The US stock market’s internal agonies have reached epic proportions

Over the past three weeks, we’ve seen two unicorns in the US stock market: generational divorces between what the stocks in S&P 500 are doing compared to the performance of the index itself.

First, on June 25, we saw the S&P 500 rally 0.4% despite the number of stocks falling exceeding those that were rising by 274. That was the first time the benchmark US stock gauge rose with that many of its constituents falling in nearly 30 years.

Second, just yesterday, we saw the S&P 500’s advance-decline line (the number of stocks up on the day less those that fell) at 289 — but the overall index fell 0.9%. That’s the first time the S&P 500 ended in the red despite so many of its constituents rallying in data going back to October 1996. You would typically expect the S&P 500 to be up about 1.2% if advancers outnumbered decliners by that much – not down almost 1%.

The session was characterized by a violent rotation out of megacap tech and into everything else (particularly small caps and other interest rate sensitive pockets of the market) after a soft inflation print calcified expectations that the US Federal Reserve will cut its policy rate in September.

“We are getting a dose of the ‘healthy rotation’ that many have hoped for, yet it is impacting key indices nonetheless,” wrote Steve Sosnick, chief strategist at Interactive Brokers, in a note to clients on Thursday. “As someone who has been advocating and hoping for a broader market rally and a rotation into value from growth, today’s activity makes me wonder if I should be more careful about what I wish for.”

You would not know how wild the market has been by looking at the volatility of the S&P 500 as a whole. During this stretch, the annualized realized volatility of the benchmark US stock gauge has been 8.1 – less than half of its long-term average.

It’s kind of like how “Mad Men” protagonist Don Draper seemingly achieved the American Dream from an outsider’s perspective, but that was only a façade for his inner anguish.

The stock market’s overall volatility has been much, much less than the sum of its parts because of the low correlation within the megacap stock cohort (besides Thursday!) as well as heavyweights like Nvidia having a negative correlation with the average stock.

More and more, trading days have become the classic example of the person with half their body in the freezer and the other in the oven. On average, the temperature is unremarkable, but the range of outcomes is extreme – and the oven and freezer thermostats are increasingly getting cranked in the opposite directions, as we’ve seen over the past three weeks.

JPMorgan’s results have now unofficially kicked off earnings season – a period when dispersion within the equity market tends to be high, because stocks are marching to the beats of their own drummers as new results come in. It would likely take a combination of investors curbing AI-linked expectations and economic data deteriorating to overwhelm all the micro company-level news and drive correlations significantly higher during earnings season. 

Wall Street is, understandably, not of one mind when it comes to what to make of these violent market rotations and what will come next.

Peering at history, UBS Securities suggests this shift in market leadership will have a bit of staying power – and the implications are positive for the stock market as a whole.

“Historically, when the market experiences a significant one-day rotation from large to small caps, the trend tends to continue for the following four weeks,” writes Patrick Palfrey, equity strategist at the Swiss-based bank. “When reviewing the top 5 instances, the largest 10 companies underperformed the rest of the market by -4.8% over the next month. Importantly, the S&P 500 advanced by 4.5% over the same period.”

Conversely, Wells Fargo head of US equity strategy Christopher Harvey believes that there’s a missing ingredient in the macroeconomic backdrop needed to unlock a sustained rotation from what’s been working to what hasn’t worked as well.

“We believe the ‘Great Rotation’ needs lower rates and earnings optimism,” writes Harvey on the potential for a shift in outperformance from megacap tech towards value, cyclical, and smaller-cap stocks. “CPI delivered the lower rates, but earnings concerns linger post-Delta.”

Within US sectors, Harvey maintains a preference for communication services (which houses internet platform powerhouses Meta and Alphabet), and is now advising clients to boost the interest rate sensitivity of their stock portfolios by increasing exposure to the utilities sector.