The Bottom Line:
- The stock market has been dominated by a small selection of large-cap tech companies, creating an illusion of a massive bull market.
- However, when these ‘Magnificent Seven’ stocks are removed, the broader market has only risen 8% in 2023, compared to a 26% gain in the S&P 500.
- Investors are now pulling money out of these tech giants, leading to a ‘great rotation’ as funds flow into smaller, beaten-down companies.
- This shift is driven by factors such as valuation concerns and the impact of rising interest rates, which disproportionately affect smaller businesses.
- The Russell 2000 small-cap index has surged 11% in just one month, mirroring the decline in the tech-heavy Nasdaq and S&P 500.
Dominance of Large-Cap Tech Stocks Distorts Market Perception
Magnificent Seven’s Dominance Skews Market Perception
For more than two years, a small selection of large-cap technology companies, often referred to as the “Magnificent Seven,” has been driving the stock market forward. These companies, which include Apple, Amazon, Nvidia, Meta, Google, Microsoft, and Tesla, dominate the major indexes and have created an illusion of a massive bull market. The S&P 500, which contains America’s 500 largest companies, has risen a staggering 50% since September 2022, far exceeding the long-term average return of around 10% per year. However, when these tech giants are removed from the equation, the story changes significantly. Smaller, lesser-known stocks in the American market haven’t experienced the same level of growth over the same period.
The Great Rotation: Money Flows from Tech Giants to Small Caps
Recently, there has been a shift in the market, with money flooding out of the highflying Magnificent Seven and flowing back into smaller companies. This phenomenon, labeled as the “great rotation” by the media, could be the first sign of the US stock market starting to correct. The rotation is the most significant since December 2022, and it comes at a time when macroeconomic conditions seem to defy the logic of the stock market’s performance over the past two years. Interest rates have risen from effectively zero to 5.5%, the highest levels since the turn of the century, which typically puts pressure on businesses and consumer spending. However, the S&P 500 has continued to reach new all-time highs, primarily due to investor speculation around the future potential of AI, causing huge sums of money to flow into the Magnificent Seven.
Earnings Reports Trigger Tech Stock Selloff
The Magnificent Seven’s dominance in the S&P 500 has led to the index becoming more concentrated than ever, with these seven businesses accounting for almost exactly one-third of the index. However, this concentration has recently started to unravel, with huge sums of money flowing out of these companies. Last week, the NASDAQ and the S&P 500 experienced their worst day since 2022, with the S&P 500 falling 2.31% and the tech-heavy NASDAQ sliding 3.64%. This selloff was triggered by disappointing earnings reports from some of the Magnificent Seven companies, such as Google’s parent company Alphabet and Tesla. Despite Google beating estimates for revenue and net income, investors were not impressed by the company’s YouTube revenue, which came in below expectations. Similarly, Tesla reported weaker-than-expected results, including a 7% year-over-year decline in automotive revenues. These reports set the tone for investors, who started pulling money out of the Magnificent Seven stocks, even before some of them had released their earnings.
Broader Market Lags Behind S&P 500 Gains
Magnificent Seven’s Dominance Skews Market Perception
For more than two years, a small selection of large-cap technology companies, often referred to as the “Magnificent Seven,” has been driving the stock market forward. These companies, which include Apple, Amazon, Nvidia, Meta, Google, Microsoft, and Tesla, dominate the major indexes and have created an illusion of a massive bull market. The S&P 500, which contains America’s 500 largest companies, has risen a staggering 50% since September 2022, far exceeding the long-term average return of around 10% per year. However, when these tech giants are removed from the equation, the story changes significantly. Smaller, lesser-known stocks in the American market haven’t experienced the same level of growth over the same period.
The Great Rotation: Money Flows from Tech Giants to Small Caps
Recently, there has been a shift in the market, with money flooding out of the highflying Magnificent Seven and flowing back into smaller companies. This phenomenon, labeled as the “great rotation” by the media, could be the first sign of the US stock market starting to correct. The rotation is the most significant since December 2022, and it comes at a time when macroeconomic conditions seem to defy the logic of the stock market’s performance over the past two years. Interest rates have risen from effectively zero to 5.5%, the highest levels since the turn of the century, which typically puts pressure on businesses and consumer spending. However, the S&P 500 has continued to reach new all-time highs, primarily due to investor speculation around the future potential of AI, causing huge sums of money to flow into the Magnificent Seven.
Earnings Reports Trigger Tech Stock Selloff
The Magnificent Seven’s dominance in the S&P 500 has led to the index becoming more concentrated than ever, with these seven businesses accounting for almost exactly one-third of the index. However, this concentration has recently started to unravel, with huge sums of money flowing out of these companies. Last week, the NASDAQ and the S&P 500 experienced their worst day since 2022, with the S&P 500 falling 2.31% and the tech-heavy NASDAQ sliding 3.64%. This selloff was triggered by disappointing earnings reports from some of the Magnificent Seven companies, such as Google’s parent company Alphabet and Tesla. Despite Google beating estimates for revenue and net income, investors were not impressed by the company’s YouTube revenue, which came in below expectations. Similarly, Tesla reported weaker-than-expected results, including a 7% year-over-year decline in automotive revenues. These reports set the tone for investors, who started pulling money out of the Magnificent Seven stocks, even before some of them had released their earnings.
Investors Shift Funds from Tech Giants to Smaller Companies
Small Caps Gain Momentum as Investors Seek Better Value
As investors take profits from the overvalued tech giants, they are shifting their focus to beaten-down small-cap stocks that offer better value. This trend is evident in the Russell 2000 Index, which comprises the smallest 2,000 stocks from the Russell Total Market Index. Over the past two years, these smaller businesses have struggled, with their share prices remaining relatively stagnant. However, in the past month, the Russell 2000 Index has surged by approximately 11%, coinciding with the decline in the Magnificent Seven stocks.
Macroeconomic Factors Influence the Small-Cap Surge
The Federal Reserve’s monetary policy plays a crucial role in the recent shift towards small-cap stocks. As interest rates have risen from near-zero to 5.5%, businesses face tougher sales conditions and more challenging debt acquisition. While the Magnificent Seven companies can weather these changes due to their substantial cash reserves and profitability, smaller businesses are more vulnerable to macroeconomic fluctuations. However, recent positive inflation metrics from the Bureau of Labor Statistics have raised hopes that the Federal Reserve may consider lowering interest rates in the future. This prospect has led to increased investor interest in small-cap businesses, as evidenced by the money flowing into the Russell 2000 Index.
Earnings Growth Prospects Favor Small Caps
According to a Market Watch article citing Bank of America Global Research, the pace of year-over-year earnings growth for stocks in the small-cap 600 index is set to outpace that of their large-cap peers later this year. This trend is expected to continue through the foreseeable future, further bolstering investor confidence in small-cap stocks. As macroeconomic conditions improve and the Federal Reserve potentially eases its monetary policy, smaller companies are poised to benefit from more favorable business conditions and increased investor interest.
Valuation Concerns and Interest Rate Impacts Fuel the Rotation
Valuation Concerns and Interest Rate Hikes Trigger Rotation
The dominance of the Magnificent Seven stocks in the S&P 500 has led to concerns about their lofty valuations. Investors have been bidding up the prices of these companies to such high levels that everything needs to be perfect for them to justify their valuations. Any slight miss in expectations, such as Google’s YouTube revenue or Tesla’s automotive revenue decline, can trigger a significant selloff. The recent disappointing earnings reports from some of these tech giants have set the tone for investors to start pulling money out of the Magnificent Seven stocks, even before some of them had released their earnings.
Small Caps Benefit from Improving Macroeconomic Conditions
As investors seek better value opportunities, they are turning to small-cap stocks that have been relatively beaten down over the past few years. The Russell 2000 Index, which tracks the performance of small-cap companies, has seen a significant uptick in the past month, rising approximately 11%. This surge in small-cap stocks coincides with the decline in the Magnificent Seven stocks, indicating a rotation of money from the overvalued tech giants to the more attractively priced small-cap sector.
Federal Reserve’s Monetary Policy Plays a Crucial Role
The Federal Reserve’s monetary policy has a significant impact on the performance of small-cap stocks. Higher interest rates put pressure on smaller businesses, making it more challenging for them to access debt and maintain profitability. However, recent positive inflation metrics from the Bureau of Labor Statistics have raised hopes that the Federal Reserve may consider lowering interest rates in the future. This prospect has led to increased investor interest in small-cap businesses, as they stand to benefit from more favorable business conditions and easier access to capital.
Small-Cap Index Surges as Tech Stocks Decline
Russell 2000 Index Surges as Investors Seek Value
As the dominance of the Magnificent Seven stocks in the S&P 500 begins to wane, investors are turning their attention to small-cap stocks, which have been relatively undervalued in recent years. The Russell 2000 Index, which tracks the performance of small-cap companies, has experienced a significant surge over the past month, rising approximately 11%. This uptick in small-cap stocks coincides with the decline in the tech giants, indicating a rotation of money from the overvalued Magnificent Seven to the more attractively priced small-cap sector.
Macroeconomic Conditions Favor Small-Cap Growth
The Federal Reserve’s monetary policy plays a crucial role in the performance of small-cap stocks. Higher interest rates can put pressure on smaller businesses, making it more challenging for them to access debt and maintain profitability. However, recent positive inflation metrics from the Bureau of Labor Statistics have raised hopes that the Federal Reserve may consider lowering interest rates in the future. This prospect has led to increased investor interest in small-cap businesses, as they stand to benefit from more favorable business conditions and easier access to capital.
Earnings Growth Potential Attracts Investors to Small Caps
According to a Market Watch article citing Bank of America Global Research, the pace of year-over-year earnings growth for stocks in the small-cap 600 index is set to outpace that of their large-cap peers later this year. This trend is expected to continue through the foreseeable future, further bolstering investor confidence in small-cap stocks. As macroeconomic conditions improve and the Federal Reserve potentially eases its monetary policy, smaller companies are poised to benefit from more favorable business conditions and increased investor interest.
