(Bloomberg) — Last week’s massive stock market selloff, sparked by fears that the Federal Reserve had missed its chance to help the faltering U.S. economy, ended one rotation trade and possibly started another, leaving investors wondering what will happen next for the stock market.
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After the Fed decided to leave rates unchanged at its two-day meeting that ended Wednesday, stocks tumbled, even as Chairman Jerome Powell seemed to signal that rate cuts could come as early as its next meeting in September. The tech-heavy Nasdaq 100 Index plunged, while the S&P 500 Index lost 3.2% over two days, its worst two-day streak in March 2023.
But not every sector paid a price. Yes, technology and consumer staples took a beating. But utilities and real estate, which pay hefty dividends and are popular with income investors when bond yields fall, were by far the best performers in the S&P 500 this week.
“As interest rates fall on a cooling labor market, the rotation trade continues, but which 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 bet is dividend payers because small companies have more debt and aren’t a safe bet.”
That move is already starting to work. Investors poured nearly $1 billion into U.S. real estate and utilities exchange-traded funds last week, compared with just $300 million into tech ETFs, data compiled by Bloomberg Intelligence showed.
This is of course the second stock market rotation that investors have had to deal with recently.
The first gained momentum in late June as demand for small-cap companies surged. At the time, the Russell 2000 Index was trading at 23 times forward earnings, nearly in line with the S&P 500’s multiple of 21.2. Such a narrow valuation gap is traditionally a buy signal for small caps, and investors have been shedding positions in Big Tech in favor of shares in riskier smaller companies.
That lasted for a few weeks until the valuation spread between the two widened, bringing it back to a level where traders typically favor large caps. So the Russell 2000 bid dried up. The index, often seen as a proxy for risk appetite, peaked on July 16 and is down 6.8% since then.
With interest rate cuts looming and government bond yields tumbling, investors are flocking to dividend-paying, less volatile stocks from utilities to real estate investment trusts. Both 10-year and 2-year government bond yields fell below 4% last week, with the 2-year falling to its lowest level since May 2023 on Friday.
That means more pain could be ahead for stocks than just dividend-driven investments, as the calendar heads toward what are historically the two worst months of the year for U.S. stock market returns: August and September.
Meanwhile, volatility is rising, with the Cboe Volatility Index, or VIX, hitting a high of 29.66 on Friday, a level not seen since March 2023. And the so-called VVIX Index, which measures the volatility of the VIX, is hovering near its highest levels since March 2022, when the Fed began its rate-hike cycle.
What makes this market so difficult for traders to play is the extreme extent to which risk assets are ahead of the Fed’s first rate cut. Before the selloff on Thursday and Friday, the S&P 500 had risen 34% over the previous nine months from the index’s 52-week low on Oct. 27 — and since then, the index has still finished the week up 30%. Clearly, there’s still some excess exuberance left in stocks.
“Some of this could be a sell-the-news trade because there’s so much desire for rate cuts — but also be careful 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 is indeed economic weakness, that’s going to hit small caps harder.”
Yet investors still aren’t paying to hedge against a potential selloff. In the options market, contracts that protect against a 10% decline in the largest ETF tracking the S&P 500 over the next 60 days currently cost just 1.9 times more than options that profit from a 10% rally, according to data compiled by Bloomberg.
“This sell-off is more of a reset from a frothy stock market than a panic mode,” said Chris Murphy, co-head of derivatives strategy at Susquehanna International Group. “There is certainly a shift in concern, but the order flow at a single stock level still signals a lot of put selling, which suggests a willingness to buy further weakness.”
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