By Louis Krauskopf
NEW YORK (Reuters) – With U.S. interest rate cuts looming, investors are facing a tough choice: hang on to the big tech stocks that have driven returns for more than a year, or turn to less-favoured areas that could benefit from easier monetary policy.
Owning tech giants and growth companies like Nvidia, Microsoft and Amazon has been a highly profitable strategy for investors since the start of 2023, even as their stock market dominance has drawn comparisons to the dot-com bubble of the late 1990s.
That calculation may begin to change following Thursday's unexpectedly sobering inflation report, which bolstered expectations of a near-term interest rate cut from the Federal Reserve. Lower rates are seen as beneficial for many sectors of the market that have underperformed this year, including cyclical sectors like small caps, real estate and industrials.
Market action over the weekend suggested a new shift may already be underway. The tech-heavy Nasdaq 100 index posted its biggest drop of the year on Thursday, while the small-cap Russell 2000 index had its best day of 2024. The Nasdaq 100 is up about 21% this year, while the Russell 2000 is up just 6%. Also on Thursday, the equal-weighted S&P 500, a proxy for the average stocks in the benchmark index, posted its biggest relative gain since 2020 against the S&P 500, which is more heavily influenced by the biggest tech and growth stocks. That cuts into the S&P 500's big advantage, which is up about 18% in 2024, compared with a 6.7% gain for the equal-weighted index.
“The trade has become too one-sided and we are seeing a reversal,” said Walter Todd, chief investment officer at Greenwood Capital.
Small-cap stocks and the equally-weighted S&P 500 continued to rise on Friday despite a rebound in tech stocks.
Investors have warned that the move could be a backlash after the performance gap between tech stocks and other market sectors reached an extreme.What’s more, recent periods of market expansion have been short-lived.Small-cap stocks, for example, surged in late 2023 when investors thought interest rate cuts were imminent, only to stagnate in the months that followed.
Still, there is reason for optimism about the expansion: Federal funds rate futures on Friday were pricing in a nearly 90% chance of a 25 basis point rate cut at the central bank's September meeting, according to CME FedWatch.
Smaller businesses that rely heavily on credit, such as biotechnology companies, are among the ones that stand to benefit most from low interest rates, said Matthew McCurry, president and director of private wealth at Cumberland Advisors. Industrial companies that can rely on borrowing for capital-intensive projects could also benefit, McCurry said.
If bond yields continue to fall, stock valuations across the market could also become more attractive as traders price in lower interest rates. Lower yields mean less competition between bonds and stocks, but many analysts' models still push equity valuations higher.
The 10-year Treasury yield, a benchmark that moves inversely to prices, was recently around 4.2%, down about 50 basis points from its April high. The S&P 500 index recently traded at 21.4 times forward earnings, compared with a historical average of 15.7, according to LSEG Datastream.
“If we can start to stall (around 4%), I think we'll start to see broader moves across multiple sectors of the equity market,” McAleer said.
Many skeptics say that will sway investors away from shares of larger companies that are seen as more resilient in an uncertain economic environment.Big technology companies could be attractive investments if the U.S. economy starts to weaken more than expected after months of high interest rates, said Chuck Carlson, chief executive officer of Horizon Investment Services.
Mega-cap tech stocks are also at the heart of the artificial intelligence theme that's excited investors this year, said Rick Meckler, a partner at Cherry Lane Investments.
“We may see some increased buying of the stocks,” Meckler said, “but as long as AI theory dominates the market, I think it will be hard to see these stocks falling significantly.”
A sustained departure from large-cap stocks could pose problems given the large stocks' large weighting in the index.
The S&P 500's gains so far this year have been concentrated in stocks such as Nvidia and Microsoft, and analysts have warned that any weakness in these stocks could hurt the major index.
If big tech stocks continue to fall, “at some point, that will lead to a broader market decline,” Matthew Murray, chief market strategist at Miller Tabak & Co., said in a note on Friday.
(Reporting by Louis Krauskopf; Editing by Illa Iosebashvili and Richard Chang)
