Updated August 5: August has greeted investors with a global sell-off, starting with a more than 12% drop in Japanese equities. All three major US indices are down, as well as the Stoxx 600. Since their recent peaks in mid-July, the S&P 500 has retreated 5.5%, while the Nasdaq has seen a more pronounced decline of 9.3% through Friday's close. The latest jobs report released last week revealed a softening labor market, with July hiring falling short of expectations and the unemployment rate edging up to 4.3%. This data prompted a downward shift in both stocks and interest rates, as markets began pricing in more substantial interest rate cuts for September.

While a cooling job market might initially raise concerns about economic health, it's important to view this development in the context of the Federal Reserve's recent monetary policy objectives. The post-pandemic labor market has been exceptionally tight, and some moderation was anticipated as part of the Fed's strategy to curb inflation.

From politics to global turmoil to ‌the financial markets, July was chock-full of drama, pivots, and rotations. Out with the past and what worked before, and in with the new and an eye toward the future. Despite high volatility, which saw the DJIA reach a new record and the S&P 500 and NASDAQ experience their worst one-day drop since 2022, all three indices rallied to end the month — the S&P 500 gained 1.1% and the Dow rose 4.4% while the NASDAQ lost 0.8%. 

July’s performance across the three indices is atypical of what we’ve seen all year. Led by the Magnificent Seven (Mag 7), the NASDAQ and S&P 500 indices have been gaining year-to-date, with the Dow rising as well, but trailing behind. But in July, the stocks that were fueling the market’s rally during the first half of the year experienced a pullback as investors flocked to other market sectors such as small- and mid-cap stocks. The Russell 2000 index (an index of small-cap stocks) finished the month up 10%, marking the largest monthly outperformance against the S&P 500 since 2020. The chart below clearly shows this rotation out of large-cap growth stocks into large-value, small- and mid-cap stocks.

What’s driving this shift, and why now?

Economic data shows a cooling economy 

Inflation — across both goods and services — is slowing. June’s report shows the Personal Consumption Expenditures Price Index (PCE), the Federal Reserve's preferred inflation measure, at 2.5%, which is edging closer to the Fed’s annual target of 2%. The unemployment rate, while still historically low, has risen to 4.3%; wage growth has eased; and consumer spending, while still robust, is down compared to prior periods. Latest GDP growth is at 2.8%, down from 3.4% last year but still healthy and better than predicted. All of this data suggests that the economy has cooled off enough that the Fed will be primed to lower interest rates sometime in the fall. Just this week, Federal Reserve Chair Jerome Powell confirmed that “the economy is moving closer to the point at which it will be appropriate to reduce our policy rate.”  

Less-than-stellar earnings reports from some of the Mag 7

Tesla reported a 45% drop in profits. Alphabet reported lower than expected revenues from slowing advertising growth. Microsoft just missed growth expectations in its cloud computing business. Companies are spending billions on AI and it’s unclear whether such investments will eventually pay off. Many believe that the hype around AI and AI stocks is overdone, and that the promise may be much greater than its reality, at least in the foreseeable future. 

As we know from history, some companies will emerge as winners in the AI race and others will fail, but it’s far too early to know which is which. And that makes it challenging for investors to determine whether valuations for these companies are justified, too rich, or underestimated.

Greater certainty of lower rates starting in September

The Fed has set the stage for lower rates starting in September. While lower rates benefit all companies, they’re especially helpful for smaller companies that are more sensitive to interest rates and economic growth. Small businesses have fewer financing options compared to their larger counterparts and rely more heavily on variable-rate loans. If interest rates come down, their cost of capital would get cheaper, which in turn would help boost profits. 

Whether this rotation is temporary or a longer-term trend is anyone’s guess. Some believe the wind is already out of the small-cap sail and big tech will continue its trajectory with the recent volatility being just a pullback.

July’s market performance (as well as these dismal first few days in August) is an important reminder for long-term investors that being too concentrated in any one stock, sector, style, region, and/or strategy can be a risky bet. It’s easy to overweight the best performers when momentum is going your way, but difficult, if not impossible, to determine when it’s time to pull back and move on. This applies not only to tech stocks versus other sectors, but to US versus international and growth versus value stocks as well. 

Case in point: In mid-July, value stocks had their best day relative to growth stocks since 2020, and for the month, developed international stocks beat the S&P 500. And the 10-year US Treasury yield is down to a one-year low (remember when bond yields go down, prices go up). The drop in equities and increased market volatility can be scary. But from history, we’ve seen that sudden, sharp sell-offs (compared to slow continuous declines) are often driven by over-reacting investors and speculative traders. As shown in the chart below, intra-year volatility is not uncommon and occurs more frequently than one might expect.

Markets continuously ebb and flow, with sometimes sudden movements. Stocks, sectors, and asset classes will fall in and out of favor. The tough part is determining when — in advance. No one can predict that consistently and accurately over time, which is why diversification is still an investor’s best bet for long-term investing success.

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Disclosures