Upcoming earnings will determine whether the stock market rotation is here to stay or a one-day wonder

Published Fri, Jul 12 202410:30 AM EDTUpdated Fri, Jul 12 202412:51 PM EDT

You can call Thursday the "revenge of the diversified portfolio." With advancing stocks beating declining ones 6-1 on the New York Stock Exchange, it wasn't so much a negative on tech stocks day as it was a positive on diversification day, with strong rallies in cyclicals, interest rate sensitive and banks. Here's the one issue that matters: Was it more than a one-day wonder? Certainly lower interest rates are a huge help, particularly for small-cap companies that are generally more sensitive to interest rate changes. Confidence that the economy is slowing but still strong is also key to the belief that the Federal Reserve will cut rates beginning in September. But none of this matters without earnings. There must be a belief that earnings will broaden out beyond a small group of megacap tech stocks. The root source of the long tech rally is the superior earnings growth of technology. Two questions follow: With the massive rise in tech prices, is most or all of that earnings growth now priced in, and what are the prospects for earnings growth in other sectors? With earnings, it's not just whether earnings are going up or down, it's how much they are going up or down. What is the rate of change? In the case of megacap tech stocks, I pointed out two weeks ago that while earnings for megacap tech are continuing to grow, the rate of change in earnings growth is slowing , particularly in market leaders such as Nvidia. This is a warning sign for investors who continue to throw money at megacap tech. Earnings growth beyond tech Strategists are already getting out ahead of this. "Expectations are for the rest of the market to close the gap with megacap tech. That means that earnings are broadening out," Supriya Menon, EMEA head of multi-asset strategy at Wellington Management, said in an interview with Bloomberg TV. "When we look ahead, we see big-cap tech moderating in terms of the earnings they can deliver in the coming quarters." Bank of America's Savita Subramanian is also in the "broadening out" camp. "2Q is expected to be the first EPS growth quarter for the Other 493 since 4Q22, whereas growth for the Mag 7 is expected to slow for the second straight quarter and again in 3Q. Growth is broadening out and so should the market," Subramanian said. It's great to be optimistic about earnings broadening out. The problem is identifying where this additional earnings growth is coming from, and how robust it might be. Consumer stocks have not seen much growth at all. In a recent note, BofA's consumer analyst Bryan Spillane said, "Demand remains stubbornly weak broadly across our consumer staples coverage universe." Outside of weight loss drugs, neither has health care. Large-cap banks have been doing better, but regionals are lagging due to deposit flight, poor loan growth and exposure to commercial real estate. If revenues drive earnings, it's hard to be exuberant. Even Subramanian admits, "Excluding the Mag 7, consensus expects just +1% in real sales growth in 2H," she noted. Put all this together and BofA's global sales advisory desk, in a note yesterday, concluded "it hasn't really paid to be experimental, yet."