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I opined last week that the market's gains during this cycle have been driven largely by a handful of secular investing themes such as the revolution in computing, robotics, quantum, and the increasingly large need for additional electricity capacity. The bottom line here is that if you have owned stocks in the leaders of these themes, you are enjoying another banner year.

So, of course, and right on cue, traders decided to focus on something completely different last week. Instead of reveling in the earnings growth seen by the year's big winners, the emphasis shifted to companies that benefit from lower rates. Namely the small caps, cyclicals, and value plays.

For those of you keeping score at home, it is worth noting that the small caps have had quite a resurgence of late. For example, the IWM (an ETF proxy for the Russell 2000 small cap index) has been a top performer sporting a gain of +7.67% over the last 30 days. The little guys have actually trounced Megacap tech as the Q's (QQQ ETF - a proxy for the Nasdaq 100 index) are up less than +2% during the same period.

What's more, the IWM trend appears to be accelerating. Over the last 3 months (using a rolling 3-month calculation) the IWM is up +13.5% versus +8.8% for the Q's and +8.9% for the SPY (S&P 500 ETF). Sure, the QQQ still enjoys a comfortable 5.2% lead over the IWM on a year-to-date basis. But the point is that the "troops" have been playing a fair amount of catch-up to the "generals" of late.

The Question is Why?

Whenever this type of leadership rotation occurs, it is important to understand why the move is happening. Granted, there are times when the spread between sectors, styles, and cap sizes becomes so large that traders simply decide to play the mean reversion game and tighten things up a bit. We call such moves a "trade" and as such, they generally don't last very long.

From a big picture perspective - and yes, I can be accused of oversimplifying things here - small caps need two things in order to thrive: lower rates and a strong economy. And from my seat, the former has a lot to do with the catch-up move occurring in the smaller cap indices.

Cutting to the chase, it has been the increasing expectations that the Fed will cut rates - and soon - that has lit a fire under the until-now floundering small cap space. This makes sense as the mega caps have all the capital they need to expand and grow whereas smaller companies are more directly affected by rates.

So, with a September rate cut now all but assured after a couple surprisingly weak jobs reports, traders are betting that earnings in the small caps will improve. Makes sense, right?

But...

However... You knew this was coming, right? I mentioned earlier that small companies really need two things in order to thrive in the long term. And while they most definitely appear to be getting lower rates, I'm not so sure about the second element - you know, the strong economy part.

Here's my take - and my problem with the idea of embracing the small cap move in a big way. Rates are falling right now for a reason. The Fed is going to cut rates for a reason. And that reason is weakness in the labor market. Which, from a big picture perspective, doesn't suggest a stronger economy.

Yes, the stock market is indeed - everybody join in now: "A discounting mechanism of future expectations." And yes, even I can argue that lower rates "should" be a catalyst for improved economic growth down the road.

For me though, the fly in the ointment here is inflation. As in "sticky" inflation. It is true that the Fed is "too tight" right now relative to the level of inflation. And my bet is that the Jay Powell will emphasize the plan to "normalize" rates by reducing the Fed Funds rate later in the month. But, with inflation running well above the FOMC's target, I question how much room Powell's merry band of central bankers has to cut rates as we head into 2026.

I'm not suggesting that the Fed will be "one and done" in September. Yet I'm not sure we should view the upcoming cut(s) as an ongoing trend - aka an "easing cycle." As long as inflation continues to move in the wrong direction - which certainly looks probable as the tariffs finally start to kick in - I can't see Powell and Co. moving beyond "neutral."

Therefore, from my perch, the current "rotation" that the financial press continues to yammer on about is likely to be another in what is now a long string of shorter-term mean reversion trades.

Looking Ahead

As long as I'm making projections, I might as well keep going and detail what my crystal ball (I just got it back from the repair shop) is saying about the rest of the year.

It is worth noting that according to the reports I've seen, the hedge fund types are once again underinvested in stocks generally and growth/megacap tech in particular. Recall that this is the same play these guys/gals made in the beginning of the year - which resulted in a quick trip down about 20% for the market.

My thinking is this is why the market is largely moving sideways at the present time. Retail investors continue to buy the dips while the hedgies counter with sell programs at every opportunity.

It is also worth noting that the 2025 calendar is starting to run short on days. So, my take is if the masters of the universe that are currently underinvested in the market leaders can't get something going to the downside during the remainder of the "seasonally weak period" (which runs through mid-October this year), they are likely to flip the script and jump back into the companies that are actually growing like weeds and printing money.

While you are certainly entitled to be rolling your eyes as you move the cursor toward the big red X in the upper right of your screen, I can say that I've seen this type of game play out a time or two in my career. And since the market tends to move higher into the end of calendar years, this is my $0.02 guess as to what we might see play out over the coming months.

Of course, my investing approach is NOT based on my projections, feelings, or hunches. No, I prefer to try and stay in tune with the primary market cycles. And while there may be some internal rotation going on at the present time, this is a bull market until proven otherwise. So, my plan is to stick with the leaders and stay seated on the bull train - for now, anyway.

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