Market Insider

This stock market rotation could add some spark to Friday's trading

Key Points
  • The Fed is the next big thing for markets when it meets next week.
  • Traders are watching a trend that could become part of a bigger market rotation.
  • Financials and small caps were the outperformers Thursday.
Why is Fed getting so 'aggressive' now?

The next potential turning point for markets is the upcoming Fed meeting, and it could become the catalyst for a market that's been going nowhere.

Julian Emanuel, UBS equity and derivatives strategist, said there were early signs both Thursday and Wednesday of a possible turn coming in the market, and that could continue to get more clear, depending on the Fed, when it releases its statement next Wednesday.

"The Fed is coming and for us the Fed holds the potential to catalyze a reversion trade that we started to see in the last couple of days, with the financials trading as strong as they have been," said Emanuel.

The S&P financial sector was up 1.1 percent Thursday, and 1.6 percent on the week. Goldman Sachs was up 1.4 percent Thursday, and JPMorgan Chase was up 1.2 percent.

"It could well be if the Fed is perceived to be less dovish — or more hawkish — than the market thinks then you could get what we think was, in the last two days, the start of a rotation back into the financials and that could move out into other cyclical areas," he said, noting beaten down energy could be one of groups benefiting. He pointed to small caps, up sharply Thursday as another group participating in a possible rotation.

But the broader indices may not be big movers as the rotation gets underway. For example, the S&P 500 was up less than a point at 2,433 Thursday, but the small cap Russell 2000 rose 1.3 percent to 1,415. S&P futures were slightly higher Friday.

The loser would be utilities, now down 1.2 percent for the week but up 3 percent in the last month, as bond yields fell and investors looked for yield. A key to the rotation would be the Fed confirming that the economy is picking up after a sluggish first quarter and a string of weaker-than-expected data points in the second quarter. In that environment, the FANG and other tech stocks could continue to do well but financials could move up to a leadership role.

Friday's markets promise to be quiet, after an event-filled Thursday which included testimony from former FBI Director James Comey. There was also a meeting of the European Central Bank and more dovish talk from ECB President Mario Draghi. The U.K. also held a national election, where Prime Minister Theresa May's Conservative Party lost its majority. The pound was slammed but U.K. and other European stock markets were steady.

"The Comey testimony has come and gone and the market is yawning, as it's yawning with everything else. … The market's reaction tells you that investors dismissed it completely," said Emanuel.

Comey's testimony, released Wednesday ahead of the hearing, was viewed favorably since traders didn't see that it implicated the president for obstructing the Russia investigation and he was not a target of the investigation. But it also left unanswered questions and the investigation continues, leaving a cloud of doubt over the market.

Markets have been concerned Congress and the White House will be too preoccupied with the investigation to push tax reform and other stimulus programs.

"We will have to see how the next several weeks unfold before we can figure that out. What we want to see is a renewed discussion on elements of tax reform," said Emanuel.

In the bond market, yields stayed in a tight range before and after Comey testified Thursday. The 10-year was at 2.19 percent in late trading. "It seems to me this is not going away, and as long as you don't have a focus on legislative priorities, it's difficult to make a case that this resolves anything," said Aaron Kohli, director of fixed income strategy at BMO.

Kohli said the market is still anticipating a very dovish Fed. While fed funds futures point to a rate hike next week, there is just about a 20 percent chance of a September interest-rate hike. The Fed has forecast two rate hikes, but the markets have dismissed the potential for a second one this year after disappointing jobs data and weak inflation.

CPI consumer inflation data is reported next Wednesday morning, as the Fed meets.

Friday's calendar is quiet with just wholesale trade, reported at 10 a.m. ET.