After a strong performance by technology stocks in the first half of 2024, the second half of the year is showing a different trend, which traders are calling “The Great Rotation,” marking the first time in years that such a notable change has occurred.
The Russell 2000 index, which is the accepted benchmark for these smaller-sized companies, has shown a remarkable return this year – higher than major US indices, such as NASDAQ100, S&P500,and Dow Jones 30.
What is driving this phenomenon now? And is the trend likely to continue in the rest of 2024 and 2025? In this article, we will explore these questions and explain some of the factors behind this significant market shift.
Key Takeaways
- “The Great Rotation” is a renewed trend that describes a major shift in the stock market, with small-cap stocks significantly outperforming large-cap stocks.
- The anticipated reductions in Federal Reserve interest rates are playing a crucial role in reshaping the market dynamics, favoring small-cap companies that benefit more from lower borrowing costs.
- The persistence of the 2024 Great Rotation remains uncertain, as the trend’s duration will depend on continuing economic factors, such as further interest rate decisions and global market conditions, which could alter the momentum at any time.
The 2024 Great Rotation Begins
Since mid-2024, small cap stocks have outperformed mid and large cap stocks, setting the ground for the Great Rotation – a market condition that refers to investors’ shift to small caps over megacap tech stocks.
The Russell 2000, which includes 2,000 smaller US companies and serves as a benchmark for small-cap stocks, recorded an impressive additional return of 12.5% over the Nasdaq and 9.5% over the S&P 500 in July 2024 (data shown until July 30th). The last time that happened, when Russel 2000 outperformed major US indice, was way back in 2001, around the Dotcom bubble .
In the chart below, you can see the Russel 2000 index performance since July 1st versus two mega cap stock indices – S&P500 and NASDAQ100.
source TradingView
Factors That Effect 2024 Great Rotation
As mentioned, the rotation into small cap stocks has been quite clear since early July 2024, leaving investors to wonder whether the great rotation into small cap is overdue. This is heavily dependent on several economic factors and market condition.
Let’s explore these different factors that explain such a market shift.
Forecasting Fed Rate Cuts – Cheaper Loans
The first and most significant factor that may influence the rotation into small cap stocks is interest rates. According to the CME Group’s FedWatch tool, which predicts rate changes based on futures trading data for fed funds, the market anticipates that the Federal Reserve will likely reduce its benchmark fed funds rate by around 1.75% from its current level by September 2025.
The rapid reduction in interest rates reflects the Federal Reserve’s anticipation of an economic recession. Lower interest rates make borrowing cheaper, which can benefit smaller companies that may rely more heavily on credit to finance their operations and growth. This gives small-cap stocks an edge over large-cap stocks, which may be less sensitive to interest rate changes.
Source CME Group
Expected Earnings
Expected earnings in small cap stocks is another factor that may contribute to the rotation. Once there is an economic regime change, it will affect market expectations. The economic slowdown will make the market adjust the expected earnings, which is a key driver for a stock price, which is presented as a P/E ratio (price to earnings).
During the last market surge, the “Magnificent Seven” exhibited extremely high P/E ratios. High market valuations mean that any reduction in earnings could have a significantly magnified impact on these stocks.
For instance, if Nvidia’s future sales fail to meet expectations, its high-growth stock, which is sensitive due to its elevated P/E ratio, might suffer significantly. In contrast, value stocks, which are less affected by shifting expectations and economic downturns, might see steadier or increasing prices. In other words, sectors involving basic necessities, like clothing and food, often thrive even during slowdowns, potentially boosting sales for companies in these areas.
Analyst reports already reflect these expectations, indicating that earnings for smaller-cap companies are projected to increase more significantly in the coming quarters compared to large-cap companies, as quoted in a Bloomberg interview.
High Peaks, Steep Falls: The Nasdaq and S&P 500’s Vulnerability
The intensity of this 2024 Great Rotation can be partly attributed to the initial conditions of equity markets.
Currently, the relative valuation between the Nasdaq and the Russell 2000 is significantly skewed, reminiscent of the dot-com era (2000). However, unlike the dot-com bubble, where many “dream stocks” had little to no income, today’s scenario is different. For instance, if stock markets will crash, the fall of large cap growth stocks that comprise NASDAQ may have a steeper fall than small cap stocks.
How Long the Great Rotation Will Continue
Generally, this great rotation trend can take months or even years, mainly since the impact of interest rate reductions on the real economy isn’t immediate.
This delay occurs because businesses and consumers adjust their investment and spending behaviors gradually in response to the new financial environment. The process through which these adjustments occur involves various channels, such as
- consumer confidence
- lending rates
- and investment returns
All collectively contribute to a lag before the full impact is felt in the broader market. With that in mind, the market rotation that has started in early July is likely to continue in the upcoming months, unless something enexpeted may occur.
Challenging the Momentum of 2024 Great Rotation
An interesting tweet presents data indicating that small-cap companies are experiencing high levels of low profitability. This is an important point since earnings significantly influence stock prices. However, this perspective could shift dramatically with the expected reduction in interest rates.
44% of Small-Cap companies are unprofitable.
— Mike Zaccardi, CFA, CMT 🍖 (@MikeZaccardi) August 3, 2024
Higher than the tech bubble. pic.twitter.com/z0jfE0RkMU
Summary
July 2024 saw a major market shift from large-cap tech stocks to smaller-cap companies in the Russell 2000 index. The 2024 Great Rotation indicates changing investor focus due to expected Fed rate cuts and economic slowdowns.
We can’t predict exactly how the markets will behave in the future since uncertainty is always part of investing. For instance, US elections can significantly impact the markets, as discussed on our website here. However, we can outline possible reasons for market trends. If the shift towards smaller companies persists, it might be due to their expected resilience against the predicted economic downturn.
Disclaimers:
For this article, we used AI for research and drafting, with human editors finalizing to ensure accuracy and coherence. We encourage readers to critically evaluate the content and consult additional sources as needed.
This article is for educational purposes and should not be considered professional financial advice. Always perform your own research and consult a qualified advisor before making investment decisions, as all investments involve risks.
