How to play the market rotation?

The inflation rate flashed negative for the month of June indicating a new trend of much slower inflation to what we witnessed in the last 2 years or so. The US inflation fell to a symbolic year-over-year rate of 3%! The promising decline increases the likelihood of interest rate cuts.

On the 11^th of July, the day the inflation report was released, the market reacted in a spectacular fashion.

The US tech-heavy Nasdaq sold off and the US small-cap index Russell 2000 capitalization surged. This event could be the start of a major market rotation from high-valuation stocks to lower-valuation stocks. In essence, what worked so well since the October 2022 market rally (technology and high quality names), may now leave room for other market segments to outperform.

The Russell 2000 & Nasdaq on 11^th July, when the US inflation data was released

Bloomberg data, as of 15 July 2024

In recent years, the market has been increasingly concentrated in a select group of high-quality stocks, a trend known as "flight to quality", where investors flock to safer, well-established companies. This shift has emerged at the expense of broader stock picking, leaving many smaller or more fragile companies overlooked and underinvested.

Record-low percentage of stocks outperforming the S&P 500 index

Source: Stifel as of June 2024

However, we believe this trend is ending and see the recent fall in inflation as what could be the long-awaited catalyst for a massive market rotation, prompting large investors to rebalance portfolios to cheaper areas of the market as confidence grows that interest rates are set to come down.

US small cap stocks in last 5 years 

Bloomberg data, As of 12 July 2024

Here's what we see happening now: investors are taking profits from high-quality, popular stocks and moving their capital into more speculative and potentially high-reward stocks such as small-cap stocks, leveraged companies, and other unpopular stocks such as consumer staples.

Global semiconductors are a recent example of fierce market rotation. The sector sold off as the US government called for stronger limits over giving access of high-end tech to Chinese firms.

US semiconductor index over 3 years

Bloomberg data, As of 17 July 2024

Which stocks should benefit from the rotation?

To capitalize on this shift, consider the following:

1.    Caution on large tech exposure: "Magnificent Seven" stocks have delivered, but they could now be well over-extended, as markets tend to overexaggerate on the upside. Quality stocks have strongly outperformed the rest and valuation may be too steep at current levels. Investors may thus benefit from reducing exposure to reallocate elsewhere with lower valuations.

2.    Positive on Defensive Sectors: Healthcare, Consumer staples, and Utilities are your go-to sectors. They offer stability and consistent returns, especially when uncertainty looms. Those sectors can still offer interesting returns and re-rate, with some stocks currently offering interesting risk/reward ratio. Additionally, high dividend stocks might come back into favor and may do so even more in the case of stronger than already priced in interest rate cuts.

3.    Stock Picking might be back: Leveraged companies, Value, Cyclicals, Energy Transition stocks… Since 2022, investors were harsh with these companies, offering cheap valuation on a lot of interesting investment cases while indices were on everyone’s mind. Now with cooling US inflation (potential rate cuts looming) this could be the awaited catalyst to enact a re-rating of all these stocks. Stock pickers may now get the chance to outperformed indices again.

4.    Compelling valuation for European Small-caps: With interest rates likely to come down, we keep our bullish stance on small-caps to catch up large caps. These companies should thrive in a more favorable economic environment. While US small caps have started to rerate already, European small caps remain very much underappreciated by investors, in our view.

In conclusion, with further signs of inflation being under control, it looks increasingly likely that the US Federal Reserve will proceed with its first interest rate cut. This has triggered in our view what could be the start of a significant market rotation in favor of cheaper segments of the market. We suggest considering rebalancing exposures to cheaper segment of the market that should outperform in the next phase of this cycle, in our view.

This article is brought to you by the Advisory Solutions Team.