Opinion: The Great Rotation: Tech stocks to small caps

Richard Baker

It’s funny to remember how my friends and I played spin the bottle at junior high birthday parties. I didn’t have a girlfriend, and all the girls were cute, so I didn’t mind who the bottle pointed to.

Up until now, that was what I considered the Great Rotation.

Today, the Great Rotation isn’t innocent kisses among middle schoolers but huge amounts of money moving from the world’s largest companies to some of the smaller ones.

Since July 10, the day the June Consumer Price Index was released, the Magnificent Seven (Apple, Tesla, etc.) group of large tech companies has been negative 11% while the S&P 500 has been down just 3%. The Magnificent Seven group has lost over $1.5 trillion in value in just three weeks. That is because investors are rotating out of technology stocks in mass and into parts of the market that might benefit from a Federal Reserve rate cut.

The CPI report’s release showed inflation cooling faster than expected, which led many investors to expect the Fed to start its rate-cutting stretch in September. This motivated investors to lower their exposure to the Magnificent Seven, this year’s market leaders, and to invest in shares of companies that have yet to run up this year. In a sense, they were selling high and trying to buy low before the smaller companies made a run.

Investors don’t want to miss the rush. The investment world has known for some time that the Fed would begin lowering rates sometime in the next several months, but they didn’t know when. The June inflation report pointed to September, and they didn’t want to miss the next big move. So, they sold some tech shares and rotated to smaller companies that tend to rally when rate cuts make their loans less expensive and increase their profits.

Small caps generally perform better to interest rate cuts than larger caps since these smaller companies use more bank lines of credit to finance their company growth. On the other hand, a slowing economy also has a bigger negative impact on small caps.

However, investors see opportunity in small caps and are moving in that direction despite the risk.

So much so that in July, the Russell 2000, which is small-cap heavy, outperformed the Nasdaq, which is tech-heavy, by almost 13%.

Five months remain this year, and the investing storyline is changing from the big Magnificent Seven to the other end of the size spectrum. The rest of the market is catching up to the big guys on earnings growth. The Magnificent Seven is no longer the only game in town, and the broadening out of earnings growth means a healthier overall market.

I leaned into small caps in July and am staying neutral toward technology and the growth style.

I suspect my next move will be toward value as earnings growth continues to broaden and growth-style valuations remain high.

Today’s teenagers may have cellphones, but in the 80s, we had spin the bottle. Last night, I asked my wife if she wanted to play spin the bottle, and she just rolled her eyes and turned on the Olympics. I guess she rotated away from that game long ago.

Richard Baker, an accredited investment fiduciary, is the founder and executive wealth adviser at Fervent Wealth Management LLC in Springfield. He can be reached at richard@ferventwm.com.