Great Rotation, Great Correction or Head Fake?

In second half 2024, investors need to be ready for all three.

Is there a Great Rotation underway in the stock market—with hundreds of billions of dollars getting ready to flow from stretched Big Tech stocks to unloved dividend and value companies? Are we instead headed for a Great Correction, with all stocks headed for a plunge later this year? Or is what we’ve seen the past month just a head fake, with Big Tech getting ready to resume leadership?

It’s no exaggeration to say that there’s plenty of reasons to support all three possibilities. The argument for a Great Rotation is simple and convincing.

No trend in the stock market runs forever. Big Tech is as over-owned as its ever been, with the four largest sectors in the S&P 500 all technology related and nearly 40 percent of the overall index. And conversely, dividend and traditional value stocks are close to being as under-owned as they’ve ever been, with the largest utility NextEra Energy (NYSE: NEE) not even making the S&P 500’s top 50.

It was the same in early 2000, when many considered price/earnings multiples of 50 and higher for Big Tech as the “New Normal.” And the outcome was basically the revenge of “Old Normal,” with prices plunging even for tech stocks that went on to transform global business. Old Normal’s return corresponded with renewed popularity of dividends in the ‘00s, and the result was dividend stocks and Big Tech traded places—resulting in massive losses for investors who didn’t react soon enough.

Arguably, the potential impact of a shift from over-owned and under-owned in the S&P 500 is far greater in the current stock market than it was in 2000. That’s because for the first time ever, there’s now more money passively invested in stocks than is actively managed.

Fewer decision makers—either human or algorithm or some combination—means more money moving around faster than ever before. And we’ve seen at least a hint of the resulting volatility in the past week. Things could get ugly in a hurry for investors caught on the wrong side, especially those with leverage that won’t allow them to ride out the severe ups and downs.

The other key argument for a Great Rotation is a potential pivot by the US Federal Reserve. Over the past couple months, there’s a growing investor consensus that the US economy is weakening, notably employment data. And several large Wall Street firms have increased their odds of a recession in the next 12 months.

At the same time, inflation indicators have been generally well-behaved. And that’s increased investor expectations that the US Federal Reserve will at last pivot toward lower interest rates—with a cut in the benchmark Federal Funds rate by the September meeting at the latest.

My view is this is a highly reactive Fed. And for all the governors’ protestations of being economic “data driven,” the indicator they’re most attuned to is the stock market itself.

The rotation we have seen over the past month or so to dividend stocks—which have essentially traded places with Big Tech in terms of year to date total returns—has been fueled largely by the conviction a Fed pivot is imminent. And that’s made many big funds more willing to shift funds from increasingly stretched Big Tech to decidedly underowned dividend ETFs.

Will they indeed act? It’s worth noting that twice this year already there have been expectation of a Fed pivot. The first was early in the early, when hopes were dashed by an unexpected spike in inflation numbers. The second was this spring, when once again more than a few Fed governors threw cold water on speculation of an imminent cut.

Despite an horrific start to the week, the S&P 500 led by the Big Tech-dominated Nasdaq finished the week with a blistering performance. And if that’s sustained into the coming week, I suspect the Fed will feel considerably less pressure to cut rates, regardless of what other economic indicators they supposedly follow say.

As for dividend stocks, so long as the Fed is holding interest rates higher for longer, money market funds and other cash alternatives will be yielding 5 percent and more. Elevated borrowing costs will continue to restrict investments in more capital intensive industries, unless there are offsets. And we’ll see more companies freeze or cut dividends, so they can devote more cash to limiting debt.

Those are all big negatives for dividend stocks. And with few exceptions, they will likely hold back buyers, and investor returns—even for companies that have consistent and long-term records of sustainable dividend growth.

That’s not to say Big Tech will stay in favor forever. But it does mean investors need to be as conscious of business quality with “value” stocks as we are of valuations for over-owned Big Tech stocks.

As for the danger of a broad-based correction, the risk will grow so long as the Fed is holding interest rates higher for longer, increasing odds of a recession. At this point, economic weakness in the US has mainly been concentrated in certain areas, such as commercial real estate. The world’s second largest economy—China—however, has generally disappointed. But higher rates mean less investment. And that ultimately means slower growth and lower employment.

We’re not there yet. And the fact that this is a market-watching Fed also means the central bank is likely to act quickly when there’s crisis in the air, rather than stand on academic theory. But the longer they wait to pivot now, the more weakness is likely to appear. And the greater the danger of a broad-based correction, which will likely take even unloved and under-owned stocks down as well at least initially.

Eventually, there will be a great rotation. The Big Tech frenzy of the late 1990s eventually yielded to the rise of value and dividend stocks in the ‘00s—the triumph of “Old Normal” over the self-proclaimed “New Normal,” And there are numerous similarities between that period and this one.

But the rotation of the ‘00s first had to go through the Bear Market of 2000-02. And while the Big Tech stocks leading in the 1990s took most of the damage, even unloved dividend and value stocks lost ground during the worst of the selloff before surging in later years.

So how do investors position for all three scenarios: Great Rotation, Great Correction and Head Fake? First, don’t abandon the stock market yet.

If you own an S&P 500 ETF, you have plenty of exposure to a resumption of the Big Tech rally. And if you own individual stocks that have made big runs, it’s always a good idea to lock in a portion of the profit, regardless of sector.

If you own value and high dividend stocks of companies backed by strong businesses, continue to build positions. Even if there is a Great Correction, they will hold their own and recovery will be swift.

Keep a fair chunk of cash on hand to take advantage of the values likely to appear in coming months. Money market funds still yield 5 percent and more and funds can be easily accessed for investment when the time is right.

And finally, make a list of stocks you’d want to buy in a Great Correction at “Dream Buy” prices. These are deep value entry points that have historically paid off richly for investors willing to buy when everyone else is selling.