In recent weeks adaptation in the market has been puzzling. Stocks that were previously underperforming, such as small caps, have started to show signs of recovery. This shift can be attributed to last week’s cooler inflation data combined with dovish comments from Federal Reserve Chair Jerome Powell that have paved the way for a potential rate cut in September. Notably, the small-cap iShares Russell 2000 ETF (IWM) has surged by more than 4% this week alone, marking an 11% increase since the beginning of the year. On the flip side, mega-cap tech stocks have been experiencing a downturn. Nvidia, a once-favored stock, has witnessed an 8 Draught in just one week and is currently down by roughly 15% from its recent peak.
While some market participants view these market shifts as a positive sign of a broader market rotation, others like Sam Stovall, chief investment strategist at CFRA Research, remain cautious. Stovall predicts a looming double-digit correction in the S & P 500, potentially as early as September. He expressed his hesitance during a call with CNBC where he highlighted concerns about the overvalued nature of large-cap tech stocks. The S & P 500 is currently trading at a 37% premium to its 20-year average price-to-earnings ratio, while tech stocks, which hold significant weight in the index, are trading at a staggering 75% premium. Furthermore, the relative strength of cap-weighted tech stocks versus equal-weighted stocks has surged to levels not seen since 2000. This confluence of factors has led Stovall to believe that large-cap stocks are overpriced and vulnerable to a significant pullback.
Stovall also emphasized the lack of support from small- and mid-cap stocks if large-caps were to falter. Large-cap stocks currently represent over 92% of the total U.S. stock market value, significantly outweighing the 8% contributed by small- and mid-caps. This stark contrast led Stovall to draw the analogy that attempting to fit 92% into less than 8% is as implausible as draining one of the Great Lakes into a backyard swimming pool. The disparity in market cap values underscores the challenges of expecting small- and mid-caps to prop up the index in the event of a large-cap downturn.
Stovall advised investors to tread cautiously and consider taking profits in overvalued large-cap stocks. He recommended rotating into attractive mid- and small-cap stocks or ETFs to capitalize on potential outperformance. However, he cautioned against going all-in, noting that a declining market environment leaves very few safe havens. In such scenarios, a widespread market downturn is likely, with varying degrees of decline across different assets. Stovall’s prudent approach urges investors not to be overly optimistic and to exercise caution in navigating the current market landscape.
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