet. “However, it’s hard to attribute this rotation solely to political events. Historically, the impact of presidential elections on the market has been far less pronounced than perceived.”
What really matters is the impact of interest-rate cuts, the strength of the economy, and the direction of earnings. Rate cuts, in particular, are most helpful for companies that are economically sensitive, have a lot of debt, or are just plain small. That’s reflected in the performance of small- versus large-caps, with the Russell 2000 outperforming the S&P 500 by 12.7 percentage points over the 12 days ended July 24, the largest gap for that period on record. The rally has been so intense, and the drop in the S&P 500 large enough, that the Russell, which started July up 1% for the year, is now up 11%—just three percentage points behind the large-cap index’s 14% rise.
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Sustaining the rotation won’t be easy. Much of the tailwind from rate cuts is already reflected in the
exchange-traded fund, which is trading at a steeper premium to the
ETF than it had been at the end of June.
The expectation of rate cuts—and the widening valuation gap—means that further gains in small-caps will likely be smaller and come at a reduced pace, says 22V Research strategist Dennis DeBusschere.
Whether the rotation has legs could come down to both rates and the economy. Bank of America’s Ohsung Kwon looked at when the equal-weight S&P 500—another proxy for the rotation trade—outperformed the market-cap-weighted version of the index. He found that it did so 90% of the time when the yield on the 10-year Treasury fell a full point from its 12-month high and when the Institute for Supply Management’s manufacturing purchasing managers index rose over four points from its lows. For those two things to happen now, the 10-year yield would have to drop to 3.99% from a recent 4.21%, and the PMI would have to hit 50.5, from June’s 48.5. That seems like a big ask.
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Tech stocks have their own issues. Partially weighing on the stocks: the big spending on AI and whether those investments will ultimately pay off.
Investors will get more information this coming week when
Apple
,
and
report earnings. John Higgins, chief markets economist at Capital Economics, is optimistic about the ability of Big Tech to keep Wall Street satisfied through the end of 2025.
“Even if the Magnificent Seven only meet expectations for growth in EPS through the end of next year…we suspect their aggregate market value will continue to rise as their combined price/forward 12-month earnings ratio expands further,” he writes.
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The stock market as a whole, though, may still be headed lower. August and September are historically 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 drop to at least 5250—or 8% below its recent high—before getting set to rally again. He also worries that small-caps and other rotation beneficiaries are showing signs of “exhaustion,” leaving investors in something of a bind.
For now, it might be best to simply ride it out: Don’t give up on the tech trade, but hold a little cash and make sure to have exposure to stocks beyond the Mag 7. Right now is one of those times when it’s better to find a middle ground than pick a side.
Write to Ben Levisohn at Ben.Levisohn@barrons.com
