The Federal Reserve and small-cap stocks are both walking a tightrope! Will Powell determine the fate of the US stock market?

The U.S. stock market was particularly tense in the past week as investors faced significant selling pressure in large-cap tech stocks and shifted towards small-cap and value stocks. This "rotation from large to small" is one of the main market trends in July.

Dave Sekera, Chief U.S. Market Strategist at Morningstar, said, "When I consider the market and its valuations reaching such high levels, I do believe that the adjustments in the past week or two have been very healthy. This also indicates a rotation beneath the surface, where we see artificial intelligence companies, large growth stocks, and tech stocks shifting towards value stocks and small-cap stocks."

Although days of sharp stock price declines may be frightening, investors seem increasingly unable to justify the high valuations of large-cap stocks. Investors have tasted this, as Alphabet announced last Wednesday that its earnings exceeded expectations, but the stock still fell by 5%.

Emily Roland, Co-Chief Investment Strategist at John Hancock Investment Management, said, "I think the challenge is that earnings are not bad, but they have to be amazing to prove that the price increases we are seeing are justified."

However, the momentum of this trend may depend on a significant event next week—the July Federal Open Market Committee meeting.

The Federal Open Market Committee is scheduled to meet on July 30th and 31st local time. While Fed officials are not expected to cut rates at the meeting, investors will closely watch to better understand when the Fed might start cutting rates.

Thomas Martin, Senior Portfolio Manager at GLOBALT Investments, said, "It is generally believed that rate cuts are beneficial for small-cap stocks in multiple ways. Small-cap companies are more sensitive to variable rate financing, floating rates, and short-term rates."

Martin said that rate cuts mean that loans for small businesses can become cheaper, so their operating costs should decrease, which is beneficial for earnings. He said that low rates could also stimulate the economy, potentially meaning that consumers have more ability to spend money.

Ahead of the first rate cut in this cycle, investors began shifting from large-cap stocks to small-cap stocks, which means that when the Fed starts cutting rates, small-cap stocks may gather more momentum. Martin believes that to some extent, the big rotation may continue.

This may be related to the dual nature of rate cuts. Rate cuts can stimulate the economy, but the act of cutting rates itself may indicate the need to stimulate the economy. Will the Fed cut rates because it has beaten inflation, or because high rates are pushing the economy in the wrong direction? Investors will closely watch how Fed Chair Powell answers this question.

Sekera said, "I suspect the comments we will hear are that they are increasingly confident that inflation is really falling, which is what they want so they can reach the level at which they can start cutting rates "I will also closely listen to Chairman Powell's comments on the strength of the U.S. economy and his views on the economic outlook."

If the Fed signals that the economy has slowed down, it would be a good thing for combating inflation. However, if the economy slows down too quickly, the risk of an economic recession will increase. Small-cap companies are often more sensitive to economic slowdowns because they are not as immune to economic downturns as large-cap companies.

Roland said, "We are seeing these small cracks in the labor market and the economy, and I think these small cracks are enough to prompt the Fed to start cutting rates. The Fed is trying to orchestrate this soft landing, but the problem is, it's really tricky."

He added, "Investors have not yet seen whether these small cracks in the economy will develop into more terrible things. The Fed and small-cap stocks are both walking a tightrope towards a soft landing."