Previous week's weekly market wrap

The Tides Turn in Three Key Matchups

Key Takeaways:

• Stocks saw wide swings last week, with an early-week rally that sent U.S. markets to new highs but which faded toward week's end, led by weakness in the tech sector. The major indexes finished mixed, with the S&P 500 and Nasdaq closing lower on the week, while the Dow posted a solid gain.
• After both stock prices and interest rates moved higher together through the early part of 2024, the relationship has shifted more recently, with interest rates declining appreciably (amid moderating inflation and approaching Fed rate cuts), while equities have continued their uptrend, helped by rising corporate earnings.
• Leadership rotation was the key theme for financial markets last week. The tech sector faded while cyclical sectors, which have lagged this year, saw upward momentum. This was underscored by the sharp rally in small-cap stocks.
• This shift in underlying performance and leadership highlights the value and importance of disciplined diversification and balance within investment portfolios. We think leadership can continue to broaden as we advance, helped by an extended economic expansion, more favorable Fed policy, and rising corporate profits.

The market's spotlight widened out last week to include the evolving political landscape. But the shift in the presidential-election matchup wasn't the only notable turn, as a sizable rotation within the stock market captured significant attention. Coming into this year, one of our 10 key calls for 2024 was our view that while equity markets would continue to perform well, the underlying leadership would rotate, broadening out beyond 2023's "Magnificent 7" (technology stocks) concentration.

It's too early to declare complete victory for broadening market leadership, but the comeback story was on full display last week. Here's a look at how this showed up within three key market matchups, and what this means for investors' portfolios:

Matchup No. 1: Stocks vs. Rates: Pricing in a soft landing.

• Weakness in the tech sector was the primary driver last week, highlighted by a divergence in the broader indexes, as the S&P 500 and Nasdaq posted losses while the Dow (with a lower exposure to technology stocks) finished higher, briefly topping 41,000 for the first time and extending its weekly winning streak to three.
• The relationship between stocks and rates has been the dominant theme in 2024. The connection has undergone three distinct phases, the third of which has emerged in recent weeks. For the first three months of the year, stocks and rates moved higher together, with the former shrugging off hotter-than-expected inflation readings (which were sending the latter higher), as incoming data showed the economy remained strong. That changed in April, when concerns that the Fed would need to tighten the monetary-policy screws further prompted a surge in rates and a pullback in equities. That relationship has taken on a new complexion of late, with stocks rallying amid a rather steep drop in interest rates, driven by the prospects of an approaching Fed rate cut alongside ongoing growth in the economy.
• The "soft landing" story (falling inflation, easing Fed policy, sustained economic growth) has gained traction and looks to us to be the outcome that is largely priced into the markets. We have no qualms with this, as our base-case view is that the Fed can thread this needle and ease off the brake in a manner that sees inflation moderate further without the economy falling into recession. This is far from assured at this stage, but we think the Fed can cut rates in September, initiating a new, friendlier phase of interest-rate policy. This, in our view, will be broadly supportive for market performance; however, futures markets moved last week to price in a 100% expectation of a September Fed rate cut. While we also see this as the likely outcome, the fact that everyone has seemingly moved to the same side of the room presents a potential for volatility in the event the next batch of inflation data doesn't cooperate.

Stocks have rallied on the prospects of a soft landing for the economy.

Matchup No. 2: Mega-cap Tech vs. the Broad Market: Signs of a leadership change.

• While equities have delivered solid returns this year, overall S&P 500 gains have been flattered by the sharp gains in the largest tech companies. Because the S&P 500 is market-cap weighted, larger companies have a larger influence on index moves. The average year-to-date gain for the mega-cap tech names (Apple, Microsoft, Amazon, Alphabet, Meta, NVIDIA, and Tesla) of 37% has been a powerful force for much of 2024, a continuation of 2023's trend in which the vast majority of the S&P 500's 26% gain was attributable to the so-called "Magnificent 7" cohort.
• This tide turned noticeably last week, with the S&P 500 equal-weight index materially outperforming, reflecting the underperformance of the largest technology and communication services names, while cyclical sectors, like financials, industrials and energy, outperformed recently.
• We don't think this signals the end of mega-cap tech leadership, as we suspect the combination of defensible earnings streams and long-term AI growth prospects will remain a tailwind for that group. That said, we think the shift last week reflects what could be a more durable trend in which lagging sectors and segments of the U.S. large-cap market play catch-up. Earnings and valuations should support this trend. The rate of Magnificent 7 earnings growth has begun to moderate, while the growth rate of S&P 500 profits, excluding the Magnificent 7, is forecast to accelerate in each of the next four quarters. Against that backdrop, and the elevated valuations for high-flying tech stocks, we think the broadening of market leadership can continue this year.

The "rest of the market" played catch-up after extended leadership from the largest companies.

The Dow outperformed as the tech sector hit a soft patch.

Sector leadership shifted toward cyclical sectors.

Matchup No. 3: Small-caps vs. Large-caps: A long-awaited rotation.

• Perhaps the most notable tide change last week was the renaissance in small-cap stocks. After spending much of 2024 treading water, small-caps surged early last week, which we'd attribute to a combination of
  • Growing confidence in a coming Fed rate cut;
  • Signs that the economy is slowing but still exhibiting sufficient vigor to sustain the expansion; and
  • Election read-throughs, with a shift in expectations for Trump and pro-growth policies (such as a proposed lower corporate tax rate).
• Similar to our comments above on sector rotation, the outperformance of small-caps reflects the potential for leadership to shift toward more cyclical, economically sensitive investments, as the prospects of easier Fed policy bode well for performance in these segments of the market. Second-half consensus earnings estimates for small-caps are healthy but will require the economy to demonstrate resilience in the coming quarters. If that occurs, we think small- and mid-cap stocks would benefit from renewed economic optimism. On the other hand, any indications of waning growth or a less-favorable Fed would put potholes in this path. For perspective, small-caps rallied 27% during November and December of 2023 as signs of economic resilience grew. That rally faded as persistent inflation dashed hopes of a spring Fed rate cut. We don't think last week will prove to be a complete head fake for small-caps and cyclical investments, but we think sustained evidence of a soft landing (positive economic growth alongside falling inflation) will be a necessary ingredient for this rotation to be sustained.

The market rotation last week was highlighted by a sharp rally in small-cap stocks.

Small-caps got a boost from increased expectations for an upcoming rate cut.

Craig Fehr, CFA
Investment Strategy

Weekly market stats

^{Source: FactSet, 7/19/2024. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. *Morningstar Direct 7/21/2024.}

The week ahead

Important economic releases this week include second quarter GDP and PCE inflation data for June.