Since the bull market began in October 2022, much of the stock rally has been driven by artificial intelligence and the outperformance of a few large stocks, raising investor concerns that the gains are not broad-based enough for the rally to continue.
This could change.
Better-than-expected inflation data released Thursday has sent the stock market into disarray in recent days. As investors quickly priced in the higher odds of a September interest rate cut by the Federal Reserve, the market’s most beloved sectors over the past year have underperformed as investors gravitate toward sectors outside of technology.
The Roundhill Magnificent Seven ETF, which tracks the group of big tech stocks that led the stock market’s 2023 rally, is down more than 1.5% over the past five days. Meanwhile, real estate (XLRE) and financials (XLF), two interest-rate-sensitive sectors, have been the market’s biggest gainers over the same period. The small-cap Russell 2000 (RUT) is up more than 7% and finally broke its 2022 high for the first time during the current bull market.
In another sign that a broad range of stocks is rising, the equal-weight S&P 500 (^SPXEW), which ranks all stocks in the index equally and isn’t overly influenced by the size of stocks that move up or down, outperformed the traditional market-cap-weighted S&P 500.
Callie Cox, chief market strategist at Ritholtz Wealth Management, told Yahoo Finance that the market action of late has been “refreshing” and could be a sign of a maturing bull market, with a broad range of stocks contributing to the rally, providing further support for stock indexes at record highs.
“If this trading continues, if the prospect of a rate cut is still on the table for this fall, then we could finally see the bull wake up, and that would be good news for all investors,” Cox said.
This is not the first time that strategists have been optimistic about market rotations like the one currently occurring. Other bouts of broad-based rallies were celebrated in December 2023 and in the first quarter of this year.
The question is whether a broad extension of stock market gains is finally underway this time, or whether this is another fakeout as the market becomes overly optimistic about Fed rate cuts.
“Our conviction level is higher now than in December (during the Fed-driven rally),” Ohsung Kwon, senior equity strategist at Bank of America Securities, told Yahoo Finance.
Kwon noted that the narrative driving the rally – the hope of a soft landing and gradual rate cuts from the Fed – remains largely unchanged from previous bouts of widening. But this time, he said, “the earnings backdrop is also really supporting this rotation.”
Bank of America’s earnings analysis shows that all 493 stocks, excluding the “Magnificent Seven” of Big Tech, are expected to see year-over-year earnings growth for the first time since 2022 during the current reporting period. As the chart below from JPMorgan Asset Management’s June midyear outlook shows, earnings growth for these stocks is expected to accelerate in the coming quarters, while earnings growth for Big Tech is expected to slow.
Given that earnings are typically the primary driver of stock prices, this would support the theory of a broad-based rally. But the main caveat is that these are just expectations. And given the market’s struggles so far this year to produce a broad range of winners, some strategists are keen to see actual earnings growth to confirm the narrative that’s currently emerging from estimates.
“I want to see earnings growth coming from sectors other than technology,” Cox said. “I think that’s the big theme of this season in particular. You know, seeing how many sectors can actually help drive up S&P 500 earnings expectations.”
The same could be said of the other argument underlying the recent rotation. Markets now price in a more than 90% chance that the Fed will cut interest rates in September, according to the CME’s FedWatch tool. But again, Cox is wary of saying that the widening will certainly continue.
“Until we officially enter this rate-cutting cycle, it’s going to be hard to tell if this rate hike is here to stay,” Cox said. “I hope it is. I’m optimistic, but the market is still going to be hanging on every piece of economic data that comes through.”
Kevin Gordon, senior investment strategist at Charles Schwab, is also cautious about the announcement of a massive widening. Gordon stressed that “greater clarity” on the Fed’s rate-cutting cycle and why it would begin cutting interest rates remains critical, particularly for the most interest-rate-sensitive segments of the market like small caps.
Gordon called the recent market move a “big step in the right direction.” But a broad-based recovery won’t happen overnight, he added. “Everyone tends to say this is a big rotation, but big rotations tend to take a little longer than a few days.”
And while that rotation is happening slowly, the index’s recent performance suggests it will also mean a different, slower trajectory for the S&P 500. The S&P 500 closed lower Thursday despite a promising June inflation report as investors dumped big tech stocks, which have a larger weighting in the index than smaller stocks.
“We could see a bit of a shakeout, where some stocks hand off to other stocks,” Cox said. “Tech stocks hand off to other stocks. Sure, we might not see prices rise as quickly as they have. But that’s the kind of move that builds the foundation for a bull rally. That means that rally can be stronger and last longer down the road.”
Josh Schafer is a reporter for Yahoo Finance. Follow him on X @_joshschafer.
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