In case you’ve missed, the U.S. equity market has been in the midst of a massive reversal. Out are tech, growth and the magnificent 7 stocks. In are small-caps, value and dividend stocks. The market hasn’t seen a rotation like this since the 4th quarter of 2023 when it began pricing in 6-7 rate cuts by the end of 2024. It’s also pricing in cuts this time around too, but this environment is different.

Last year, markets rallied because they believed high inflation had peaked and the Fed would be able to finally normalize rates. Employment was strong, GDP growth was good and investors were enthused.

Today, the Fed may be cutting rates to try to stave off a slowdown or even an eventual recession. Powell said so himself recently when he proclaimed that "reducing policy restraint too late or too little could unduly weaken economic activity and employment.”

Investors aren’t panicking, but they are positioning themselves more defensively. In that sense, a powerful move into small-caps wouldn’t make sense, but considering they trade at just 14 times earnings, a more than 40% valuation discount to the S&P 500, it’s a logical move in terms of pure value alone.

And it’s that concept that has led to one the best stretches for small-caps in several decades!

Just How Well Have Small-Caps Been Performing?

In terms of performance relative to the S&P 500, it’s been nothing short of historic.

For the five days ending July 16th, the Russell 2000 gained 11.5%. That’s the 22nd best five-day stretch in the 40 years of the index (out of more than 10,000 rolling 5-day periods total)!

In terms of performance versus large-caps, it’s been, well, unprecedented!

The best two stretches in history have been the ones ending Wednesday and Tuesday of this week. And it’s not even close.

The caveat is to look at when these stretches have taken place historically.

• October 1987: “Black Monday” - A single-day market crash where large-caps fell more than small-caps. Stocks gained in the year following this, but it was large-caps that performed relatively better.

• January-May 2000: “Tech Bubble” - The markets had a couple of distinct periods where small-caps did comparatively well. Unfortunately, this was just before the bubble burst and ushered in a bear market that lasted the next three years.

• November 2016: “Trump Election” - Stocks initially fell in the immediate aftermath of the election results. A day or two later, investors pivoted to embrace Trump’s pro-business agenda and the S&P 500 gained nearly 20% over the next year.

• March-April 2020: “COVID Recession” - The S&P 500 fell by more than 30% in one month’s time, but sharply reversed higher after the government injected trillions of dollars of stimulus cash into the economy.

Is there anything to be gleaned from the history of short-term periods of significant outperformance from small-caps? Not really. Each of the four previous instances were unusual circumstances are unlikely to be repeated. 2024 may be the most traditional example of value stocks outperforming growth in the lead-up to an economic slowdown.

We have time to see how this plays out, but in the meantime, let’s look at a handful of charts that tell us how the markets look right now. Is small-cap outperformance a harbinger of good things to come? Is it time to panic?

The short answer is that the markets are looking better, but it may not last for long.

Small-Cap Outperformance Over Large-Caps Has Been Historic

This is a bit of a reiteration of the data table I laid out above, but it’s important to show just how unusual the past week and a half has been.

This is looking at the S&P 600-to-S&P 500 ratio, so it’s slightly different than using the Russell 2000, but the takeaway is the same. Small-caps have been outperforming by 10%. Only on incredibly rare occasion has this gap even gotten to 7%, fewer than a dozen times over the past 40 years. On most occasions, that gap doesn’t even get to 3% in either direction. The 10% performance gap we’re seeing right now is multiple deviations above what we’d expect under normal conditions.

Large-Cap Growth to Small-Cap Value Rotation Has Been Unlike Anything We’ve Seen

If you think the rotation from large-cap to small-cap has been eye opening, take a look at the rotation from one corner of the style box to the other.

Small-cap value, which has been incredibly unloved and incredibly cheap for years, led the large-cap growth category by more than 15% over a 6-day span, easily the widest over the 13-year history of these two ETFs. It’s also interesting to note how volatility between these two categories noticeably picked up during the COVID recession and has remained that way ever since.

If you’re betting on the value trade, this would be the place to capitalize. With more than a decade of continued underperformance and P/E ratios of 13 and 33, respectively, there’s a lot of room for small-cap value to catch up.

Market Breadth Has Improved Substantially Even Though The Nasdaq 100 Has Fallen

The magnificent 7 giveth and the magnificent 7 taketh away. The success of NVIDIA, Microsoft and Apple was able to mask a lot of weakness that was occurring below the surface, but that trend has now completely reversed.

Even though the Nasdaq 100 has fallen by roughly 5% and the magnificent 7 has dropped by 7% collectively, the number of stocks trading above their 200-day moving average has soared, hitting their highest level since April. The pullback in mega-cap tech has allowed other sectors and smaller companies to stand out. It’s also created a much healthier market overall that’s finally rewarding diversified portfolios, even though the major averages have moved lower recently.

The Nasdaq 93 Is As Dominant As The Magnificent 7 Was Before

2024 could be characterized by a relatively few stocks driving the averages higher even though they were nearly the only ones doing so. In the past week, those ignored stocks have moved back into the spotlight.

Even though the advance/decline line on the Nasdaq was flat for much of the year, May really highlighted the largest issue with the market - stocks overall were performing worse, but the heavy mega-cap tilt was making it look to investors like everything was just fine. With just a few stocks controlling the market, the risk was always there that the pullback could be steeper than average because of the over-concentration at the top.

Now we’ve got the opposite. The Nasdaq 100 is heading lower, but the overall market is looking much better and broader than before. If you’re loaded up on the S&P 500, Nasdaq 100 or stocks, such as NVIDIA, it’s probably not been a good week. If your bets are spread out, you’re doing much better.

The Large-Cap to Small-Cap Rotation Has Been Orderly & Without Volatility

If I were to tell you that the Nasdaq 100 has pulled back by nearly 5% in just over a week, you’d probably assume that volatility spiked in the process. It hasn’t. In fact, it’s barely budged.

The VIX did tick up modestly, but 14 is hardly the level that would incite concern. Even the 1-day VIX readings haven’t indicated any abnormal selling. A suppressed VIX is generally a good sign for bullish investors, so I’m not terribly concerned about an imminent correction here. In fact, I’m quite encouraged that trading has been orderly, even if it’s involved a huge rotation from one asset class into another.

Final Thoughts

The past week or two has undoubtedly been historically unusual, but I’m not ready to say that a bull or bear market is upon us.

Seeing small-caps rallying is generally a good sign because investors typically take on risk when conditions are positive. However, a huge rotation from growth into value can be taken as a negative because it could mean investors are positioning themselves more defensively.

Overall, I view the current situation positively, but not with great conviction. The fact that Treasuries aren’t really rallying here suggests that there is not a flight to safety element at play. The rotation into value could be used as defensive posturing, but the fact that investors are mostly remaining in equities and not rotating into bonds is a good sign. That means investors are probably still bullish on equities, in general, and the lack of movement in the VIX would confirm that.

That being said, stay prepared! This already feels like a much different market than it did a month ago. If the labor market keeps slowing and the Fed keeps sounding warnings about economic growth, that flight to safety trade could come quickly.