Just when it seemed mega-caps may never go down and small-caps may never go up again, we have seen a short-term reversal of epic proportions. The tech-heavy NASDAQ 100 is down about 8% while the small-cap Russell 2000 is up almost 10% over the last 13 trading days. The outperformance spread is the second most extreme reading dating back to 1985 when NASDAQ 100 data began.
The small-cap rally is more than just a “Trump Trade” as earnings for the Russell 2000 are expected to rise 18% in the second quarter, far surpassing large-caps. Earnings growth is going to be a crucial factor in determining whether this upward price trend will continue. A continued strong economy and (presumably) lower interest rates on the horizon should help. Smaller companies tend to be more vulnerable than big ones to high interest rates.
The rally in small caps has broadened the rally in this month’s second half (in addition to sector rotation). It is very healthy for this bull market to see more names participating in the advance. But can it continue? Small caps are way “overbought” in the short-term. That is what happens when an index’s market cap shrinks to the point where it is smaller than each of the three largest stocks in the S&P 500; even a small rotation out of mega-caps can cause a massive move in the Russell 2000. We expect the small-cap rally to continue due to lower interest rates, a strong economy, robust earnings growth and a historic valuation gap with larger stocks.
The current earnings season is about half over, with this week being the busiest of the season. EPS beat rates have been very good at almost three-quarters of reporting companies. Revenue beat rates continue their trend of fading at 59% of reports. Guidance raises are at their lowest levels since the final pre-Covid earnings season (4.5%). Triple plays only account for 3.7% of reports.
Expectations coming into the season were high, and there has been lots of dispersion across results. Companies missing the mark on earnings, revenues, or guidance have generally seen their stocks get slammed. Some of the price moves downward have been vicious. Specifically, guidance cuts have resulted in a one-day price drop of 5.6% on average.
For the second quarter in total, companies in the S&P 500 are expected to report 9.8% growth in earnings. For all of 2024, 10.9% growth and 14.8% for calendar 2025 (source: FactSet). The corporate profits pillar is still intact although we have some concerns about guidance.
Last week’s first reading of Q2 GDP came in at 2.8%, just higher than the Atlanta Fed GDPNow forecast of 2.6% which, once again, beat the consensus private sector estimate. Q2 GDP saw strong investment numbers and satisfactory consumer spending. Consumers don’t appear to be running out of spending power. Over the past year and a half, personal consumption expenditures have risen 2.5% annualized on average, exactly where they were pre-pandemic.
Friday’s PCE inflation data (personal consumption expenditures) came in as expected. The big development in core inflation over the last couple of months is the badly needed slowdown in rent prices. Excluding rent, core PCE is up 1.6% annualized in June, settling into a level consistent with inflation reaching its target near-term. The PCE print has kept the market odds for a September Fed funds rate cut at 100%.
HOW QUICKLY THINGS CAN CHANGE
Well, we got what we wished for (mostly). In previous commentaries, we mentioned that we needed more participation from non-tech stocks to give us more confidence the bull could continue for a long period of time. Since the inflection point on July 10th, non-tech stocks have rallied and mega-cap tech has been re-priced lower. Some of the mega-cap tech stocks are now in bear market territory because of dramatic price moves lower. The Mag 7 have been particularly hard hit.
While we are not happy to see tech get hit so hard, we are ecstatic that roughly 75% of our client portfolios have come to life and have advanced this month even though the S&P 500 has been flat. However, we are not giving up on the tech trade. The fundamentals are just too strong to overreact to short-term downside price momentum. For example, analysts expect the Mag 7 to report a 28% jump in earnings for the second quarter. So far, only two of the Mag 7 have reported: Tesla’s stock was hit hard when they reported an ongoing deterioration in operating margins, and Alphabet stock sank when ad sales for YouTube were light. Investors’ reaction to Alphabet’s otherwise strong quarter was silly, in our view.
Market breadth has experienced significant improvements. For several weeks, bulls have been waiting for breadth to confirm the rally. We finally got that confirmation the week before last. All in all, the sector rotation we are seeing along with strength in small caps gives us confidence the bull market has entered its next phase. Continued growth in earnings and lower interest rates ahead should pave the way for higher stock prices in this year’s second half, in our opinion.