The 'Great Rotation' is Here.

For more than two years, the primary theme that we've seen in the stock market has been a small selection of large cap technology names leveraged to AI and semiconductors driving the stock market forward: Apple, Amazon, Nvidia, Meta, Google, Microsoft, Tesla. These massive stocks dominate the major indexes and have created an illusion of a massive bull market. Looking to the S&P 500, which is the market index containing America's 500 largest companies, we've seen this basket of stocks rise a staggering 50% since September of 2022.

For context, the long-term average return of the S&P 500 is around 10% per year, so 50% in two years is absolutely crazy. However, when you take these companies out and look to the smaller, lesser-known stocks in the American market, the story changes quite a bit. Over that same time period, these smaller companies haven't gone up at all. Well, recently, that seems to be changing, with money flooding out of the high-flying Magnificent 7 and flowing back into smaller companies. This effect is being labeled throughout the media as the great rotation, and it could be the first sign of the U.S. stock market starting to correct.

It's a rotation, the long-awaited rotation story. It's the worst since December of 2022. If we consider current macroeconomic conditions, what the stock market has done over the past two years almost defies logic. Interest rates have risen from effectively zero to now 5.5%, the highest levels we've seen since the turn of the century. But this broadly isn't good for stocks; it puts the clamps on businesses, making borrowing and thus expansion more challenging. It also puts the clamps on the consumer's ability to spend, which in turn puts stress on business profits. The higher rates go, the more businesses are likely to underperform, disappointing shareholders and leading to stock price declines.

However, turning to a major market index like the S&P 500, you'd have no idea these macroeconomic conditions were currently in place, as the index has continued to rip to new all-time highs. This is quite simply due to investor speculation around the future potential of AI, which has caused huge sums of money to float into just seven mega-cap businesses at the very top end of the market. Collectively, the Magnificent 7 climbed 75.71% during 2023, causing the S&P 500 to rise 26%. But once you take out those seven tech businesses, the numbers tell a very different story, with the index only rising 8% across that same time period.

It's no secret that, thanks to these huge inflows into the Magnificent 7 stocks, the S&P 500 is becoming more concentrated than it has ever been, with these seven businesses now accounting for almost exactly one-third of the index. Well, that was until recently when huge sums of money started flowing out of these companies. In fact, just on Wednesday last week, the NASDAQ and the S&P 500 experienced their worst day since 2022, with the S&P 500 falling 2.31% while the tech-heavy NASDAQ slid 3.64%. You guessed it, it was all because of the Magnificent Seven stocks getting crunched.

Shares of Google's parent company Alphabet fell 5% for their biggest one-day drop since January 31st. Tesla shares declined 12.3%, their worst day since 2020. Nvidia lost 6.8% for the day, and Meta stumbled 5.6%. Even Microsoft lost 3.6%. So, money was flowing out of these stocks and flowing out fast. But why was this happening?

Well, it's no secret that the reason these companies are flying so high is because investors are expecting a lot of future growth on the back of their investments in AI. These seven businesses—Apple, Amazon, Meta, Microsoft, Nvidia, Tesla, and Google—are seen by most investors as the businesses in the best position to invest heavily in AI technology and reap the long-term benefits. With so much bullishness around the potential of AI and what it could do for businesses, money has flowed into these seven stocks in such vast quantities that now they need to do everything right to justify their lofty valuations.

The problem is, last week, we started to see some earnings reports coming in, showing exactly how these companies performed in the second quarter of 2024, and investors weren't too happy. For example, despite Google beating estimates for revenue and net income, investors weren't impressed by the business's YouTube revenue, which came in below expectations. Then there was Tesla that reported weaker than expected results, including a 7% year-over-year decline in automotive revenues. This set the tone for investors who started pulling money out of these and the other Magnificent Seven stocks, even before some of them had released their earnings.

But the crazy thing about all this is, when you look at both of these businesses' financials, they weren't even that bad. Tesla we knew would be under pressure due to the cyclical nature of the automotive industry, but looking to Google, we can see that they posted 14% year-over-year revenue growth. They grew their operating income, improved their operating margin to 32%, and took home $23.6 billion in net income, up 28% year-over-year. This just shows you how overbought these stocks really were.

Investors had bid the prices of these companies up so high that everything needed to eventuate absolutely perfectly, and anything that wasn't perfect would lead to a drop in stock prices. In fact, just two of these companies posting their earnings even triggered a wave of selling into the other Magnificent Seven stocks that hadn't even reported their earnings yet. But the interesting thing in my mind is not so much the tech correction itself, but where this money ended up flowing to.

Because the trend being discussed throughout financial media at the moment is the rotation of money out of the high-flying tech stocks and into the beaten-down smaller caps that haven't had the same level of investor support over the past few years. Many financial news sites are currently discussing the price movements of the Russell 2000 Index, which is a small cap index composed of the smallest 2,000 stocks from the Russell total market index (which is the Russell 3000 index, covering 97% of the U.S. stock market). When you look at that index, you can see that over the last two years, you've not really seen all that much movement. In fact, these smaller businesses have been struggling, and their share prices have been relatively beaten down.

Well, that is, of course, until recently, with the index up around 11% in the space of just 1 month. If you overlap the charts of the S&P 500 and the Russell 2000, it's almost a perfect match. The Magnificent Seven stocks have been falling as investors sell at the same time as the small caps have been rising as investors have been buying. Why is this?

Well, there is the most obvious argument, which is one of valuation, where investors are taking profits from one set of overvalued companies and shifting that money into beaten-down stocks that offer better value. But there is one more factor that is more likely to have triggered the great rotation, and it goes back to this guy and his merry little Federal Open Market Committee. It's no secret right now that the Federal Reserve is putting the clamps on the economy. Interest rates were at zero, but across 2022 and 2023, rates were hiked steeply to 5.5% to help slow inflation.

But what does this mean for businesses? Well, it means that the clamps get put on them too. The main two effects are tougher sales conditions, as people generally have less to spend, and also tougher conditions to take on debt. It's this second factor that really keeps the smaller businesses down, while the Magnificent 7 has been able to race ahead. It's because, in most instances, a small company is much more dependent on things like debt to survive. Many startups or small businesses don't even make consistent profits yet and frequently need to turn to business loans and investors to source more money.

On the other hand, big established profitable companies like Apple, Google, or Microsoft simply won't get affected as much by higher interest rates. I've used this example recently, but you can take Alphabet, for example, the parent company of Google. In the most recent quarter, they had to pay $67 million of interest on their debts. Now, that sounds like a lot of money until you consider the fact that they have around $27 billion of cash just sitting on the sidelines. As you can imagine, interest rates would have to be really, really high in order to even bother Google.

A great analogy I like to use is going down like a really crappy road with potholes everywhere. You know, big bumps in the asphalt, bits of gravel left right and center—it's just the worst road. What would you rather use to take on that road, a moped or a tank? At the end of the day, the small companies (the mopeds) are much more affected by what happens in the macroeconomic landscape, whereas the big companies can really ride over the bumps a lot more easily.

So, how does that analogy translate into these small caps rising suddenly? Well, over the past month, we've seen really positive inflation metrics coming out of the Bureau of Labor Statistics, which is exactly what the Federal Reserve needs to see to start considering lowering interest rates. If interest rates do get lowered, business conditions get easier, meaning the road gets smoother for our moped, leading to a higher likelihood of the smaller companies performing well.

While it's unknown whether the Federal Reserve will lower interest rates anytime soon, of course, in financial markets, these bits of information get priced in as soon as they're known. Thus, we've seen money flowing into these small cap businesses, captured in the Russell 2000 Index. This macroeconomic news also has a flowing effect into earnings estimates for the small cap companies. As you can see from this Market Watch article, they note the pace of year-over-year earnings growth for stocks in the small cap 600 index is set to start outpacing that of their large cap peers later this year.

According to Bank of America Global Research, the trend should continue through 2025. Without this optimism, small caps likely won't be able to maintain their momentum. You can see from their provided chart that the earnings predictions from smaller caps over the next year or so are expected to outpace that of the largest stocks.

When you consider that the smaller stocks as a group are much cheaper, you can understand why the big money is flowing out of the overvalued large caps and into the smaller caps. Now, of course, this doesn’t at all mean that this situation will come true in reality. We really have no idea how the earnings will fare from these two groups, but the big money loves to get into these sorts of broad guessing games and does look at future predictions, which can have an impact on the stock market right now.

But overall, guys, that is what people are talking about when they are referring to this great rotation that's happening in the stock market at the moment. If you enjoyed this video, please consider subscribing. I also just wanted to say a quick welcome to all the new subscribers that have started following the channel over the past few weeks on the back of my US debt video that really took off. It's really good to have you guys here.

Lastly, if you'd like to learn how to pick stocks the Warren Buffett way or if you'd like to learn about maybe passive investing instead, definitely check out new money education in the description. That's also the best way to financially support the channel as well, so thank you if you do decide to go and join the squad over there. I really appreciate it. But with that said, guys, please leave a like if you enjoyed, and I'll catch you guys in the next one. [Music] [Music]