Equity markets experienced one of the most severe rotations in years in July, with previous laggards like small cap and value stocks becoming leaders and previous leaders like mega cap tech stocks becoming laggards. The S&P 500 Index ended +1.2% higher on the month, a statistic which belies the turmoil that occurred beneath the surface. While the first part of the month saw a continuation of the leadership that dominated markets in the first half of 2024, the CPI release on the morning of July 11 marked a turning point. Since their peak the day prior, the Magnificent Seven stocks are down 9.4% while the Russell 2000 is up 9.9%. Further, the S&P 500 equal-weight index outpaced the cap-weighted version by 5.6% and the Russell 1000 Value Index outpaced the Russell 1000 Growth Index by just over 10%.
Exhibit 1: 2024 Equity Market Leadership
Data as of 31 July 2024. Source: S&P, Russell, UBS, and Bloomberg. Note: Mag7 vs. 493 is the UBS Magnificent 7 relative price return vs. UBS S&P ex Magnificent 7; Cap vs. Equal is the S&P 500 relative price return vs. S&P 500 Equal Weight; Large vs. Small is the Russell 1000 relative price return vs. Russell 2000; Growth vs. Value is the Russell 1000 Growth relative price return vs. Russell 1000 Value.
This shift has taken many investors by surprise and, while we view the broadening of market leadership as a healthy dynamic, the key question looking forward is will this move persist or fade out in a manner similar to several previous rotations in the last few years. We believe it is informative to analyse the five primary catalysts that sparked the rotation and to then formulate a view regarding which dynamics may have already fully played out and which may have greater durability in the coming months.
Exhibit 2: Largest Stocks Distorting Valuations
NTM = Next 12 Months. Data as of 30 June 2024. Source: UBS.
“Rapid advances in generative AI and the development of more capable models is contributing to strong adoption of AI infrastructure and services by millions of developers and leading companies across industries as AI enables them to develop better-quality software, find insights from their data and protect their organisations from cybersecurity threats.”
Given this, we do not believe that AI bubble fears currently represent a long-term driver of a leadership rotation.
Exhibit 3: Mag 7 Advantage Dissipating
Magnificent 7 data refers to the following set of stocks: Microsoft (MSFT), Amazon (AMZN), Meta (META), Apple (AAPL), Google parent Alphabet (GOOGL), Nvidia (NVDA), and Tesla (TSLA). Data as of 31 July 2024. Sources: FactSet, Russell, S&P.
Putting this all together, several of the primary drivers behind the recent market leadership rotation have the potential to persist over the coming quarters. Leadership rarely moves in a straight line, and we believe the near term (the next several months) could see an oscillation that favours the previous leadership on the perception of safety if the economy cools further. Ultimately, we believe a soft landing will play out, a view rooted in the signals emanating from the ClearBridge Recession Risk Dashboard, which had no changes this month and remains in green (expansionary) territory.
Exhibit 4: ClearBridge Recession Risk Dashboard
Source: ClearBridge Investments.
While a growth scare may nip this building leadership rotation in the bud, we believe the economy will ultimately reaccelerate. Our confidence is based on a solid macro foundation, few excesses in the market and a more accommodative Fed. This pickup in economic growth should favour the recent winners, namely small cap, value and cyclical stocks more exposed to an accelerating economy. Potentially frenetic market leadership is a good reminder of the importance of portfolio diversification and periodic rebalancing, particularly following long stretches of out- (or under-) performance. Finally, the events of the past few weeks also serve to highlight the advantage that active managers possess when market concentration reaches extremes, as passive funds are unable to sidestep areas of potential concern in the benchmarks they track.
The ClearBridge Recession Risk Dashboard improved to an overall green signal this month with three underlying indicator improvements, supporting our view of continued economic normalisation.
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