While mega-caps have been driving the market higher over the past several quarters, we can see in the chart above the mid-, small- and micro-caps have largely kept pace with the S&P 500 for more than a month now. During that time, we have seen some change in the composition of the market’s gains. Tech and growth have begun to take a back seat, while cyclicals including industrials and materials have moved back into the lead. The shift makes sense too. The market has been walking back its expectations for rate cuts for a little while and is now back to pricing in just 3-4 cuts this year, much more in line with the current Fed outlook. Growth sectors, including tech, benefit from cheaper financing to fund that growth. Now that investors feel interest rates will be higher for longer, they’re not quite as attractive as they were a month ago. We could still see another rally here, but conditions don’t appear quite as unabashedly bullish for tech as they were.
While long-term Treasury yields have been on the rise throughout 2024, they have also stabilized over the past couple weeks. As I’ve noted before, the Fed’s rate outlook and the market’s rate outlook were way out of whack and that contributed heavily to bond prices correcting throughout much of this year. Now that we’re seeing long-term yields start to stabilize again, we’re likely back to a point where traditional risk-off behavior could take hold if the right set of conditions presents itself. When Treasury rates are largely just responding to what the Fed is doing, you get a situation like 2022 where risk-off opportunities don’t really have a chance to breathe because bonds have to respond to inflation risks. Now that yields are stabilizing, inflation is stabilizing and the large-cap/small-cap gap is starting to come back into balance, I think the market has a much better chance of reacting to larger underlying macro risks.
How long that window remains open is unclear. I’ve pointed to the first half of March as the point where we could see a real shift. The lumber/gold, utilities and Treasuries signals are all sitting relatively neutral right now and, while that doesn’t necessarily ensure we’re going to see a big, massive all-in-one flip over the next week or two, the setup is definitely there. The shift in equity market leadership combined with more settled Treasury yields and a slow recovery in small-caps essentially confirms this. The Fed has been consistently preaching a message of patience to investors, which translates to “don’t expect rate cuts anytime soon”. With this policy tailwind off the table for the time being, tech is probably going to have a much tougher time dominating the market as they have in the past.
Keep reading with a 7-day free trial
Subscribe to The Lead-Lag Report to keep reading this post and get 7 days of free access to the full post archives.