Is it time to dump Big Tech and invest in smaller companies again?

The Great Rotation began in July as overvalued companies slipped while undervalued small caps revived

Global stock markets are crashing, and Big Tech is at the heart of it. Reuters

We all knew the Magnificent Seven US mega-cap tech companies couldn't shoot the lights out forever.

The only question was when they’d be knocked off their saddles. The answer appears to be right now.

Global stock markets are crashing, and Big Tech is at the heart of it.

Suddenly, instead of anticipating a soft economic landing, investors are panicking over the prospect of a hard one, as the US Federal Reserve's decision to hold interest rates in August backfires.

Recession fears have rocketed after last week’s feeble US manufacturing and job data, and disappointing earnings from Amazon, Apple and Intel.

Fears of escalation in the Middle East have added to the sense of dread plunging markets into “absolute turmoil”, says Chris Beauchamp, chief market analyst at online trading platform IG.

“In two days, markets went from looking forward to a September rate cut in a growing economy to fretting about an impending recession.”

Asian, European and UK markets are plunging but this sell-off is made in the US, Mr Beauchamp says.

“We're likely to have a summer of volatility ahead of us.”

The next Fed rate-setting meeting is not due until September 17, six weeks away.

The Fed may have to double down with a 50-basis point cut, but Mr Beauchamp says: “Even this may be too little, too late.”

Money markets are pricing in a 60 per cent probability of an emergency Fed cut. While this could stem the rout, it might also spook investors further, by suggesting US policymakers have lost control of events.

At the time of writing, artificial intelligence chip maker Nvidia’s shares are still up 136 per cent over one year and a scarcely believable 2,686 per cent over five.

Global financial markets in turmoil amid fears the Fed is behind the curve

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Now they’re falling fast and the rest of the Mag 7 (Alphabet, Amazon, Apple, Meta, Microsoft and Tesla) are being trampled in the stampede to sell.

The panic has brought into focus a second question that investors have been asking. When Big Tech finally falls, will smaller companies take its place?

Smaller company performance is highly cyclical. They tend to grow faster when the economy is booming and investors are ready to take on more risk but are first in line for a beating when markets crash.

Inflation hits smaller companies relatively hard as they typically borrow more to fund their operations and face higher bills when interest rates rise.

Also, rising prices reduce the value of their future earnings in real terms.

If the Fed does speed up rate cuts, that process could reverse in their favour.

The Great Rotation, as it has been called, began in July as overvalued Big Tech slipped while undervalued small caps revived, says Vijay Valecha, chief investment officer at Century Financial in Dubai.

“The rotation reflects a growing belief in smaller companies as market conditions shift, particularly in the financial, biotechnology and energy sectors.”

The Russell 2000 Index of US smaller companies jumped 10.1 per cent in July, its biggest monthly gain since December.

July is typically a good month for the S&P 500 but this year it grew just 1.1 per cent, its worst July performance in 10 years. The Nasdaq Composite fell 0.8 per cent, which also marked its worst July in a decade.

Many expect smaller companies to enjoy a further lift if Republican candidate Donald Trump wins November's presidential election, Mr Valecha says.

“Mr Trump has proposed cutting corporate tax from 21 per cent to 15 per cent and curbing the influence of financial regulators. Both would be particularly advantageous for small caps,” he adds.

However, it would take a brave investor to pile into the sector right now.

The Great Rotation is now hanging in the balance, with the Russell 2000 falling almost as fast as the S&P 500, as investors dump all they can in a race for the exits.

“High-quality large-cap companies typically have stronger balance sheets and proven resilience, making them relatively more attractive in a dip,” Mr Valecha says.

Tony Hallside, chief executive at Dubai-based brokers STP Partners, says overlooked small caps have much to offer, including greater agility, higher growth prospects and the opportunity to tap into niche markets and emerging industries, but it’s important to strike a balance.

“Diversification remains key. Rather than switching horses entirely, investors should maintain a diversified portfolio that leverages the strengths of both Big Tech and smaller companies,” he says.

Charu Chanana, head of FX strategy at Saxo Bank, is also sceptical about making a big sector shift right now.

“The idea of dumping tech stocks in favour of smaller companies is an intriguing one. But it’s not really about one or the other.”

The idea of dumping tech stocks in favour of smaller companies is an intriguing one. But it’s not really about one or the other

Charu Chanana,
head of FX strategy, Saxo Bank

Investors must remember that the smaller companies sector “largely comprises unprofitable companies”, she says.

“Investing in high-quality stocks with strong fundamentals and a defensive positioning is key to hedge against the risk of a broader market downturn.”

However, Mohamed Hashad, chief market strategist at Noor Capital, still favours smaller companies and says the market cycle may finally shift back in their favour once the current panic eases.

“Tech giants have enjoyed substantial growth but as dominant players, they face major challenges, while smaller companies offer the potential for disruptive innovation.”

Many investors will have outsize exposure to Big Tech and should consider plugging gaps in their portfolios by investing in smaller businesses.

“Rebalancing allows one to seize opportunities while mitigating potential downsides,” he says.

For those who think small is beautiful in today’s climate, Mr Hashad highlights the Vanguard FTSE Developed Markets ETF, which provides exposure to developed markets outside the US.

Vanguard FTSE Emerging Markets ETF could balance that by targeting emerging markets.

For those who want US exposure, Mr Valecha highlights the iShares Russell 2000 ETF, Invesco S&P SmallCap Financials ETF and Invesco S&P SmallCap Health Care ETF.

When the dust settles on today's turmoil, investors have a decision to make. Some will continue to think big by taking advantage of reduced Mag 7 valuations.

Others may decide they’ve gone too large and it’s time to think small instead. As ever, it's probably best to get a bit of both.