High-speed rotations can cause vertigo. Internal conflicts have a way of creating visible signs of stress. Both tendencies apply to stocks over the past week and a half, as a violent set of reversals among segments of the market has taken things from gentle, healthy rebalancing into an erratic tape sending staticky economic signals. The rapid redirection of money — from the biggest stocks to small ones, quality companies to riskier ones, crowded winners to neglected laggards, and growth into value — began from a place of extreme outperformance by large, quality, growth stocks. Which means investors were profoundly ill-positioned for it, and the rotation unusually spring-loaded. By Tuesday, after a five-day, 11% rip, the small-cap Russell 2000 had exceeded its 50-day average level by a record degree. It was enough to essentially turn the iShares Russell 2000 ETF (IWM) into a virtual meme stock, ranking by Wednesday as the fourth most-mentioned ticker on Reddit’s Wall Street Bets forum, according to Axonic Capital. The source for all that fast money rushing into the long-suffering small-cap benchmark came out of the biggest winners of the first half. Semiconductors as a group lost 8% last week and are more than 11% off their peak, threatening to break down on a relative basis after a long run of leadership. The four best-performing stocks in the S & P 500 year to date were down an average of 13.5% last week. .SPX 5D mountain The S & P 500’s performance in the past five trading days. Factors behind the sudden shift Such furious turnabouts in performance tend to have a plausible fundamental basis exaggerated by forced mechanical accelerants. The confluence of a convincing retreat in inflation readings leading to overwhelming agreement on a likely September Federal Reserve rate cut in a still-growing economy got a further push in the same direction by a surge in real-time expectations of a Donald Trump election win. The dog-eared playbook for reacting to each of these conditions – a soft economic landing protecting cyclical companies and a probable election outcome preserving tax cuts and lowering regulation – is essentially the same: Buy cyclical, financial, and small-cap stocks. Cash out of expensive, high-momentum, defensive secular-growth mega-caps. By the middle of last week, this by-the-book action raised the hazard that investors were pricing in an excess of certainty about key elements of the outlook: That the economy was benignly decelerating, that Fed rate cuts were a clear catalyst for a risk-seeking rotation, and that the betting markets’ take on Trump’s advantaged electoral position was both correct and carried clear market-friendly policy implications. The messier action to finish the week – with most stocks down and no major indexes immune – implied a reconsideration of those assumptions. The economic data perked up (retail sales, industrial production, housing starts) after months of downside surprises and just as the consensus decided slowdown risks made rate cuts a lock. Treasury yields, while not moving much, finished a bit higher on the week. Parag Thatte, strategist at Deutsche Bank, views the early-week market action as the market seizing on the perceived certainty of an election outcome – an unexpected development roughly 100 days ahead of what was thought to be a coin-toss contest. Thatte says, “As in the past, we see market reactions to these swings as being tied more to whether the election is becoming tighter (negative for equities as it raises uncertainty) or more predictable (positive for equities), rather than a preference for a candidate. In our reading, the market sell-off over the last 2 days partly reflects the modest re-tightening in the presidential race.” A broader – but not necessarily more stable – market As for the mechanical accelerants to the whipsaw market action, outflows from small-cap ETFs hit an extreme in early July, according to Renaissance Macro, while speculators had built an overwhelmingly lopsided short position in Russell 2000 index futures, leaving them tightly coiled for a dramatic snapback. The resulting short squeeze and grab for exposure to the resurgent parts of the market might be fairly far along by now, if not complete. Goldman Sachs’ hedge-fund clients as a group executed one of the most dramatic “de-grossing” episodes on record last week. This involves reducing both long and short positions quickly to lower risk exposures. This is the stuff that jarring market shakeouts are made of. Most of the historical studies on such a powerful momentum surge in small-caps and overall market breadth suggest that after a digestion phase (perhaps the past two days’ Russell 2000 declines qualifies), smaller stocks tend to go on to further outperformance for a bit. In some ways, this is an odd moment for such a blast-off of riskier, lower-quality stocks, which are more common coming out of an economic downturn. Then again, the profound underachievement of littler and more cyclical stocks in an economy growing above trend most of this year was also in its way an anomaly, now partially reversed. If nothing else, it’s a reminder that a broader stock market is not a more stable one. The anchoring effect of a persistently strong half-dozen $1-trillion to $3-trillion companies atop the S & P 500 while most stocks wallowed had the effect of suppressing index volatility. The sell-off in S & P 500 – down 2% this past week – untethered the Cboe Volatility Index (VIX) and sent it to a three-month high above 16 from a recent low under 12. Tumultuous action that is also timely In many respects, this unsettled market weather is arriving right on time. Seasonal patterns shift from positive to challenging in mid-July. In most of the past 25 years, the S & P 500 has had a 5% or greater pullback in the three months starting in mid-July, according to Cantor Fitzgerald. Election years tend to see stocks stall or churn lower in the months before the vote. While this means that no one should be surprised with more turbulent market action to work off elevated valuation, positioning and sentiment, not much yet suggests a more consequential trend change afoot. The S & P 500 is now about 3% off its record, and the Nasdaq 100 is in a roughly 5% retreat from its high. History says when the S & P 500 has been up more than 10% in the first half of a year , as in 2024, it has gone to further highs by year’s end nearly every time. The burst of strength in the majority of stocks in recent weeks might need to be digested, but it has at least countered bears’ complaints about the narrow rally and bought the tape a bit of a technical cushion. While the initial batch of second-quarter earnings reports has been met by generally ungenerous market responses, the numbers themselves are solid. They are tracking at a 10% annual pace, with growth broadening somewhat away from tech — enough to lend some support to the current (admittedly stout) valuations. Hardly a table-pounding bullish case, perhaps, but enough to encourage investors to stay involved while keeping expectations in check.
Markets broaden as investors sell tech winners, but further turbulence may be on the way
Jul 20, 2024
