The Stock Market Is Rotating. The Question is Where It Goes Next

(Bloomberg) -- The violent stock market selloff last week triggered by fears that the Federal Reserve missed its chance to help a faltering US economy ended one rotation trade and may have started another, leaving investors guessing where equities go from here.

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After the Fed decided to hold rates steady at its two-day meeting that concluded Wednesday, equities collapsed, even though Chair Jerome Powell seemed to signal that rate cuts could be coming as soon as the next meeting in September. The technology-heavy Nasdaq 100 Index tumbled into a correction and the S&P 500 Index lost 3.2% in two days, its worst two-day stretch March 2023.

But not every sector paid a price. Yes, technology and consumer discretionary stocks took a beating. But utilities and real estate companies, which pay hefty dividends and are popular with income investors when bond yields sink, were by far the best performers in the S&P 500 for the week.

“With rates set to fall on the back of a cooling jobs market, the rotation trade continues, but what stocks do you buy? Big Tech doesn’t need cuts because they have strong balance sheets and stretched valuations,” said Eric Diton, president and managing director of the Wealth Alliance. “So the play is dividend payers because small companies hold more debt and aren’t a sure bet.”

That move is already starting to take hold. Investors poured nearly $1 billion into real estate and utility sector US exchange-traded funds last week, compared with just $300 million into tech ETFs, Bloomberg Intelligence data show.

This of course is the second stock market rotation investors have faced recently.

The first picked up steam in late June with demand for small-capitalization companies taking off. At the time, the Russell 2000 Index was trading at 23 times projected earnings, nearly in line with the S&P 500’s multiple of 21.2. A valuation gap this narrow traditionally is a small-cap buy signal, and sure enough investors shed their positions in Big Tech to grab shares of riskier smaller companies.

That lasted for a few weeks until the valuation spread between the two widened, putting it back at a level where traders typically favor large caps. So the Russell 2000 bid dried up. The index, which is often seen as a proxy for risk appetite, hit a peak on July 16 and is down 6.8% since then.

Now, with rate cuts seemingly on the way and Treasury yields plunging, investors are piling into dividend paying, lower volatility stocks from utilities to real estate investment trusts. Both the 10-year and 2-year Treasury yields slid below 4% last week, with the 2-year falling to its lowest level since May 2023 on Friday.

That means more pain may be coming for equities beyond dividend-driven plays as the calendar turns to what’s historically the worst two months of the year for US stock market returns — August and September.

Meanwhile, volatility is surging, with the Cboe Volatility Index, or VIX, leaping as high as 29.66 on Friday, a level it hasn’t touched since March 2023. And the so-called VVIX Index, which measures the volatility of the VIX, is hovering around its highest levels since March 2022, when the Fed’s hiking cycle began.

What’s making this market so hard for traders to game is the extreme degree that risk assets have front-run the Fed’s first rate cut. Prior to the selloff on Thursday and Friday, the S&P 500 had rallied 34% over the previous nine months from the index’s 52-week low on Oct. 27 — and it still ended the week up 30% since then. Clearly there remains some excess exuberance that can come out of stock prices.

“Some of this could be a ‘sell-the-news trade,’ because there’s so much desire for rate cuts — but also be careful for what you wish for because a lot of people still fear the Fed made a mistake by not easing policy sooner,” said Julie Biel, a portfolio manager at Kayne Anderson Rudnick. “If there’s indeed economic weakness, that will hit small caps harder.”

Still, investors still aren’t paying up to hedge for a possible selloff. In the options market, contracts protecting against a 10% decline in the largest ETF tracking the S&P 500 in the next 60 days currently cost just 1.9 times more than options that profit from a 10% rally, data compiled by Bloomberg show.

“This selloff is more of a reset of a frothy equity market as opposed to panic mode,” said Chris Murphy, co-head of derivatives strategy at Susquehanna International Group. “There’s definitely a shift in concern growing, but order flow on a single stock level still signals a ton of put selling, indicating willingness to buy further weakness.”

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