Stock Rotation Is Back on Bets Fed Will ‘Go Big’: Markets Wrap – Yahoo Finance

September 13, 2024

(Bloomberg) — Wall Street traders revived expectations of a half-point interest rate cut by the Federal Reserve next week, prompting a shift in funds into stocks that would benefit most from easier policy.

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Economically sensitive stocks outperformed the big tech companies that have driven the bull market rally, with the Russell 2000 index of smaller companies rising 2%. An equal-weighted version of the S&P 500, where companies like Nvidia Corp. have as much influence as Dollar Tree Inc., outperformed the benchmark U.S. stocks. The index is less sensitive to rallies by big companies, offering a glimmer of hope that the rally could extend.

As the S&P 500 continued to hit new records earlier this year, some investors grew concerned that only a handful of stocks outside of Big Tech were participating in the rally. Now the rest of the market is surging higher as investors become more confident that the start of the Fed's rate-cutting cycle will continue to energize U.S. companies.

“The biggest news from the last 24 hours is the increased likelihood of a 50 basis point rate cut at the Fed meeting next week,” said Jonathan Krinsky at BTIG. “Small caps offer a better balance of risk/reward in the near term, and large tech stocks are likely to take a breather again, but would certainly participate if the S&P 500 makes new all-time highs.”

The S&P 500 rose 0.6%, and its equal-weighted version rose 1%. The Nasdaq 100 rose 0.4%. The Dow Jones Industrial Average added 0.8%. The two-year Treasury yield fell 4 basis points to 3.6%. The dollar fell. Gold hit a record high.

Cantor Fitzgerald's Eric Johnston said the consensus is that the Fed will cut rates by 25 basis points next week, but it's “certainly” possible that regulators could ultimately cut rates by a larger amount.

His view is that if the central bank chooses to cut rates by 50 basis points, small caps in particular would “rise significantly” and even a “very dovish 25” would rise.

Valuations still appear to favor small-cap stocks, and performance has had little impact on those levels, according to Simeon Hyman of ProShares.

“An expected Fed rate cut this month could be the catalyst for realizing this valuation-driven opportunity,” he said. “Interest rate sensitivity in small-cap stocks is one of the most widely accepted investment principles, and the Fed rate-cutting cycle may provide further impetus for small-cap stocks this time around.”

Hyman said small-cap stocks' interest-rate sensitivity is due in large part to the group's greater leverage compared to larger companies, which typically have more borrowed capital.

“This is clearly true today, with the Russell 2000 index being nearly three times more leveraged than the S&P 500,” he says. “That difference alone is more than enough to show that small caps are a big beneficiary of lower interest rates, because reducing debt burdens has a bigger impact on small caps than usual.”

“While many long-time growth leaders are showing cracks, overall technical analysis indicates that underlying participation remains broader than typically accompanies cyclical peaks,” said Doug Ramsey of The Leuthold Group. “We continue to view this widening as more likely a sign of a change in leadership (from growth to value) than a harbinger of further gains for the blue-chip average.”

Beneath the market's surface there's a broad rotation out of tech and communications into more defensive sectors, according to Ryan Grabinski of Strategas Securities, but the only problem is that earnings growth at the top of the market is still expected to outpace the rest of the index.

“As growth stocks become scarce and investors flock to growth stocks, it wouldn't be surprising to see the largest, most liquid names rally again,” Grabinski said. “Of course, these stocks are facing legal and regulatory challenges, but in fairness, this is nothing new. Valuing the Magnificent Seven too low could pose a big risk to a portfolio.”

Essentially speaking, the expected growth of “Mag7” will make it “hard to fade,” he concluded.

Countdown to the Fed:

Admittedly, it will be a difficult road, but I believe the Fed will cut interest rates by 50 basis points at its next meeting. The case for further action up front is strong.

The common reason for not going for 50 is the message it sends: “The Fed must know something we don't.” I don't believe this for a second.

There is a risk to the market if the Fed only cuts by 25%, especially considering the unlikely threshold of a “dovish cut” would be met. Therefore, the “how will the market react” argument is weak. My sense is that the market will welcome this move.

Just after shelving a 50 basis point rate cut next week, talk of a 50 basis point rate cut has resurfaced.

Initially we called for a 50 basis point cut and we think a 50 basis point cut is the right decision, but we just can't imagine the Fed, with its fixation on retrospective numbers, will be able to cut rates to 50 basis points. The consensus for Jerome Powell is that he would not have enough votes to cut rates to 50 basis points. So his strategy will be to cut rates to 25 basis points and then be super dovish in his press conference. This is what we think, not what we want.

Judging by the price action, investors are definitely expecting a dovish interest rate decision, which could take the form of a surprise 50 basis point cut or even a 25 basis point cut, with at least one 50 basis point cut likely in the remaining two meetings later this year.

It's all about economic growth and the job market right now. After the inflation data went up, you would think the chances of a 50 basis point cut would drop to zero. In fact, it did approach zero, but then recovered and we're back to square one. This means there is an equal chance of either a 25 basis point or a 50 basis point cut next week.

And here's the thing: the market is currently pricing in a 50 basis point cut as likely as a 25 basis point cut, and anything other than 50 will disappoint market prices.

While we maintain that a 0.25 percentage point cut would be the path of least resistance, it is clear that a 50 basis point cut is on the table and will be part of the Fed's discussions. We recognize that CPI and PPI will likely lead to more moderate movements in core PCE. As they are the Fed's preferred measures, the overall inflation profile will be less of a concern to policymakers, allowing the FOMC to focus on the labor market.

The decision on the 25 and 50 basis points cuts could be closer than most expect. In our view, the dot plot will be the most visible part of the Fed's guidance next week, along with Chairman Jerome Powell's post-meeting press conference. We expect the Fed's forward guidance to be largely dovish.

For Treasuries, the size of the cut, dot plot, and Chairman Powell's comments will be key indicators to watch. As we expect the Fed to start the cycle with a 25bp cut while remaining generally dovish, rates may continue to rise and the yield curve may continue to bull steepen. We recommend buying at the dip in duration.

Company Highlights:

Adobe Inc. offered a forecast that did little to assuage investors' impatience for its new artificial intelligence tools to start generating profits.
Oracle Corp. said it expects annual revenue to rise to at least $104 billion in fiscal 2029, signaling optimism about the growth prospects for its cloud infrastructure business. The company's shares soared to an all-time high.
Boeing factory workers have gone on strike for the first time in 16 years, halting production at the company's entire Seattle facility after members of the company's largest union voted overwhelmingly to reject a contract proposal and go on strike.
Energy company Halliburton Corp.'s rating was downgraded to sector perform from outperform by RBC Capital Markets.
Furniture retailer RH Inc. reported second-quarter revenue and profit that beat Wall Street expectations. The company touted improving customer demand in recent months but lowered its full-year sales forecast, saying revenue was not keeping up with demand as it trimmed its product lineup.

Some of the key market developments:

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