July Turned the Stock Market Upside Down. Will It Stay That Way?

July was the month the stock market was turned on its head. The tech stocks that powered market gains in the first six months of the year stumbled while small-caps, which had just barely recovered from 2022’s bear market at the start of the month, surged. 

In a surprising inversion of the first half of the year, only two of the S&P 500’s eleven sectors posted declines in July: Communication Services (-4.2%) and Information Technology (-2.1%). The market was led by Real Estate (+7.1%), one of the worst-performing sectors over the last twelve months, and Financials (+6.3%). 

Rate-sensitive stocks got a boost on July 11 when data showed consumer prices unexpectedly declined in June, raising conviction on Wall Street that the Federal Reserve will begin cutting interest rates as early as September. Investors piled into small-caps, which are more likely to carry floating-rate debt than their mega-cap counterparts. In the five days following that inflation report, the small-cap Russell 2000 rose 11.5%, its biggest rally since the Covid turmoil of 2020.

Simultaneously, investors sold off cash-rich big tech companies, the market values of which stood at historic highs after more than a year and a half of market leadership. The Magnificent Seven fell 2.7% while the Russell surged, creating a 14.2 percentage point gap between the performance of the two groups, the largest divergence in data going back to 2015. 

Expectations for rate cuts also buoyed the industries that have been hit hardest by the Fed’s campaign of rate hikes. An index of regional banks, which have been hammered by higher interest rates, surged 18.5% in July. Homebuilder stocks gained 17.6% as investors bet lower rates would reinvigorate the dormant U.S. housing market. 

What To Expect in August

One big question hanging over markets is whether the rotation out of tech and into small-caps will continue.

Some technical analysts see signs it will. Bank of America’s Stephen Suttmeier recently noted that the Russell 2000’s rally coincided with a surge in the number of small-cap stocks hitting 52-week highs, confirmation of what he called a “big base breakout.” He also pointed to increasing trading volume and an increase in the number of stocks trading above their 200-day moving averages as more reason to be bullish on small-caps going forward.

The macroeconomic stars could also be aligning for small caps.

“The latest data releases, including a positive second-quarter GDP print, and even the durable goods report with a weak headline number, but with positive data on capital expenditures, suggest that while the economy has been cooling it isn’t on the precipice of collapsing,” said Quincy Krosby, Chief Global Strategist at LPL Financial, in a recent commentary. 

A report earlier this week suggesting the U.S. job market continued to cool in June added to conviction the economy remains solid, but not so strong as to deter the Fed from cutting interest rates this year. That balance—healthy but not overheated—should continue to support the rotation into small caps, Krosby said.

To be sure, chasing the rally comes with risks. Small caps, Krosby warns, are “known to sell off quickly when they perceive a material change in direction.” And markets are rife with economic and political uncertainty at the moment.