The S & P 500 might be in for a rocky ride ahead, despite the recent rotation trade taking place in the market. As small-cap stocks start to outperform, there is speculation that this shift could translate to further gains for the overall index. However, Sam Stovall, chief investment strategist at CFRA Research, remains skeptical about the sustainability of this trend. He predicts a potential double-digit correction for the S & P 500 in the near future, possibly as early as September.
Recent market dynamics have been quite peculiar, with last week’s cooler inflation data and dovish remarks from Federal Reserve Chair Jerome Powell triggering a change in market performance debuted by small-cap stocks. The small-cap iShares Russell 2000 ETF (IWM) has surged over 4% within a week, marking an 11% gain for the year. Contrastingly, renowned mega-cap tech stocks like Nvidia have experienced setbacks, with the latter plunging approximately 15% from recent highs.
Stovall’s apprehensions are primarily rooted in the overbought status of large-cap tech stocks, which command a significant share of the S & P 500 index. The current trading premium for the S & P 500 exceeds its historical average by 37%, while tech stocks exhibit a staggering 75% premium. Moreover, the imbalance between cap-weighted tech stocks and their equal-weighted counterparts has reached unprecedented levels, reminiscent of the dot-com bubble era.
The dominance of large caps in the U.S. stock market poses a challenge for small- and mid-cap stocks to single-handedly drive the index’s performance. With large caps constituting more than 92% of the entire market value, the relatively smaller share held by small- and mid-caps raises doubts about their capacity to buffer the index against potential large-cap downturns. Stovall aptly likens the scenario to attempting to pour the contents of a Great Lake into a backyard swimming pool.
In light of the uncertainties surrounding the market’s future trajectory, Stovall advises investors to exercise caution and consider locking in profits from overvalued large-cap stocks. He suggests reallocating funds into promising mid- and small-cap equities or ETFs as a hedging strategy. However, he warns against making drastic investment decisions in anticipation of a market downturn, emphasizing the risk of widespread value erosion during bearish market conditions. Stovall’s prudent advice rings true: in a declining market, even seemingly stable assets are susceptible to varying degrees of decline.
As the market continues to grapple with shifting dynamics and valuation concerns, investors must remain vigilant and adaptable in their investment approach. While the rotation trade presents opportunities for diversification and potential gains, the looming specter of a market correction necessitates a cautious and strategic investment stance.
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