The stock market had a split personality in July. Which one will win out in August?
In the first half, the S&P 500 raced to its seventh all-time monthly high, and 38th record close of 2024, according to S&P Dow Jones Indices. But in the second half, large caps sold off as signs of a slowing economy boosted the odds of a Federal Reserve rate cut in September. Investors lightened up on popular megacap tech stocks driven by AI and rotated into rate-sensitive laggards, such as small caps and value stocks.
"July was a month of two halves," said Henry Allen, macro strategist at Deutsche Bank.
Sizing Up July's Stock Market
The S&P 500 still eked out a 1.22% gain in July. That stretched its year-to-date total return to 16.7%, says Lipper Refinitiv. The Nasdaq was the only major U.S. stock index to lose ground, falling 0.73% to cut its annual gain to 17.71%. The small-cap Russell 2000 was the big winner, gaining more than 10%. The Dow Jones Industrial Average rose 4.4%.
July mutual fund performance highlights the market's shift away from the popular trades. The average U.S. diversified equity fund gained 3.42%. But many leading market categories began to crack, Lipper data shows. Science and technology funds, for example, fell 1.94% in July, slashing the hot sector's year-to-date return to 15.55%. Large-cap growth funds also lost ground, tumbling 1.78%.
Winners From The Stock Market Shift
Value stocks and small caps benefited from the rotation from leaders to laggards. Both sectors benefit from falling rates. Vanguard Small Cap Index fund (NAESX), for example, rallied 6.77% in July, the best performer among popular funds. The value vs. growth story is best illustrated by Vanguard Value Index (VIVAX) fund's 4.73% gain. That handily outpaced Vanguard Growth Index (VIGRX), which declined 1.73% in July.
In July, the market broadened out from just the Magnificent Seven. Part of the move can be explained by valuation.
Ann Holcomb, manager of T. Rowe Price U.S. Equity Research Fund (PRCOX), a 2024 IBD Best Mutual Funds Award winner, says big-cap market leaders benefiting from momentum often eventually run out of steam. And they drag down the rest of the S&P 500.
Sell-Off An Opportunity?
The fund's analyst team, though, views the sell-off as an opportunity to upgrade the portfolio with top stocks at attractive valuations. Looking at past tech sell-offs, including the 2000 dot-com bust, Holcomb says today's megacap tech leaders have solid fundamental underpinnings.
"We take the opportunity in volatile markets to upgrade the quality of the portfolio where we can," said Holcomb. "A lot of times the market is indiscriminate when it sells. So, when you've done all the research ahead of time, you can really jump in and take advantage of those opportunities."
Go The Distance In The Stock Market
Despite all the market unknowns, Holcomb is still focusing her portfolio on long-term trends and companies with durable business models. AI is one trend with legs. Breakthrough weight-loss drugs, and leaders like Eli Lilly and Denmark-based Norvo Nordisk are another. She also likes restaurant stocks with a differentiated concept like Chipotle Mexican Grill and Wingstop.
Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, expects August to remain bumpy. Investors will reshape their views on the size and speed of Fed rate cuts, inflation, the pace of economic growth and uncertainty tied to the November elections.
"August is typically slow, but volatility is expected to increase," said Silverblatt.
More Than Just Tech Stocks
The performance of ETFs in July, according to Morningstar data, also illustrates investors' search for investments that go beyond tech stocks and large-cap growth. This year's top-performing U.S. diversified ETF, Invesco S&P MidCap Momentum invests in midcap stocks, not the market-cap giants like Nvidia and Apple. The fund continued its strong performance last month, rising 5.05% to extend its 2024 gain to 33.53%. Similarly, Invesco S&P MidCap Quality rallied 6.15% in July.
And when it comes to all stock ETFs, small-cap portfolios shined brightest. The No. 1 gainer was iShares US Small Cap Value Factor ETF, which soared 15.07%, according to fund-tracker Morningstar. ProShares Russell 2000 Dividend Growers gained 14.17% and Invesco S&P SmallCap 600 Revenue ETF jumped 13.53%.
Similarly, Vanguard Total Stock Market ETF, which invests in large-, mid-, and small-cap stocks, gained 1.89%, topping the large-cap Vanguard S&P 500 ETF's gain of 1.16%.
The Chips Are Shuffling
While 2024's No. 1 sector ETF performer VanEck Semiconductor fell 5.26% in July, an ETF that invests in homebuilders that benefit from lower rates topped the sector performance chart. IShares US Home Construction ETF rallied 19.33%. And SPDR S&P Homebuilders ETF jumped 16.93%. Regional bank ETFs, whose underwater bond holdings will be reduced by Fed rate cuts, also performed well. The SPDR S&P Regional Banking ETF rose 18.7%.
International stock investing delivered positive returns in July, with the MSCI EAFE index, which invests in developed foreign markets, rising 0.77%. That boosted its year-to-date gain to a respectable 11.91%.
Bonds Vs. The Stock Market
Bond investors had another good month in July. Rate cut odds rose. And the outlook for the economy dimmed.
The Bloomberg US Aggregate Bond index, which tracks a diversified basket of investment grade bonds, gained 2.34% to wipe out its 2024 loss. The index now boasts a 1.61% annual return, according to Lipper. U.S. government debt was the place to be. The No. 1 fixed-income mutual fund category was General U.S. Treasury Funds, which advanced 2.67%. Core bond funds, which invest in a diversified basket of high-quality bonds ranging from Treasuries to corporates, gained 2.25%.
Money market funds ticked up 0.42% in July to increase their year-to-date return to 2.94%.
Stephen Hooker, manager of Virtus Newfleet Core Plus Bond fund (SAVYX), says the weaker economic data coupled with lower inflation readings show the Fed rate hikes in recent years are slowing the economy. And that means Treasury yields will continue to drift lower and the yield curve will steepen. "The Fed hasn't embarked on its initiation of rate cuts, but it's coming," said Hooker.
There's concern now over whether the Fed will be able to engineer a soft landing, says Hooker. The latest readings on U.S. manufacturing and job growth came in shy of estimates. That boosts odds of a recession.
"The question is, do we stabilize here or does it become something else," said Hooker.
Hooker says with Fed rate cuts coming, investors sitting in cash and earning 5% should prepare to earn less going forward. "Your returns on cash are close to heading the wrong way," said Hooker.
Stock Market Bet Going Long
He recommends putting money to work in longer-duration high-quality bonds that will generate better returns than cash. longer-duration assets, such as long-term Treasuries, produced total returns of 12% in the fourth quarter of 2023 when the 10-year Treasury yield declined almost three-quarters of a percentage point.
Hooker expects bond market volatility. He recommends buying on the dips or dollar cost-averaging in until the Fed makes its first cut. "I'd be a regular buyer of bonds," said Hooker. "That's a prudent long strategy to pursue."
Will the rotation away from tech last?
Jason Draho, head of asset allocation and chief investment officer Americas at UBS Financial Services, thinks a "reversal of the reversal" will occur. In other words, the previous winners (megacap techs and the AI plays) will rise to the top again.
The reason? The rotation into laggards can only be lasting if a perfect trifecta of macro conditions occurs. You need steady economic growth, falling inflation and Fed rate cuts sustained for a lengthy period. But Draho argues that might be too much to ask. The recent fear of recession is a sign that not all three conditions are likely to be met.
"Our core investment views have not changed," said Draho. "The data needs to be great, not just good, for the rotation to continue."
Playing The Pullback
The recent pullback in marquee AI names such as Nvidia could make the valuation price point for the megatech leaders more palatable. "Once you get a pullback in valuations, investors (likely) have more confidence in those megacap companies to deliver earnings," said Draho.
And now that small caps have been hit hard in the early-August correction, the return to tech might be the trade to execute, adds Draho. "The moment investors think the rotation trade has run its course, they'll probably go back and say, 'let's reload by buying tech,' " Draho said.
