Market Rotation Underway

Stocks opened mixed this morning on the heels of a very important inflation report (see below). At the moment, the S&P 500 is down .8%, the Dow is up 50 points and the Nasdaq is down 1.7%. The bond market is rallying in reaction to the same report. The iShares Core US Aggregate Bond ETF (AGG) is up .6% in early trading.

According to Josh Brown of Ritholtz Wealth Management, “This is one of the most interesting days of the year” because we’re seeing a “massive shift in the factors that are driving performance of the market.” For example, the S&P 500 Index is down today even though roughly 490 of the stocks within the index are rallying. That’s because the most heavily weighted components—Nvidia, Apple, Microsoft, Amazon, Meta, Alphabet—are down big today, whereas most of the rest of the stock market is up. This is a clear departure from recent trend. Does it mean investors are rotating out of high-fliers and into cheaper sectors like energy, industrials and healthcare?

My view is that valuations need to be reset. This massive differential between the fortunes of the few largest tech & interest stocks, and the rest of the stock market, cannot go on forever. The S&P 500 equal weighted Index is up less than 5% year-to-date. Compare that to the normal market-cap-weighted index up 18%. So we may see something of a catch-up trade.

Inflation decelerated more than expected last month. The Consumer Price Index (CPI) actually ticked lower in June vs. the prior month, and the annual rate slowed to 3.0% (lowest since March 2021). Following an unexpected resurgence in price growth during the first quarter, inflation has settled down again. This report likely cements the case for at least two interest rate cuts by the Federal Reserve before year-end. San Francisco Federal Reserve Bank President Mary Daly noted “increasing confidence that we are on a path to 2% inflation,” and said “policy adjustments are likely warranted.”

Bond traders are racing to price-in this new reality, betting on rate cuts in both September and December. Not only are short-term interest rate expectations falling, but so too are longer-term inflation expectations. A quick look at the TIPs market shows the anticipated 2-year inflation rate is down to 1.95% and the 10-year rate is around 2.2%. In other words, for the first time investors actually believe the Fed will achieve its 2% inflation target in relatively short order.

Fed officials have been dangling the carrot of rate cuts since December, but haven’t followed through because for a while inflation seemed stubbornly high and the economy remained very strong. That narrative changes now. Economic indicators have been gradually decelerating for the past several months, and this latest confirmation of slower inflation cannot be ignored. Investors increasingly believe the Fed is on the clock and should bring rates back down to normal before causing real damage to the economy.