Chip stocks are sinking in Wednesday's trading session amid reports the Biden administration is considering toughening its trade restrictions with China. Meanwhile, the Russell 2000 (^RUT) has been on a winning streak as small caps make gains. President of Yardeni Research Ed Yardeni joins Market Domination to break down the state of the market and whether small-caps can continue their momentum.

"On a day-to-day basis, there's a lot of confusion about whether this is it, this is the great rotation into SMID-caps or whether this is just a short-covering rally by a bunch of hedge funds that were short the SMID-caps and long the mega-caps," Yardeni explains. He says the overall economy looks "pretty good" given bottoming in the housing market and strong industrial production data. He explains that this backdrop "makes you want to scratch your head and say, 'So why is the Fed lowering interest rates exactly?' So there's a lot of crosscurrents here."

He believes the Federal Reserve is "pretty much locked into" making a 25-basis-point interest rate cut in September. Ahead of the cut, Yardeni explains that we're in "a broadening meltup in the market" as the focus that was previously on mega-caps is now seeping into the rest of the market. He holds that the economy is not heading into a recession and that investors don't need to worry about a bear market as much as they need to worry about the sectors they should be exposed to: "I think for the long haul, you want to stay with technology for sure. I think communication services also are an area where you want to be involved. I think some of it is AI-related, some of it is simply the technology companies can solve a very important problem we have, which is a shortage of skilled workers. I think you want to be in the industrials, particularly as a result of onshoring. And I like financials as the yield curve disinverts, if you will."

As small caps continue to rally, Yardeni casts doubt on the momentum. He says, "The thing that's been discouraging about the small caps is how poorly they've been performing all along here until the past week. And so that kind of raises the legitimacy of this rally. It may very well be related to just simply that the market expects the Fed will cut rates and smaller-cap, mid-cap companies will benefit more from lower rates. But when you put a microscope to it, you'll see that the big moves have been in biotech and also in banking, regional banks, small regional banks, and a lot of that could just be simply short covering. I don't know that their fundamentals have radically changed, so I'd be a little wary of chasing the SMID-caps, the Russell 2000. But I think the market is broadening within the S&P 500 (^GSPC)."

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This post was written by Melanie Riehl