Is the Market Broadening?
The Magnificent Seven companies, Google’s parent company Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia, and Tesla, were so dubbed because they were the primary driver of a positive stock market in 2023. Except for Tesla, these companies have continued to be a major driver of positive stock returns so far in 2024. However, as can be seen in the chart below, July 10 marked the beginning of a pronounced downturn in the Mag 7 and, in particular, NVDA and META.
Magnificent Seven Performance, Year-to-Date
Vertical lines represent calendar quarters. July 10 was the recent sharp peak in the orange NVDA line.
This trend has not been isolated to only the Magnificent Seven, however. The S&P 500 Index has been relatively flat in that same period. The S&P 500 Index is comprised of 11 underlying sectors which contribute to the returns of the index. As can be seen in the chart below, all 11 S&P 500 sectors are positive year-to-date, but not every sector has had a nice steady climb throughout the year. At the end of the first quarter of 2024 only Real Estate was negative, but the Consumer Discretionary and Utilities sectors both struggled throughout the quarter. Regardless, those sectors closed out the quarter up 3.06% and 4.52% respectively. The Utilities sector found footing in the second quarter and rallied to the 5th best performing sector by close of markets on June 28. The Consumer Discretionary sector struggled through much of the second quarter, but by the end of the second quarter it was still only the Real Estate sector in the negative. Then, starting on July 9, several sectors began to rally substantially. Those sectors, in order of returns from the 9th through the 19th, were Real Estate, Energy, Industrials, Materials, Financials, and Health Care.
S&P 500 Sector Performance, Year-to-Date
Vertical lines represent calendar quarters.
In addition to a sector rotation, something else started on July 9th, and that was the beginning of a rally in small-cap stocks. Before July 9 the Russell 2000 Index, a broadly followed index of small-cap stocks, had been languishing between -5% and +5% so far in 2024. Since July 9, the Russell 2000 Index had rallied over 10% in just a few trading days. Additionally, the Dow Jones Industrial Average saw a surge as well, albeit less dramatic, rallying 4.85% since from July 9 through 17 before giving back some of those gains over the next 2 days. Over half of that index is weighted to the Industrials (13%), Health Care (19%), and Financials (23%) sectors, so considering the performance of the corresponding S&P sectors, that rally isn’t too surprising. Of course, the period observed always makes a difference. Despite the impressive rally of small-caps, they have still been soundly outperformed by large-caps going back to the beginning of 2022. Regardless, this type of price action in such a small window of trading days is enough to make one sit up and take notice.
Major Market Index Performance, Year-to-Date
Vertical lines represent calendar quarters.
What Caused the Sudden Change?
The most obvious catalyst at play is increasing expectations of a rate cut from the Federal Reserve, although bets about the outcome of the election and what tax and trade policies might result could also be playing a part. Focusing on the monetary policy aspect of things, the market has decided a rate cut in September is all but a foregone conclusion. As of the time of writing this article, the futures markets are pricing in a 96% chance of at least one rate cut in September. Historically, once the Fed starts cutting rates, they tend to continue cutting and the markets are pricing in a 50% chance of a second rate cut in November and 4 more by the middle of next year. In other words, market participants aren’t just positioning for one cut, but for a new regime of declining interest rates.
So how does that explain the recent surge in small-cap stocks? Well, small-cap companies are just that, small, at least by comparison to the big fish like Apple and Microsoft. While those massive companies can invest vast sums of money into something like AI from cash flow, smaller companies often need leverage to invest in growth. In other words, they need to borrow money. Therefore, small-cap companies tend to benefit from periods of low interest rates when money is cheap because they can afford to invest in growth. Small-cap companies also tend to perform well in periods of strong economic growth. There are always a myriad of factors at play in the markets, so this may not be the whole story, but it’s at least part of the story.
Okay, low rates are good for small-cap stocks, but the S&P 500 is a large-cap index. What about all those S&P 500 sectors? Falling and low rates are good for more than just small-cap companies. The Real Estate and Financials sectors are cyclical and tend to benefit during periods of low interest rates and accelerating economic growth. When rates are low and growth is strong, people and businesses tend to take loans and build houses. Banks can lend more and pay less interest to depositors, thereby increasing earnings. The Materials and Industrials sectors both benefit from accelerating growth as well. When houses and infrastructure are being built, raw materials and industrial equipment and services are in high demand. The Energy sector is a bit different from the four just mentioned but is known for stocks which pay high dividends. While dividend paying stocks have been eschewed for higher yielding bonds for quite some time now, dividend paying stocks become more attractive relative to bonds as interest rates decline because dividend yields are not directly tied to interest rate policy.
So, falling rates are supportive for small-cap stocks and certain sectors. Are they detrimental for the Technology sector? Typically, no. The technology sector has historically been one full of upstart companies with little cash flow looking for venture capital and low cost loans to finance operations until they can turn a profit. However, the technology companies that have been the star of the show for two years now are different. The Magnificent Seven companies are well established and have substantial cash flow. There may be several factors contributing to falling Technology sector values. One factor is likely sector and business cycle rotation into small-cap and value stocks, and other areas of the market perceived to benefit from falling interest rates and broadening economic growth. This is not all new assets flooding into the market from cash accounts. Rather, many investors may be reducing their overweight allocations to technology and communications services companies and reallocating to the underperforming parts of their portfolios in anticipation of a lasting regime change. Additionally, there has been some recent news of increasing geopolitical concerns, specifically regarding trade restrictions impacting semiconductors and concerns over the future of the U.S./Taiwan relationship. Although the United States has made investments in domestic production of semiconductors through the CHIPS Act, Taiwan Semiconductors is still a major player in the global semiconductor supply chain. One U.S. International Trade Commission paper estimated that at least 44% of U.S. logic chip imports originated in Taiwan. Disruption in trade with Taiwan could have substantial impacts on adjacent industries. Lastly, there has been some weakness in earnings and earnings guidance from semiconductor companies and other AI beneficiaries which could be contributing to the rotation.
What Does This Mean Going Forward?
Alas, I have not found a reliable crystal ball since writing the last article, and it is always the case that new data will change the economic landscape. That said, we can examine certain indicators to see where we stand today. Factors which contributed to the current rotation include inflation and economic growth data. Dovish commentary from Fed officials two weeks ago likely kicked off the current rotation. Then inflation data, released on July 11, shifted it into high gear. The Consumer Price Index (CPI), a primary measure of inflation, showed a continuing downward trend (disinflation), which is good for rate cuts. However, Federal Reserve Chair Jerome Powell said in his testimony to the Senate Banking Committee on July 9 that inflation “is not the only risk we face.” Keep in mind that the Federal Reserve has a dual mandate of maximum employment and stable prices. Powell’s comment hints that the Federal Open Market Committee, the group responsible for setting interest rate policy, may be shifting their focus from the inflation mandate to the full employment mandate out of concerns over slowing economic growth. The reason for interest rate cuts from the Fed is an important factor. As we have explored before in this newsletter, we want the Fed to cut rates because inflation has been tamed and there’s no need for higher rates. It’s a different situation altogether if the Fed is concerned about slowing economic growth and is cutting rates to change economic trajectory. It is far easier to keep a boulder at the top of the hill than it is to control its momentum once it starts rolling down.
On the topic of employment, U.S. employment remains robust, but there are signs of cooling. The unemployment rate is at 4.1%, which is historically low, but it is climbing. The Sahm Rule is an economic indicator which is intended to signal to policy makers that it’s time to take action to avoid an acceleration in unemployment. This rule has a threshold of 0.50%, is currently at a reading of 0.43%, and has been creeping closer to the threshold for many months. Initial claims for unemployment insurance came in a bit hotter than expected today and continuing claims continue to tick up gradually. Meanwhile, full-time employment has continued to gradually fall. As with my article a couple of months ago, “What the Heck is Stagflation?”, this data continues to suggest the labor market is softening, but it isn’t setting off klaxons.
On the economic growth front, we have mixed data. Retail sales have plateaued, but importantly they have not collapsed. This week’s report on June retail sales came in flat (0%), but May’s numbers were revised up to +0.3% and it is possible June numbers could be revised as well. ISM Manufacturing and Services PMI reports are important indicators of manufacturing and services growth. A reading below 50 signals contraction and above 50 signals expansion. Apart from March this year, Manufacturing PMI has been below 50 since November 2022, but Services PMI was carrying the team. The Services PMI broke below 50 in April only to rebound in May and drop below 50 again in June. The Services PMI languishing below 50 for several months would be a negative indicator for economic growth. On the upside, we have seen some positive surprises as well such as durable goods orders and industrial production which pushes back on the narrative of slowing growth. If you’d like a primer on any of these economic data points, give the above-linked article a read as I spent more time explaining each of these indicators in detail. Economic growth data is a mixed bag right now. Softening economic data is good for rate cuts in the short term, but not great for the economy if those weak numbers get substantially weaker for an extended period. We are currently in earnings season and the more earnings beat expectations, the better.
The case for the rotation among sectors and into small-cap and value stocks is similar. Interest rates declining while economic growth remains robust could be supportive of the trend. The same can be said for technology stocks. Continued robust earnings growth would be supportive of continued growth. Semiconductors, specifically, would benefit from a bit more certainty in terms of future trade policy. On the other side of the coin, significant downside surprises on growth data would not be good for stocks over the long-term. As is usually the case, caution is warranted when things are moving quickly in the markets. The chickens may not have all hatched yet. The market has moved quickly from one side of the boat to the other for months now in anticipation of Fed policy. Many investors moved too quickly on positive inflation data in late 2023 only to see progress stall in early 2024. The recent price action just supports the notion that nothing lasts forever and business, economic, and market cycles will continue to come and go.
Disclosures
The information presented in this article is for informational purposes only and should not be considered investment advice. It is not intended to be, and should not be, relied upon as financial, legal, tax, or any other advice. The opinions expressed in this article are those of the author and do not necessarily reflect the views of Howe & Rusling. Past performance is not indicative of future results. The performance data cited in this article reflects past performance and should not be considered as an indication or guarantee of future performance. All investments carry risks, including the risk of loss of principal. This article may contain forward-looking statements, which are subject to risks and uncertainties. These statements are based on current expectations and projections about future events and are inherently uncertain. Investors are cautioned not to place undue reliance on these statements, as actual results may differ materially from those expressed or implied. The market and economic data presented in this article are based on information from sources believed to be reliable. However, no representation or warranty, expressed or implied, is made as to their accuracy, completeness, or correctness. The data and information are subject to change without notice. This article does not constitute an offer to sell or a solicitation of an offer to buy any securities or investment products. Any offer or solicitation will be made only by means of a prospectus or other offering documents. This article does not constitute an offer to sell or a solicitation of an offer to buy any securities or investment products. Any offer or solicitation will be made only by means of a prospectus or other offering documents. Investing in securities involves risks, including the risk of loss of principal. Investors should carefully consider their own financial circumstances and risk tolerance before making any investment. The specific securities, sectors, or markets mentioned in this article may not be suitable for all investors. Investing in securities involves risks, including the risk of loss of principal. Investors should carefully consider their own financial circumstances and risk tolerance before making any investment. The specific securities, sectors, or markets mentioned in this article may not be suitable for all investors. This article may contain links to third-party websites or references to third-party data. Howe & Rusling is not responsible for the content of such websites or the accuracy of such data. Inclusion of these links or references does not imply endorsement by Howe & Rusling.
