Warning: The concentration bubble in the stock market may finally be ready to burst, and investors may find themselves stuck in a trap.
The S&P 500 and Nasdaq, for months, have been under the control of a select number of large-cap, tech-focused stocks. These stocks have made it appear that we are in an incredible bull market. But what has really been happening is nothing more than a concentration bubble.
Now, we are seeing evidence that things may soon change.
Thursday’s soft CPI data, which showed inflation cooling for the first time in four years, resulted in a massive rotation into small-cap stocks. Since then, the Russell 2000, the index that tracks them, has been on fire. With inflation cooling, investors are betting that the Federal Reserve will move soon to cut interest rates. Such interest rate cuts could have outsized benefits for small-cap stocks that have underperformed in the current high-rate environment.
But Treasury yields are adding in a real dilemma. In a lower-interest-rate world, existing bonds would become more valuable, sending their prices up and their yields lower. That means as small-cap stocks rally in anticipation of rate cuts, you would expect Treasury yields to fall. Instead, they are holding up… and even rising.
This has me worried that we are in a stock market trap.
If my theory is right, investors will continue to cheer the rally in small-cap stocks. They will interpret this as a sign that a rotation out of the concentration bubble – out of the Magnificent 7 – is underway. It will be the first prick at the bubble itself.
But because Treasurys are not moving in alignment with small-cap stocks, investors who jump into risk-on trades will suffer. We will then see a quick pivot back to risk-off investments heading into the election.
I don’t think this is a far-fetched scenario. Although I would love to see small-cap stocks run away and start to meaningfully perform, the fact Treasury yields are still rising makes me doubtful this will happen.
For nimble traders, this means there is a great opportunity here. The next major move to pounce on will be defensive plays.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
On the date of publication, the responsible editor did not have (either directly or indirectly) any positions in the securities mentioned in this article.
