July turned the stock market upside down. Will it stay that way?

July was a month when the stock market turned upside down. Tech stocks, which had driven the market’s gains in the first six months of the year, stumbled, while small-cap stocks, which had barely recovered from the 2022 bear market earlier in the month, surged.

In a surprising reversal in the first half of the year, only two of the eleven S&P 500 sectors declined in July: Communication Services (-4.2%) and Information Technology (-2.1%). The market was led by Real Estate (+7.1%), one of the worst-performing sectors over the past twelve months, and Financials (+6.3%).

Interest-rate-sensitive stocks rallied on July 11 when data showed consumer prices unexpectedly fell in June, raising concerns on Wall Street that the Federal Reserve would start cutting rates as early as September. Investors flocked to small-cap stocks, which are more likely than their large-cap peers to hold variable-rate debt. In the five days following that inflation report, Russell 2000 small-cap stocks rose 11.5%, their biggest gain since the Covid turmoil of 2020.

At the same time, investors were selling off cash-rich big tech companies, whose market value had reached record highs after dominating the market for more than a year and a half. The Magnificent Seven fell 2.7% while Russell rose, creating a 14.2-point gap between the two groups’ results, the largest data divergence dating back to 2015.

Interest-rate cut expectations also lifted spirits in industries that have been hardest hit by the Fed’s rate-hitting campaign. An index of regional banks that have been hammered by higher rates rose 18.5% in July. Homebuilder stocks gained 17.6% as investors bet lower interest rates would revive a dormant U.S. housing market.

What to expect in August

One of the biggest questions looming in the markets is whether the rotation from technology stocks to small-cap stocks will continue.

Some technical analysts are seeing signs of this. Bank of America’s Stephen Suttmeier recently noted that the Russell 2000 rally coincided with a surge in small-cap stocks hitting 52-week highs, confirming what he called a “big base breakout.” He also pointed to rising trading volume and a rise in the number of stocks trading above their 200-day moving averages as more reasons to be bullish on small-caps going forward.

Macroeconomic stars may also favor small-cap stocks.

“The latest data releases, including a positive second-quarter GDP print and even a durable goods report with a weak headline number but positive investment spending data, suggest that while the economy is calming, it is not on the brink of collapse.” said Quincy Krosby, chief global strategist at LPL Financial, in a recent commentary.

A report earlier this week suggesting the U.S. job market continued to cool in June reinforced the view that the economy remains solid but not strong enough to prevent the Fed from cutting interest rates this year. That balance — healthy but not overheated — should continue to support a rotation into small caps, Krosby said.

Of course, chasing a rally comes with risks. Krosby warns that small caps “have a reputation for selling off quickly when they see a significant change in direction.” And markets are currently rife with economic and political uncertainty.