Game-Changing CPI Report May Drive Big Rotation Towards Value And SmallCap

seekingalpha07-15

Following a cooler than expected CPI print, the Russell 2000 had third-best day relative to S&P 500 on record, with SmallCap/Value outperforming Growth.Expectation of lower Fed rates are driving ...

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PM Images Following a much cooler than expected CPI print on Thursday 11th, the S&P 500 (SP500) dropped almost 1% day-on-day (DoD). Interestingly, the performance of the Index was almost exclusively driven by the richly valued Magnificent 7 stocks (down more than 3% on average), while the remainder of the index showed positive returns on that day (up more than 1% on average). Research 22V In fact, according to insights shared by Research 22V, the Russell 2000 (VTWO) had its third-best day relative to the S&P 500 on record (Source: Research 22V, Investor Note dated 12th July). Research 22V In other words, growth underperformed following the CPI report, while Value and SmallCap outperformed. This dispersion makes perfect sense, in my opinion; and in fact, I expect the relative outperformance of the SmallCap/ Value to continue for the rest of 2024. On an industry perspective, my top picks are Real Estate, which should benefit enormously from lower interest payments on its debt-heavy balance sheet, and Utilities, which may be seen as a bond-like investment instrument. I also continue to like Financials, which I believe have still enormous upside from back-book asset repricing, even at 1-2 percentage point lower rates. Investors should note that Consumption accounts for about 70% of GDP. The expectations of lower Fed funds rate is the major driver for the relative outperformance of SmallCap/Value relative to Growth (against the narrative that lower rates would favor long-duration assets). In my view, as the expectation for rate cuts in 2024 has shifted decisively dovish following the CPI print, investors were rushing to buy into still high-yielding assets like Treasuries and SmallCap/ Value stocks. Because with lower Fed rates, the scarcity of high-yielding assets jumps sharply. For context, investors and traders are now pricing a rate cut by September this year with more than 95% certainty, according to data collected by CME. CME Watch Tool In addition to monetary policy tailwind, I am also bullish on the economic backdrop. Defying concerns about a potential economic slowdown, the outlook for future growth remains positive, as projected by various economic indicators. Firstly, I point out that real personal income growth in the US is currently trending around 2.5-3%, which is significantly outpacing US real GDP growth expectations of below 2%. That said, the fundamental strength in personal income provides a solid foundation for sustained economic activity, which should not only counter fears of an imminent slowdown, but also add upward pressure for GDP growth to turn out more closely in line with consumer strength. At the same time, the bar for earnings performance is low, especially for the SmallCap/ Value stocks in discussion, where analysts are estimating only 3% YoY growth vs. >15% for the Magnificent Seven, according to data collected by Bloomberg. On valuation, I highlight that U.S. SmallCap/ Value (<1 z-score) stocks are still trading cheap on a 25-year observation horizon, especially when compared to LargeCap and Growth (both >1 z-Score). This should lend strength to the thesis that the rotation towards SmallCap/ Value can continue for a while longer. Pointing to equities located outside of the U.S., a similar argument for valuation re-rating can be made. However, I point out that the economic backdrop in emerging and European markets may not be as healthy as in the U.S. And thus, I would prefer to keep my equities allocation focused on the United States. J.P. Morgan - Guide To Markets According to data collected by Refinitiv, the price multiple for the Russell 2000 on 2025 earnings currently is at 16x, while the S&P 500 trades at >20x. Similarly, the P/B for the Russell at 2.1x compares to 4.3x for the S&P 500, respectively. While I do not project full convergence of P/E and P/B, because the S&P 500 is more skewed towards growth and has a higher ROIC profile due to the Tech sector weight, I would expect that a fair valuation for the Russell is around 18-20x earnings - which would be in line with a z-score of around 1 for a 25-year observation horizon. Refinitiv Investor Takeaway  The price action on Thursday 11th June following the CPI report may have been an initial taste of a longer-term trend that extends into 2025. In my opinion, the underperformance of SmallCap and Value stocks in 2024 has shifted, as recent rallies in these factors indicated a rebalancing of investor focus. While I am not necessarily bearish on the Magnificent 7 basket, the likely upcoming shift in investor appetite suggests a broader and more inclusive market rally. My building conviction in SmallCap and Value factors is also supported by a robust economic backdrop, most notably thanks to private consumer strength. At the same time, I like the stark relative valuation differential backdrop of SmallCap/Value vs. LargeCap/Growth which should suggest ample rerating potential.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":0},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2451621077"}