High-speed rotation can cause dizziness. Internal conflict can produce clear signs of stress. Both trends have applied to the stock market over the past week and a half, as a series of sharp reversals among various parts of the market have turned things from a mild, healthy rebalancing to an unstable tape sending static economic signals. The rapid rotation of money — from the largest stocks to small caps, from quality companies to riskier companies, from crowded winners to overlooked laggards, and from growth to value — starts with large, quality, growth Extreme stock performance. This means investors are very unfavorably positioned for this and the rotation is unusually resilient. By Tuesday, the small-cap Russell 2000 index had surpassed its 50-day average and hit a record high after falling 11% for five consecutive days. According to Axonic Capital, that was enough to turn the iShares Russell 2000 ETF (IWM) into a virtual meme stock, ranking fourth on Reddit’s Wall Street Betting forum as of Wednesday. The source of all the rapid money pouring into the long-suffering small-cap benchmark came from the first half’s biggest winners. Semiconductors as a whole fell 8% last week and fell more than 11% from the peak. After a long period of leading, the relative basis may collapse. The four best-performing stocks in the S&P 500 so far this year fell an average of 13.5% last week. .SPX 5D mountain Performance of the S&P 500 over the past five trading days. Factors Behind Sudden Shifts Such drastic shifts in performance often have a seemingly sound fundamental basis that is exaggerated by forced mechanical accelerators. A convincing pullback in inflation data led to overwhelming agreement that the Federal Reserve could cut interest rates in September if the economy is still growing, while a surge in real-time expectations for the election of Donald Trump further fueled the trend . The response strategy for each of these scenarios—an economic soft landing to protect cyclical companies and a likely election outcome to maintain tax cuts and deregulation—is essentially the same: buy cyclical stocks, financial stocks, and small-cap stocks. Cash out of expensive, high-momentum, defensive long-term growth mega-cap stocks. By the middle of last week, this routine action raised the risk that investors were pricing in key elements of the outlook with too much certainty: The economy was decelerating healthily, and a Federal Reserve rate cut was an obvious catalyst for a recovery. The market’s view of Trump’s favorable electoral status is both correct and has obvious policy implications that are beneficial to the market. The chaotic end of the week – with most stocks falling and all major indexes not spared – means those assumptions need to be rethought. After months of unexpected declines, economic data (retail sales, industrial production, housing starts) are picking up just as consensus is deciding that the risk of an economic slowdown makes a rate cut a foregone conclusion. U.S. Treasury yields, while little changed, edged higher this week. Deutsche Bank strategist Parag Thatte believes the move at the start of the week was the market seizing on the certainty of the election outcome — some 100 days before what was considered a coin toss contest. There have been unexpected developments. “As in the past, we believe the market’s reaction to these moves will depend more on whether the election becomes tighter (bad for stocks as it increases uncertainty) or more predictable (good for stocks),” Sutter said. Rather than favoring the broader (but not necessarily more stable) market, the market sell-off over the past two days partly reflects a mild resurgence in the presidential race, according to our reading. As for the mechanical contributors to market volatility, Renaissance Macro said small-cap ETFs Outflows reached their limits in early July, and speculators built an overwhelmingly unbalanced short position in Russell. The resulting short squeeze and exposure to the market’s recovery portion are now likely to be considerable, if not complete. Far away. Goldman Sachs’ hedge fund clients as a group experienced one of the most dramatic revenue cuts in history last week. This involves quickly reducing long and short positions to reduce risk exposure. This is the source of market volatility. Most historical research on such strong momentum and overall market breadth among small-cap stocks suggests that after a digestion phase (perhaps the Russell 2000’s decline over the past two days qualifies), smaller stocks tend to continue to outperform further for a while. In some ways, it’s a strange time for a breakout in riskier, lower-quality stocks that are more common during economic downturns. Then again, in an economic growth that has been above trend for most of this year, smaller, more cyclical stocks have severely underperformed, which is also an anomaly that has now been partially reversed. If nothing else, it’s a reminder that the broader stock market is not a more stable market. The continued strong anchoring effect of the six S&P 500 companies with market capitalizations of $1 trillion to $3 trillion has dampened index volatility amid a downturn in most stocks. The sell-off in the S&P 500 – down 2% last week – took the CBOE Volatility Index (VIX) off its shackles and lifted it from recent lows below 12 to a three-month high above 16. In many ways, this volatile market weather is coming just in time. In mid-July, seasonal patterns shift from positive to challenging. Cantor Fitzgerald says that for much of the past 25 years, the S&P 500 has had retracements of 5% or greater in the three-month period starting in mid-July. Election years tend to cause the stock market to stall or fall in the months leading up to the vote. While this means no one should be surprised by more volatile market behavior to counter rising valuations, positioning and sentiment, there aren’t many signs yet that a more significant trend change is occurring. The S&P 500 is currently down about 3% from its all-time high, and the Nasdaq 100 is down about 5% from its high. History shows that when the S&P 500 rises more than 10% in the first half of the year (as in 2024), it almost always rises further by the end of the year. The sudden strength in most stocks in recent weeks may take some digesting, but it at least offsets bears’ complaints about a narrow rally and gives the broader market some technical cushion. While market reaction to the first batch of second-quarter earnings reports was generally muted, the numbers themselves are solid. They’re growing at an annual rate of 10%, a growth that’s somewhat outside of the tech sector — enough to provide some support for current (admittedly strong) valuations. Perhaps this isn’t a shockingly bullish case, but enough to encourage investors to stay involved while keeping expectations in check.
