Big Tech stocks are losing their appeal as investors shift focus to smaller companies and previously neglected sectors. Over the past week, the Russell 2000 small-cap index surged by 7%, driven by falling inflation and a brighter earnings outlook. This shift has seen the once-dominant “Magnificent Seven” megacap tech stocks decline. These losses, intensified by a global sell-off in semiconductor companies, contrast with gains in sectors like financials, energy, and real estate within the S&P 500 index.

Jurrien Timmer, director of global macro at Fidelity, noted, “Last year, there was really only one thing on the menu. Now, with a broader earnings recovery, a Federal Reserve pivot, and a stable bond market, there are more investment options available.”

Investors have long sought a broader market rally in the US, and recent developments suggest a shift may be underway. The S&P 500 rose 14% in the first half of 2024, but its reliance on a few large companies raised concerns about the rally’s stability.

Passive fund investors benefited, but active fund managers struggled to keep pace with benchmarks due to the narrow rally, which saw few companies outperform the overall index. Many managers were hesitant to hold large positions in just a few stocks.

Recent inflation data solidified hopes for a Federal Reserve interest rate cut in September. This has particularly benefited smaller companies in the Russell 2000 index, which typically have higher debt burdens than large-caps. Although lower rates traditionally favor fast-growing tech companies, many of the largest tech firms have benefited from high interest rates due to their substantial cash reserves.

Over the past week, gains have been widespread, with more than 1,500 of nearly 2,000 companies in the Russell 2000 rising. The equal-weighted S&P 500 outperformed the cap-weighted version, climbing almost 3% while the cap-weighted version fell.

Some market participants attribute the violent market rotation to investor positioning. Bank of America analysts noted that short covering significantly drove the Russell 2000 rally, with heavily-shorted stocks among the top performers.

Brandon Nelson, a portfolio manager at Calamos, suggested that complacency among investors who focused on megacaps and ignored or shorted small-caps contributed to the sudden shift. As other companies’ profits improve and megacap tech stocks’ earnings growth slows, investors may turn to cheaper, more cyclical companies.

Despite the shift, megacap tech stocks may still offer positive surprises. Nvidia dropped 13% following the inflation data but previously rebounded with a 72% rise after a similar decline.

Jim Tierney, a growth-focused portfolio manager at AllianceBernstein, believes the underlying trends driving growth in the Magnificent Seven and other AI-linked stocks remain strong, but their relative earnings strength compared to the rest of the market may decline.

Savita Subramanian, head of US equity and quantitative strategy at Bank of America, noted that as growth broadens, investors might shift towards cheaper, more cyclical companies. However, while many investors have awaited a broader rally, it could affect the overall index negatively. More than 350 stocks in the S&P 500 rose after the inflation release, but the index dipped 1.5% due to the heavy weighting of the largest tech groups.

The future performance of the index depends on whether new investments flow into other stocks rather than the Magnificent Seven, or if it’s merely an internal rotation where investors sell the megacaps to buy other stocks, said Fidelity’s Timmer.

He and several other analysts emphasized the delicate balance required for smaller companies to continue rising. They need the Federal Reserve to start cutting rates without triggering a significant economic downturn that could harm their earnings. Market movements on Thursday underscored this risk, as the Russell 2000 fell 1.9% following data showing jobless claims at their highest level since 2021.

Despite gains over the past week, small-caps and the equal-weighted S&P 500 still lag significantly behind the benchmark S&P 500, making investors cautious.

“You’ve closed the gap a little bit in the last week,” said Nelson at Calamos. “But you can’t undo years of underperformance in five days.”