Since late 2022, the U.S. stock market has been increasingly led by a small number of stocks – those of the large tech companies connected to artificial intelligence (AI). During this time frame, more and more money managers jumped on the AI bandwagon, led by FOMO (“fear of missing out”). As a result, surging investor inflows inflated large tech stocks’ valuations to outstretched levels.
While massive spending on AI among hyperscalers and other large firms did provide a solid basis for further earnings growth for the hardware and software providers of the AI cohort, many strategists and money managers have felt that stock prices outran their fundamentals. The wide discrepancies in performances and valuations between the group of AI leaders and the rest of the market also made many market participants uneasy.
Attempting to Rotate from the AI Trade
This uneasiness strongly demonstrated itself for the first time in the first quarter of this year, when several weaker-than-expected economic data points reignited hopes of an impending rate cut. Falling interest rates would support companies reeling under high financing costs. If these cuts result from an economic cooldown (including the job market), firms in many industries would also gain from diminishing wage increases. In short, the outlook for an easier monetary policy diminishes the appeal of large-cap technology stocks that served as a safe harbor for investors in times of high inflation and interest rates.
As the high-flying tech stocks have grown to be very richly valued, the perceived decline in their relative attractiveness led to investor attempts at rotation – i.e., the increase in investor flows into the stocks of small-cap and value stocks at the expense of the tech leaders. The problem with these attempts was that since the start of the AI rally, its leaders have gained so much that their weight in the S&P 500 (SPY) has become larger than ever. As a result, the decline in tech led to an overall market decline, igniting an across-the-board “dip-buying” spree, which cut the rotation short.
Economy and Earnings Add to Tech Wobble
Although earlier attempts at rotation didn’t last, another one came along, considerably intensifying as the latest inflation report, published on July 11th, came out cooler than expected. Recent economic data, along with Jerome Powell’s remarks about policymakers gaining greater confidence in the disinflation trend, have convinced investors that the Fed will begin rate reductions in September. That further increased the appeal of more cyclically oriented sectors, which are expected to gain the most from the Federal Reserve’s rate cuts.
In addition, investor anxiety going into this earnings season is palpable. Earnings from the tech sector as a whole are expected to have grown by double digits year-over-year, though this could pose a double-edged sword. On the one hand, if tech leaders beat expectations again, it could add some tailing to the flagging tech rally. Conversely, many of the high-flying names could suffer a “sell the news” moment, especially given current investor jitteriness.
Besides, guidance for future quarters might prove even more influential as past achievements seem to be fully priced in; any weakness in corporate outlooks may lead to a wide tech sell-off. After the S&P 500 and the Nasdaq Composite (NDAQ) indexes registered their worst week since April, the stakes on tech leaders’ guidance got a lot higher.
Politics and Geopolitics Affect the Markets
July’s rotation attempt is looking way more serious than the earlier ones, as investors now see additional reasons to take some profits from the AI rally. This money is being diverted to previously lagging sectors like healthcare, real estate, financials, energy, and materials – driving the outperformance of the Dow Jones Industrial Average (DJIA), which has very little exposure to technology compared to the S&P 500. In addition, funds flowed into the smaller stocks, leading to the strong outperformance of the Russell 2000 (IWM) small-cap benchmark over the past two weeks.
Small cap indexes include shares of more domestically-oriented firms, seen as one of the beneficiaries if Donald Trump wins the election in November. Trump is expected to increase trade restriction policies, such as import tariffs, that will support local production. As the odds of a Trump win are on the rise, other potential beneficiaries – commonly dubbed as “the Trump Trade” – are also seeing increased market interest.
Those include energy producers, automakers, health care companies, as well as other firms expected to gain from looser regulations, a freer M&A environment, import tariffs, and a much lighter hand on environmental policies.
However, one area where the incumbent administration and the Republican candidate are aligned is trade relations with China, particularly when it comes to additional, more severe restrictions on semiconductor and chip machinery exports to the country. Last week, the news that the White House is considering clamping down further on the chip equipment sales to China reverberated through the whole semis sector, adding to its troubles.
Meanwhile, Trump is known for his harsh stance on China, specifically his proposal to slap at least 60% tariffs on all imports from the Asian giant. The notion that a trade war with China is expected to aggravate no matter who wins the election is bad news for the semiconductor industry, as well as the technology sector as a whole.
Stock Rotation or Market Correction?
There is plenty of time until the election, and it’s too early to predict its outcome and the effect on stock markets. However, looking solely at tech stocks, their outsized gains and rich valuations make them vulnerable to a correction, with no need for additional reasons from the political headlines. Meanwhile, the question of whether this correction would signify a rotation to other sectors or represent a whole-market downturn hinges on several economic, political, and market forces.
Thus, investor sentiment can take a further beating if heightened earnings expectations—and specifically, guidance for further fast growth—don’t materialize.
We are already getting a test of an earnings-led market decline as Tesla (TSLA) and Alphabet (GOOGL) weigh on the sentiment – despite the fact that Tesla’s report wasn’t disastrous, while Alphabet’s was generally good. The markets had simply expected much more from the members of the “Magnificent Seven.”
As for the economy, the main driver of higher spirits this year has been the estimate that the economy is entering the “Goldilocks” state, where falling inflation allows for rate cuts while a gentle economic cooldown doesn’t turn into a recession.
While monetary easing is widely perceived as positive for stock markets overall, it would prove a poison pill if done amid an economic downturn and not because the action is made possible by easing inflation alone. If the economy slows more than expected, it would be disastrous for small caps, real estate, consumer-oriented stocks, and many others hoping to ride the wave of stock rotation.
Winners, No Matter What
Joe Biden’s announcement about dropping out of the election race hasn’t come out of nowhere. However, it does add another unknown to the vast array of uncertainties that investors are currently facing from the economy, earnings, and geopolitics. After the news, the markets are taking time to regroup, with the rotation trade seemingly on hold.
The easiness with which another attempt at rotation out of tech leaders fizzled out may serve as proof that the main reason for the latest sell-off has been these stocks’ high valuations and not a lack of trust in their future. After the worst tech rout since April, investors began flocking back to the AI cohort and the larger technology universe. Now, not-as-great-as-expected earnings are pulling them back, but we can’t know for how long.
The long-term cause for this is probably the “AI is the future” narrative, but the more immediate one is that large-cap tech stocks should not be adversely affected by any of the presidential candidates’ policies. As the accelerating flux of anxiety and uncertainty is not going to ease at least until November, investors that don’t wish to bet their fortune on any presidential candidate’s agenda would probably be better off holding on to large-cap tech and other stocks that have a foot in both camps.
Apart from technology, both parties’ candidates support reshoring – i.e., bringing chipmaking and other technological production back to the U.S. This means that American corporations working in technology, industrial production, construction, power, and materials supply, along with financials that supply funding for all these projects, will be the winners of the coming election.
