When the markets shake. How to trade nervousness using stock indices?

From mid-July to the first week of August 2024, there was a huge nervousness on the US indices. This was caused by concerns about the state of the US economy and the labor market in particular. One bank after another has gone out of its way to increase the likelihood of a recession in the US. Investors have been withdrawing from large technology companies, which are key to the S&P 500 and Nasdaq indices, in large numbers.

While the situation has calmed down in recent days, there may be more than enough nervousness in the market by the end of the year. So if you don't just want to sadly watch your investment portfolio to take one hit after another, but would rather try to take advantage of the situation, this article is for you!

What caused the sell-off of big tech companies in the US?

There are several factors behind the recent sell-off in large US technology companies. The primary one is concern about the state of the US economy. The manufacturing PMI data was the weakest since last June and then unemployment unexpectedly climbed to 4.3%. The labor market is thus the weakest in the US since late 2021. While a modest weakening of the labor market has been a goal of the US central bank in the fight against inflation, it now appears that the Fed is out of control.

As a result, investors are worried about the onset of a recession in the US and are even predicting a 50 basis point rate cut at the Fed's September meeting, double the original expectations. Such a move would probably make the markets even more nervous, as it would more or less confirm that the Fed has got out of hand. By the end of the year, then, the market expects 3 to 4 interest rate cuts. The current probabilities for the US monetary policy settings at the last Fed meeting of the year can then be found in the chart below.
 

_{Probabilities of monetary policy settings in the US at the last Fed meeting this year, source: CME}

Long live small caps!

This is what we can call the situation in the second half of July. One of the factors that caused the big indices to fall was the apparent rotation of investors from technology giants to smaller companies, the so-called small caps. The latter have been lagging significantly in recent years due to their high sensitivity to the economic cycle. Smaller companies are very sensitive to interest rates and the aggressive interest rate hikes in the US have not favoured them. However, there is now a growing belief in the US that the Fed will start cutting interest rates in September and we will see several more cuts before the end of the year. The fall in rates may then be quite brisk next year, which will be water on the mill for smaller companies. They should start to do well again, which is something that even the managers of the big hedge funds are noticing. They are thus abandoning overpriced technology titles and plunging into small caps in the fight for the highest returns. These are still significantly undervalued compared to technology.

The Russell 2000 index, which concentrates US smaller and mid-cap companies, offers an interesting comparison. Over the last five years, this index has risen by only 47%, while the Nasdaq 100 index of technology giants has added 160%. While the Nasdaq or the S&P 500 have set all-time highs several times this year, the Russell 2000 is still over 10% below its all-time high in 2021. The undervaluation of smaller companies is thus being noticed by investors in a big way, and their rotation in recent weeks has been incredible. Back in early July, the year-to-date performance of the Russell 2000 was around 0. By the end of the month, it was already up over 11%. This rotation may not be over by a long shot, and smaller companies may do better than the big ones in the second half of the year. This trend may continue for a longer period of time.

_{Year-to-date performance of the S&P 500 and Russell 2000 indices through the end of July. Source: Reuters}

Big tech companies have literally made investors overfed and are now victims of their own success. Expectations are completely defied and even relatively positive numbers are sometimes not enough. Alphabet, for example, reported very good numbers, but investors' mood was spoiled by lower-than-expected ad revenues on YouTube.

The company released its earnings on 23 July. Since then, its shares have written down over 10%, as shown in the chart below. We've seen a similar situation with Microsoft - most of the numbers are terrific, but revenue growth in the cloud section of Azure has fallen slightly short of expectations. Both mega companies were then in for a big washout after the results. A correction in these companies often takes the whole market with it.

_{Alphabet stock development on H4 chart. Source: MT4}