“Belated overreaction,” and why the American stock market has entered Bizarro World

Congratulations if you’ve been having a great year picking stock and industry winners. But, if you have, you might also be having a crappy day.

The soft June CPI inflation print appears to be catalyzing a massive rotation within equity markets rather than outright strength at the index level, as the S&P 500 is down about 0.8%.

To overgeneralize, everything that has been working isn’t. And all the things that haven’t, are. 

Coming into today, the iShares Russell 2000 ETF (which tracks small cap stocks) was roughly flat year-to-date, while the MSCI USA Momentum Factor ETF (which bets that winners will keep winning) was up nearly 30%.

Today, the small-cap fund is surging while its momentum counterpart is falling. Its the biggest one-day underperformance of MTUM since January 6, 2021, a day memorable for that intra-market divergence and nothing else. Well, that was the session following the Georgia run-off elections that gave the Democrats the trifecta of House, Senate, and White House control, paving the way for more government spending. Still can’t remember anything else, though.

The gap between small caps and the tech titans is even larger: it’s their best day of relative performance since Pfizer announced progress on a vaccine that would help allow us to return to pre-pandemic patterns of spending and activity.

A Goldman Sachs basket of stocks that have been big losers over the past year is on fire, up 2.5% as of midday. A separate index from Goldman that tracks heavily shorted stocks is doing even better, up 2.9%.

It’s worth emphasizing that these huge below the surface moves going on are (by and large) more about massive gains in things that have lagged rather than big declines in things that have done well (with the noteworthy exception of the so-called Magnificent Seven group).

If portfolio managers are worried that their bets against certain companies might not continue to work, they typically don’t just buy back those companies to reduce their short exposure. They also tend to reduce their long bets (to maintain a constant degree of overall equity exposure).

There are some fundamental underpinnings behind the major rotation we’re seeing: higher confidence in rate cuts in a cooling (but not collapsing) economy should help protect the earnings power of the many, not just the few. And in the case of small caps, this cohort tends to have more floating rate debt than their large-cap peers, so lower short-term rates are more of a benefit to their bottom lines, too.

But all in all, the likelihood of a rate cut in September went from “high” before the inflation data this morning were released to “very high.” So why such a seismic under-the-hood shift?

Mark Dow, founder of Dow Global Advisors and Behavioral Macro, calls occurrences like these “belated overreaction” – in basic terms, when a specific piece of information or the way it’s presented just hits different, and everyone clues in at the same time.

“It was in the late 2000s on the desk at Pharo and a headline came across Bloomberg that was saying something important and negative for the market on an issue that had been a market focus – but there was no reaction,” he said.  “All us risk takers spent the next hour talking about it and doing nothing. A couple of hours later, though, the exact same headline came across Bloomberg again, but this time in all caps with the red backdrop. The market then reacted hard.”

The initial conditions of the market can play a big role in determining why and when investors tend to “wake up” to new information. And for weeks upon weeks, we’d been flagging poor breadth; the narrowness of the market and the underperformance of the average stock relative to the tech titans.

“News often hits different when markets have been running on a theme and psychology and positioning is leaning hard one way or another,” said Dow. “And then, boom, news all of a sudden matters.”