Big tech stocks are “no longer the only option,” according to investors who have shifted in the past week from the megacaps that have driven stock market gains for years to smaller companies and other sectors that have been out of favor.
The Russell 2000 small-cap index is up 7% since last Thursday, a dramatic market rally fuelled by falling inflation and improving earnings prospects.
Meanwhile, the so-called “Magnificent Seven” mega-cap tech stocks that have dominated the blue-chip S&P 500 Index's gains over the past year and stoked fears of an increasingly uneven rally are falling. A global sell-off in semiconductor companies exacerbated the declines, even as most other stocks in the index rose, led by sectors such as financials, energy and real estate.
“Last year you only had one option, and suddenly you have more options,” said Julian Timmer, director of global macro at Fidelity. “With the broader earnings recovery coinciding with a shift in Fed policy and bond markets stabilizing, there are other stocks to buy.”
Investors have long been hoping for a broader rally in the U.S. market. The S&P 500 rose 14% in the first half of 2024, but its reliance on a few big companies has raised concerns the rally is fragile.
While passive investors profited, the narrow gains made it hard for active managers to keep up with their benchmarks because so few companies outperformed the broader indexes and many managers were wary of taking such large positions in just a handful of stocks.
Inflation data released last week cemented investor expectations that the Federal Reserve will cut interest rates in September. Smaller companies in particular are benefiting from the change in expectations, as that group in the Russell 2000 Index tends to have higher debt burdens than larger stocks. Lower interest rates are also traditionally a boon for fast-growing technology companies, but many of the biggest companies have huge cash reserves that allow higher interest rates to boost their profits.
The gains over the past week have been broad-based, with more than 1,500 of the roughly 2,000 companies that make up the Russell index rising in value. Meanwhile, an equal-weighted version of the S&P 500 outperformed the benchmark index, rising almost 3%, while a market-capitalization-weighted version fell.
Some market participants say the intensity of the market rotation is partly the result of investor positioning. Bank of America analysts noted on Thursday that short covering was a key driver of the Russell 2000 Index's rally, with heavily shorted stocks doing the best.
“I think a lot of people got it wrong,” said Brandon Nelson, a portfolio manager at Calamos who specializes in small and mid-cap stocks. “People were so fixated on large caps that they ignored or even shorted small caps, and they got caught off guard because small caps were the right pair trade for a long time.”
Meanwhile, other companies' profits, which lagged far behind the Magnificent Seven's profit growth last year, are now improving as profit growth among large tech stocks slows.
“Remaining [S&P 500] “We were in a technical earnings recession last year,” said Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America Corp. “As growth expands, we believe investors should become a little more price sensitive and move money into cheaper, more cyclical companies.”
But it would take a brave investor to ignore the possibility of further positive surprises from big tech stocks.
Nvidia has fallen 13% over the past five trading days after U.S. inflation fell more sharply than expected on Thursday. The last time it fell that much in five days was after it had risen 72% over the two months that followed.
Jim Tierney, a growth-focused portfolio manager at AllianceBernstein, said the fundamental trends that have driven the growth of the Magnificent Seven and other artificial intelligence stocks remain “largely intact,” but suggested the relative strength of these stocks' earnings compared with the rest of the market is likely to weaken.
“From a fundamental standpoint, The Magnificent Seven is no longer the only game with growth potential,” he said.
While many investors are hoping for a sustained expansion in the gains, that might not be good news for the index as a whole: More than 350 stocks in the S&P 500 rose in the week after the inflation report, but the index itself fell 1.5% due to its heavy weighting in big tech companies.
Whether the index keeps rising will depend on “whether new money comes into the market and chooses to invest in other stocks rather than the Magnificent Seven, or whether there's an internal rotation as investors sell the Magnificent Seven and buy other stocks,” Fidelity's Timmer said.
He and several other analysts also noted that a delicate balance is needed for small businesses to keep growing: They need the Fed to start cutting interest rates, but they also need to avoid a major downturn that would hurt their bottom lines.Thursday's market moves highlighted that risk, with the Russell 2000 Index falling 1.9% after data showed jobless claims hit their highest level since 2021.
Even after the past week's rally, small-cap stocks and an equal-weighted version of the S&P 500 are still well below the benchmark S&P 500, and investors are cautioning against getting too carried away.
“The gap closed a little bit last week,” Calamos' Nelson said, “but you can't undo years of underperformance in five days.”
