Is this the start of the "Great Rotation"?

Today saw an intriguing rotation in the stock market, prompted by a cooler-than-expected Consumer Price Index (CPI) report for June. The CPI declined 0.1% month-over-month, bringing the annual rate down to 3.0% from 3.3% in May, with the core CPI (excluding food and energy) decelerating to 3.3% from 3.4% year-over-year. These figures were below economists' expectations and spurred optimism that the Federal Reserve might cut interest rates sooner rather than later. Consequently, market rates fell, with the 10-year note yield dropping nine basis points to 4.19% and the 2-year note yield declining 12 basis points to 4.51%.

The lower inflation expectations boosted interest-rate sensitive sectors, leading to a notable divergence in market performance. The Russell 2000 outperformed the Nasdaq by a record 5.5 percentage points. The equal-weighted S&P 500 (RSP) rose by 1.21%, compared to the SPY, which declined by 0.86%. Homebuilders saw significant gains, with the ITB up 6.20% and the XHB rising 5.88%. Real estate (XLRE) jumped 2.65%, and the Infrastructure ETF (PAVE) rallied 2.44% on expectations of cheaper government borrowing costs. However, sectors like Semiconductors (SMH), Tech (XLK), and MegaCaps (MGK) saw declines, with SMH falling 3.64%, XLK slipping 2.50%, and MGK dropping 2.32%.

In particular, the MegaCap sector experienced notable declines, led by an 8.44% drop in Tesla due to delays in its robotaxi plans. Nvidia fell 5.57%, Microsoft declined 2.48%, Meta dropped 4.11%, and even Costco, despite posting better-than-expected sales, fell 4.26%. This profit-taking among tech giants and semiconductor stocks resulted in the S&P 500 and Nasdaq Composite closing lower, despite the broad market rally. The advance/decline line indicated a positive market breadth, with advancers outpacing decliners by approximately 4 to 1, yet the heavy declines in key sectors overshadowed this breadth.

The rotation away from tech and into more rate-sensitive and economically cyclical sectors raises questions about its sustainability, especially with the upcoming earnings season. While the decline in inflation is beneficial for the Fed's outlook, it also underscores the diminishing pricing power of companies. This was reflected in the NFIB Small Business survey, suggesting that firms might struggle to meet analyst expectations, particularly those without strong AI-driven growth narratives. Consequently, market participants are faced with a conundrum: should they rotate out of fundamentally strong tech names into potentially weaker sectors just as earnings season is about to reveal more about company performance?

As earnings season approaches, the key question is whether this rotation can be sustained if earnings do not support the price action. Investors will be closely watching whether the sectors that have recently gained favor can deliver strong enough results to justify the rotation. If earnings disappoint, there is a risk that investors might retreat back into the safer, market-leading tech names, or even move to the sidelines altogether, preferring cash or defensive assets until there is more clarity.

Today's market action highlights the precarious nature of the current rotation. While the cooler CPI report provided a short-term boost to certain sectors, the upcoming earnings season will be critical in determining whether this trend has legs. Investors should approach this rotation with caution, as disappointing earnings could quickly reverse the gains seen in rate-sensitive sectors and reignite interest in the tech giants that have driven the market higher for much of the year.