By Ben Levisohn

When does a rotation become a selloff? Investors may soon find out.

For many investors, 2025 has been about switching -- from winners to losers, from the Magnificent Seven to select members of the other 493 stocks in the S&P 500, from growth to value, and from U.S. to international. So while the S&P 500 has given back its gains for the year and the Nasdaq Composite has sunk into the red, the Dow Jones Industrial Average, everyone's favorite laggard, has been staying afloat, with a 1.8% gain. Growth stocks have gotten crushed -- the Russell 1000 Growth index has dropped 3.5% -- but the Russell 1000 Value index has gained 3.4%.

This kind of rotation doesn't have to be scary. In fact, it is often what keeps rallies going. It's one reason the S&P 500 is flat on the year even though the Roundhill Magnificent Seven exchange-traded fund has slumped 7.7%. "'Rotation' has historically been labeled as the lifeblood of a bull market," writes Craig Johnson, chief market technician at Piper Sandler. "We believe now is not the time to worry but rather to focus on emerging leadership in other sectors demonstrating relative strength."

The culprit this time around might be a "beta reversion," according to Renaissance Macro Research's Kevin Dempster. In market terms, beta is a statistical measure of a stock's volatility relative to an index. When stocks with high betas -- think Nvidia and Super Micro Computer -- are outperforming, it signals risk-on. But the trade got too strong, with the most volatile stocks relative to the least nearing their highest outperformance on record in December. That has since reversed, and high beta is now underperforming by nearly as massive an extent. While some would attribute this unwinding to economic factors, Dempster notes that corporate and high-yield bonds would be getting hit, as would financial stocks. Bonds are holding steady, and financials are rallying globally.

Earnings suggest Dempster is on to something. For much of the past two years, a small portion of the market had a monopoly on earnings growth, resulting in the outperformance of the Mag 7 and other highflying tech companies at the expense of everything else. That's starting to change, notes Tavis McCourt, managing director of institutional equity strategy at Raymond James. Tech sector earnings-per-share are expected to spike 23% in 2025, unchanged from 2024. The remaining 10 should see accelerating growth, with consumer staples, materials, energy, and communication services flipping from declines to gains.

"The story of [fourth-quarter earnings and 2025] guidance season has been that [year-over-year] EPS growth is starting to finally broaden out across the U.S. and the world, and this appears to be driving a broadening performance across global equities," McCourt writes.

But sometimes rotations can go too far -- and the stock market is nearing the tipping point. One way to gauge whether the market is about to become more dangerous is by looking at the correlation between stocks, says John Kolovos, head of technical strategy at Macro Risk Advisors. When correlation is low and individual stocks are moving on their own accord, it's usually a sign that a rotation is happening. When they start to trade in tandem, it typically means investors have stopped looking for idiosyncratic opportunities in favor of trading everything together.

Recently, the Cboe Implied Correlation Index, a measure of correlation based on options trading, rose as high as 20.6, up from 12.1 on Feb. 20. Both levels are still low, and a correlation in the 20s isn't all that unusual. The index had four previous spikes to that level over the past 12 months, and the S&P 500 dropped an average of 3.8% when they occurred, not much less than the 4.6% decline the S&P 500 has suffered from its peak though Thursday's close. Even an August spike to 35.7 resulted in a decline of only 6.1% before the bull market resumed its climb. It was only when the correlation index surged above 50 -- and stayed there -- in 2022 that a bear market kicked in.

We're not there yet -- and perhaps never will be. That doesn't mean stocks can't fall further. But even that might be beneficial, if painful, for the market if it eventually becomes the pause that refreshes. "In an ideal world, we reset the clocks, end this game of internal rotation by washing everything out (value and defensive, too), and get back to the bull market," he says.

Sounds like a plan.

Write to Ben Levisohn at Ben.Levisohn@barrons.com

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February 28, 2025 14:17 ET (19:17 GMT)

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