After a brief reprieve, stocks linked to artificial-intelligence trade hit the skids this week, as investors once again shifted their money into anything with a whiff of value.
Tired of paying up for trendy AI stocks trading at lofty valuations relative to their expected earnings, investors went bargain hunting after the Federal Reserve delivered another interest-rate cut on Wednesday. The move convinced some that the U.S. could see a return to a "Goldilocks" scenario for the economy - one where the pace of growth remains solid, but inflation stays more subdued.
"It's a rotation out of the names that have done well and into the names that have been left behind," said Josh Schachter, chief investment officer and senior portfolio manager at Easterly Snow.
Bob Savage, head of markets macro strategy at BNY, succinctly summed up why investors' outlook brightened after hearing from Fed Chair Jerome Powell. Ultimately, a stronger economy and lower interest rates should help lift more boats in the market, he noted.
"The recession fears that dominated last year have given way to a broad consensus of economic resilience. Expectations for a soft landing in 2026 - anchored by roughly 2% U.S. growth and near-3% global growth - remain intact, supported by ongoing fiscal stimulus, accelerating AI-driven productivity gains and the prospect of Federal Reserve easing," Savage said in written commentary.
Over the past couple of years, growth stocks - particularly those belonging to the information-technology and communication-services sectors - have powered much of the bull run in stocks. Their gains have seen the influence of the largest stocks in the S&P 500 index SPX, particularly in the tech sector, climb to the highest level in decades. Some have warned about the risks of such extreme concentration.
While the selling of leading AI names might make some investors nervous, Matt Orton, chief strategist at Raymond James Investment Management, said this week's weakness was likely just investors using the latest batch of headlines as an excuse to take profits. He expects that any further losses for tech and other AI stocks will likely be limited, as investors are still looking to buy these names on pullbacks.
At the same time, the fact that more money is now flowing into shares of cyclical stocks like small caps, financials and industrials is sending a positive message about the economy.
"Economic expectations are improving and inflation is coming down," Orton said. "So what we're seeing is a bit of a healthy rotation under the surface of the market."
Unfortunately, this growing optimism failed to stave off more losses in the market on Friday. On Wall Street, the pain intensified as a selloff in the AI trade spread to other corners of the market.
Yet even amid the selling, the rotation trade continued. The Dow Jones Industrial Average DJIA on Friday cemented its biggest three-day outperformance versus the Nasdaq Composite COMP and the S&P 500 since Jan. 27, Dow Jones Market Data showed.
Also on Friday, a ratio comparing prices of growth stocks and value stocks hit its lowest level in months, as investors continued to shy away from more expensive names.
The ratio of the price of the iShares Russell 1000 Growth ETF IWF to the price of the iShares Russell 1000 Value ETF IWD had fallen to 2.22 as of Friday's close, according to Dow Jones Market Data - the lowest level since Sept. 2. On Oct. 29, the ratio hit a record high, just as the tech-heavy Nasdaq was tallying its most recent record closing high.
Even precious-metals prices appeared to benefit from the rate cut, as gold prices (GC00) settled at a record high on Friday. Meanwhile, the S&P 500's IT sector XX:SP500.45 fell 2.9%, its biggest drop since Oct. 10, Dow Jones Market Data showed.
Easterly Snow's Schachter, who helps manage several value-focused funds, said rate cuts will likely continue to benefit small-caps, particularly regional banks, which make up a sizable chunk of major small-cap indexes like the Russell 2000 RUT.
Cyclical sectors like financials, industrials and energy should also do well as President Trump's tax cuts help put more money in consumers' pockets next year while boosting corporate profit margins. And a more permissive regulatory environment could open the door to a wave of mergers among smaller lenders, Schachter said.
Orton at Raymond James stressed that, so far, the rotation trade looks healthy. But that could change if the sectors in the lead are more defensive in nature. When the economy is expected to weaken, investors typically buy shares of consumer-staples companies, as well as healthcare and utilities stocks. The idea is to own companies rooted in everyday essentials; even in a downturn, people still need to eat, and they still need healthcare. Healthcare stocks have been rallying lately, but largely due to developments out of Washington, Schachter noted.
A value stock typically refers to any stock trading below its intrinsic value. Exact definitions can vary, although they tend to pay dividends and usually have lower price-to-earnings ratios. A growth stock, meanwhile, is a company that is expected to see its earnings grow more quickly.
Growth stocks have dominated value names for more than a decade now. Since the current bull run began in October 2022, investors have seen several rotation trades, including one that sent small caps barreling higher in the summer of 2024. Each time, tech stocks eventually reasserted their market leadership, and often quickly.
Some see signs that the latest rotation trade could soon face a test. Adam Turnquist, chief technical strategist at LPL Financial, said rising long-end Treasury yields could crash the party.
With the yield on the 10-year Treasury note BX:TMUBMUSD10Y moving up to about 4.2% on Friday, Turnquist said it's "make-or-break time for this rotation."
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