Much of the market has been undergoing a stealth correction. Small-caps, high-momentum names and a majority of stocks in the market have lost ground the last two days although the DJIA has traded up 1.2% and hit a new all-time high and the S&P 500 has gained 0.32%.
This sort of rotational action has not been unusual in recent months but the intensity of the shift is dramatic. Some stocks, including many in the biotechnology sector, have gone bidless while key DJIA names such as Boeing (BA) and 3M (MMM) are completely untouched by the action.
If the indices were moving in tandem it would be easier to find an explanation for the movement. Higher interest rates, worries about third-quarter earnings, inflation fears or any number of other headlines could provide a convenient excuse for the price action. However, this aggressive rotation doesn't fit into the normal macro headline. There isn't any easy cause and effect relationship.
What would cause major funds to dump small-caps and buy a few big-cap DJIA stocks instead?
One explanation is that many fund managers have been underperforming for a while because they are not in the small group of large-caps that have produced most of the gains for the indices. There has been some significant underperformance especially by those that have owned small-caps, which have done nothing as a group for months.
We don't hear much about it but one of the most powerful forces in the stock market is pension and retirement funds. When they change their allocations between different sectors or areas they move many billions of dollars of stocks and have a huge impact. It isn't easy to see when it happens and there are no news headlines to tell us about it.
It is likely that this recent action is primarily a product of new allocations by major funds. It doesn't seem very logical to make a shift from small-caps into some big DJIA name at this point but there is no doubt that something like that is occurring.
The good news is that this sort of rebalancing should come to an end fairly fast and the stocks that are impacted the most are likely to revert to the mean. That means that small-caps are likely to outperform the DJIA names, although that could happen in a number of ways.
It is a very messy market right now and very dangerous as there is no way to know for sure how much longer this rotational action will persist. The good news is that many "good" stocks are being unfairly punished in this shift and are likely to recover, but it may take some time for the technical damage to be repaired.
While it has been a tough start to the fourth quarter, so far this is just a very severe rotation rather than major topping action. The likelihood is that there will be a reversal of the pressure soon, but volatility will likely stay quite high into earnings season in a couple weeks.