The current financial cycle is witnessing a bull market at its climax. The accumulation of “firsts” and “unprecedented extremes” over the past few years is a sign that this bull market has truly left a unique mark. Last Thursday, 87% of S&P 500 stocks outperformed the index itself, which Goldman Sachs called “the largest in the history of our dataset.” This comes six months after the fewest stocks outperformed the S&P 500 in any half-year. Similarly, Strategas Research said that the New York Stock Exchange had the highest percentage gains and losses of any day the S&P 500 was down. While the drop was only 0.8%, it was the largest one-day drop since April, and of course it came after a weak CPI report raised the possibility of the Federal Reserve cutting interest rates in September. The most notable move was the reversal of the extremely skewed advantage of big tech vs. small caps. The Russell 2000 rose 5.5%, while the Nasdaq 100 fell more than 1%. More broadly, the Russell 2000’s one-day surge against the large-cap Russell 1000 was one of the four largest since 1980, according to Renaissance Macro. And all three previous occurrences occurred near market-wide bottoms in 1987, 2009, and 2020, rather than six months after the large-cap index had hit a new all-time high. All of these rare and unprecedented features of last week’s move tie into a key feature investors have been noticing for months: the massive concentration of market value in a tight cluster of the largest stocks. This configuration is, mathematically speaking, the easiest way for a chunk of stocks to diverge from the S&P 500 in such an unusual way. Remember, the market got this way because the best financial quality stocks with the most attractive earnings profiles and the most attractive long-term dynamics are also among the most expensive and most defensive stocks in times of macro anxiety and scarcity of solid earnings growth. The plausible but untested conventional wisdom is that the ideal market “expansion” should coincide with the Fed cutting interest rates and the associated democratization of earnings growth. This seems a bit too tidy, and history is not clear that market preferences have shifted so suddenly. But today conventional wisdom translates into pre-set automated trading tactics, reinforced by exaggerated rotation mechanisms. That’s what gives rise to days like Thursday that seem both logical and perhaps overdone. 21 Months in a Bull Market Yet it’s not just the internal back-and-forth of this latest phase of the ascent that makes this cycle unique. According to Fidelity Investments, the ongoing bull market that began in October 2022 is now 21 months old, exactly half the average duration of all bull markets since 1877. Its total gain of 57%, as measured by the S&P 500, is also almost exactly half the average since 1929. And it is the only bull market (at least in the past 70 years) that began in the midst of a Federal Reserve tightening policy. (This may be true given that the previous bear market began before the first interest rate hike in March 2022, bucking decades of precedent in which stocks tended to rise in the first months of a tightening policy.) Just to be clear, this year the S&P 500 is off to its best start ever for a presidential election year. Certain macroeconomic “rules” are also malfunctioning: the 2-year and 10-year Treasury yield curves have been inverted (short-term yields exceeding long-term yields) for two years, the longest period without a recession. There are plausible reasons why the interplay between market rhythms and macro factors has frequently exceeded the limits of historical norms over the past few years. The forced flash recession and weeks of market crash were greeted with a bounce-back backed by massive stimulus, and households came out of the economic shock stronger than they were at the start. The tendency for the largest technology platforms to monopolize and perpetuate network dominance is a decade-long factor, allowing winners to consume greater capital. And of course, almost at the moment when stocks bottomed and inflation peaked in late 2022, the AI capital investment boom exploded, enriching large growth segments of the market and compensating for weakness elsewhere. It also makes sense to be humble when predicting the market’s next move, given its recent tendency to break patterns. What can be said with certainty is that this is a bull market, and the wisdom of respecting a solid uptrend will not be overturned by recent extremes or unusual circumstances. It is also notable that very strong first halves of a year tend to be followed by above-average second halves, with the market’s average positive year (as opposed to the average of all years) seeing gains of over 20%.Counter to these encouraging facts, at least tactically, is the fact that a historically strong first half of July is over and seasonal factors are starting to be a bit unfavorable from here on out. This year so far the seasonal rhythm of an election year is not really relevant, but most such years experience turmoil and weakness after midsummer. Is the rotation sustainable? It is unclear whether last week’s sharp reversal of fortunes partially sacrificed acclaimed winners in favor of miserable losers. Surely, a violent and broad burst of momentum like the one we saw in most small caps is not just a fluke. According to multiple technical studies available, such things tend to last at least a few weeks. As the relative chart of the Russell 2000 vs. Nasdaq 100 below shows, the rubber band is pretty stretched and only the forces of mean reversion can give the small laggards a boost. But it also suggests that those seeking a permanent change in market characteristics have a large burden of proof. As mentioned above, the one-day surge in small cap outperformance most similar to the one that occurred last Thursday occurred at the culmination of a widespread damaging sell-off, not a mild bull market hoping that a Fed rate cut would give the economy a boost. The best initial rate cuts are “optional” cuts in healthy economies that aim to gradually normalize policy to sustain and extend the economic expansion. Historically, slow and shallow easing cycles have been more bullish than fast and deep easing cycles. This scenario certainly still plays out. Something close to it is probably already pretty priced in, pushing the S&P 500 back up to 22 times expected earnings. But if earnings actually increase and the Fed is not in tightening mode, the market can usually hold its full valuation. In conclusion, the S&P 500 is solid but slightly overbought, sentiment is a bit lopsidedly optimistic, and an economic slowdown is underway to an unknown degree. Elevated sentiment is normal in bull markets. But it comes with occasional pauses and setbacks. (The determined rally in 2021 is a notable exception that virtually ignored rising sentiment.) And with Fed rate cuts becoming fully priced in, it’s fair to wonder whether a painless rotation from large to small, growth to value, crowded to ignored stocks will solve the market’s narrow leadership and uneven internals. This will seem a bit cutesy, perhaps too gratifying, to the vast majority of investors frustrated by a fractured market and a hard-to-beat S&P 500. But as we’ve seen so many times recently, anything can happen.
