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Written by: Nick Williams | AAM
The month of July has ushered in one of the strongest factor rotations in recent memory. A quick comparison of the returns across various indices from the first half of the year relative to the last few weeks illustrates a clear shift in momentum.
Source: AAM, Factset | Past performance is not indicative of future results.
The last 18 months could be defined almost entirely by the dominance of mega cap growth, fueled in part by the prospects for new AI technology. The so-called Magnificent 7 enjoyed a meteoric rise and grew to account for over 30% of the S&P 500 cap weighted index.
But in recent weeks, something changed. The growth over value, mega cap dominance that propped up major indices to all-time highs was abruptly abandoned in favor of the factors that seemed to have been forgotten since the market bottom in 2022.
In just two short weeks:
- Small caps outperformed the large cap-dominated S&P 500 by over 10%.
- Value outperformed growth by more than 9%.
- The Magnificent 7 basket underperformed the average stock (S&P equal-weight) by more than 13% and small caps by nearly 19%!
By now you could argue we’re well past the point of calling this a head fake, but the real question is, will it continue?
If durability is the defining factor, should we consider this a trade (short-term) or a trend (long-term)?
A tactical trade opportunity is where we would deviate slightly from our home base in the short run to take advantage of mostly price swings. In contrast, a more durable trend might compel us to reposition our strategic asset allocation.
To answer this question, let’s examine a few of the possible culprits that many pundits have identified as contributing factors. We’ll also narrow our analysis to focus on the size factor (large caps relative to small caps) using the S&P 500 vs. Russell 2000 for reference.
Lower Interest Rates
On July 11, after a string of stubbornly elevated prints, June CPI finally showed progress and came in below expectations giving the market confidence that the Fed is finally poised to deliver the first rate cut in September. High interest rates have traditionally been a headwind for small cap companies burdened by higher borrowing costs, less pricing power, and elevated discount rates on future earnings. Rates have remained higher for longer than most had expected in the first half of the year. Markets had initially priced in as many as 6-7 cuts for 2024 and were forced to walk back all but one by early summer.
In theory, lower interest rates should serve as a tail wind for smaller companies both from an operating perspective and for multiples. But that ignores the underlying weakness in the broader economy that rate cuts are usually responding to. Markets may cheer in the short-term, but late cycle cuts intended to provide support to a slowing economy generally does not bode well for small cap stocks.
In other words, future rate cuts as a catalyst likely imply trade, not trend.
Source: Strategas
Trump Bump
Following a post-debate bounce and a failed assassination attempt (along with some help from disarray on the democratic ticket), the odds of a second Trump term started to look almost inevitable by mid-July. This led many to make the case that the rotation was a ‘pull forward’ of a possible future Trump trade based on his platform of deregulation and lower taxes.
In 2016, Trump’s win caught the market by surprise. Over the next 30 days, small caps rocketed some 16%+ higher, outpacing the S&P by more than 10%. Lower taxes and deregulation were staples of the Trump platform that were expected to usher in a more conducive environment for smaller domestic companies. Despite the initial enthusiasm, the outperformance was short lived. After the sharp bounce, small caps would broadly underperform the S&P over the next few years up until the start of the pandemic.
While major policy changes like lower taxes and less red tape are thought to have longer term impacts, the small cap ‘Trump Trade’ just didn’t last.
If history serves any indication, this too supports the case for a trade, not a trend.
Fundamentals
While short-term moves are mostly price (multiple) changes, the staying power of a trend ultimately depends on fundamentals.
For small caps, earnings growth has been elusive. 2024 earnings are expected to come in about 8% below 2023 for a second consecutive year of negative growth. This is despite a rebound for the S&P 500 which has the benefit of massive growth from the Magnificent 7. With fundamentals in the driver seat, it should be no surprise that small caps have struggled to participate in the mega cap growth party where the S&P earnings picture has already reaccelerated to double digit growth this year.
While the tide has taken longer to turn for the smaller cap cohort, estimates suggest we could be at the nadir. After a two-year hiatus, analyst expect earnings to start growing again in a big way. Estimates for 2025 predict a whopping 36% jump over 2024!
Improving fundamentals should be the most powerful indication over the long-term. The problem of course is that fundamentals alone tend to lack any meaningful predictive power in the near-term. But clearly momentum has turned in their favor. When the technical and fundamental pictures converge, it tends to be a powerful set up. It’s also notable that the Russell 2000 remains below its all-time highs set back in 2021. The longer the base, the stronger the case!
Of course, small caps tend to exhibit a higher degree of volatility and are particularly exposed to a broader slowdown. Macro risks can be detrimental to a bullish set up as economic downturns are not kind to risk assets. In addition, future earnings estimates are just that…estimates. There is no assurance that these lofty growth expectations will come to fruition (and revisions often gravitate lower).
As the economy shows signs of slowing, we would remain cautious regarding risk assets. We still advocate for a well-diversified asset allocation with a defensive posture and maintain a preference for quality. If the economy continues to weaken, we expect risk assets, particularly high beta, high multiple growth (and yes small caps) to be exposed. Bear in mind over 40% of the Russell 2000 is unprofitable. Small caps also tend to have their best days rebounding from market bottoms, not playing catch up at the top.
Clearly the underperforming factors had become coiled springs, but we are not convinced that future rate cuts or shifting political winds are the catalyst we should be looking for to indicate a durable trend.
We are more convinced however that fundamentals will ultimately win out in the long run, and they appear to be improving in a big way. It is also worth noting the risk of extreme concentration to mega cap growth has played out in real time in recent weeks. An allocation to small caps would add a significant layer of diversification, even if accounting for absolute risk being higher within the group.
Make no mistake, any allocation to small caps is considered high risk, high reward. A bullish case predicated on fundamentals does not mean the timing is right. For those with a higher tolerance for risk and a long-term view, the set-up for a marathon looks more compelling than a quick sprint.
For more risk-conscious investors, one might heed the darkening macro clouds and hold out for confirmation that economic growth is an asset, not a liability.
Related: US Indices Versus Europe Indices