The stock market, particularly buoyed by the mega-capitalization AI technology sector, remains at the helm of a 21-month bull market. Currently, this seemingly robust trajectory is undergoing a standard correction, having persisted for over two weeks, while small-cap equities have surged into prominence. As we reflect on insights shared in our recent July 3rd newsletter, we cautioned: “Bullish unanimity for a strong July may be too good to be true. Our contrarian disposition prompts a cautious stance this month … we advise against augmenting equities, particularly in the tech sphere, in the portfolio this month unless a general market correction exceeds 5%.” Then last week we updated, “A correction in the S&P 500 … is projected at between 5% and 11%”. Indeed, the S&P 500 and Nasdaq indices reached their apex on July 10th and have since corrected by 5% and 9%, respectively. In a striking turn, the so-called Magnificent Seven stocks experienced a decline of 14% during this retracement, juxtaposed against the small-cap value index, which rallied 14%, achieving multi-year highs. The swiftness with which large growth stocks distanced themselves from the broader market in early July has been matched only by the speed of convergence witnessed since then.
{Mag 7 = Amazon, Alphabet, Apple, Microsoft, Meta, Nvidia, Tesla}
As mega-cap tech continues to enjoy a substantial earnings beta premium linked to future expectations, the recent corrective phase in large growth stocks represents a healthy reversion to the mean. Yet, as this theme approaches saturation, there are compelling reasons to anticipate ongoing sector rotation. Central to this reversion is the burgeoning investor confidence surrounding Federal Reserve rate cuts anticipated for September. Smaller enterprises lack the vast bulwark of long term debt financing that larger corporations enjoy at lower interest rates. The contrasting trajectories of the mega-cap tech-weighted SP 500 and Nasdaq indices versus the small to mid-cap market can be elucidated through the lens of rate cut probabilities. During the second quarter, when pessimism over Fed rate cuts was the dominant sentiment, large tech indices surged ahead, focused on the recession resistant AI theme. However, as optimism about rate cuts surged to the 100% mark, small-cap stocks ignited, while the once-mighty mega-cap stocks faltered. Lacking any alarming inflation news ahead of September, it stands to reason that the trend favoring small-cap stocks will persist. This evolution implies a rapidly expanding price-to-earnings valuation ratio that may appear inflated until the earnings cycles for smaller stocks gain momentum in the fourth quarter and into 2025.
Even as the prevailing narrative of anticipated rate cuts shifts capital flows towards small and mid-cap equities, seasoned investment managers face a precarious dilemma. When manager exposure exceeds 100% (with margin leverage), idle cash for buoyant bullish speculation shrinks. The lopsided exposure of portfolio managers set the table for a Mag 7 correction. In the context of a Bull market, these consolidation phases may persist for one to three months, while our forecast for at least a 5% pullback in the S&P 500 has now materialized.
Our call for at least a 5% pullback in the SP 500 Index has just been reached. This is an area where some retracement of the mega cap downtrend becomes more likely, supported by seasonality. As the Mag 7 giants consolidate their recent losses, small-cap value stocks, regional banks, and much of the broader market have ample opportunity to reach new zeniths. While the Bull market, measured in terms of growth-weighted companies, is now firmly established at just under 2 years, it still feels youthful, particularly when considering the valuation multiples reflected among the small and mid-cap sectors. Value stocks, regional banking and much of the lagging broader market have room to play catch up and move to new highs.
The economic backdrop remains robust, characterized by a minor slowdown in consumer spending that veers toward normalization. This stabilization offers support for continued gains in earnings per share. As long as the labor market and consumer credit remain resilient, the narrative of Government overstimulation may yet carry us further along this path of recovery.
