MW Small-caps and value stocks dominated in July by the widest margin in decades. Can the 'great rotation' continue?
By Joseph Adinolfi
Small-caps still have a ways to go to catch up to their highflying Big Tech peers. The state of the economy could ultimately determine whether the trade continues.
The "great rotation" that turned the market on its head this month has shown investors that patience can pay off.
But with tech stocks retaking the lead in Wednesday trading, many observers are wondering how much longer the catch-up trade can last.
Prior to the start of the rotation on July 11, some investors who felt they had missed out on the artificial-intelligence boom had opted for small- and midcap stocks, along with large-cap value names, reasoning that these corners of the market were too cheap to pass up.
Their instincts proved correct, as these lagging areas surged into the lead after a relentless rally in companies believed to be in a position to benefit from the AI boom had pushed valuations for small-cap and value names to some of the cheapest levels relative to the S&P 500 SPX and Nasdaq Composite COMP in decades.
Over the past month, small-caps and value stocks have outperformed their large-cap and growth rivals by some of the widest margins in years, according to Dow Jones Market Data.
However, a revival of the technology-led rally on Wednesday helped narrow the gap in favor of the Nasdaq Composite and S&P 500, as Microsoft Corp.'s $(MSFT)$ latest earnings report renewed investors' faith in the AI trade.
Here are some of the highlights:
The small-cap Russell 2000 RUT has outperformed the Nasdaq Composite COMP in July by 11.19 percentage points, on pace for its largest monthly outperformance since February 2001. Against the S&P 500 SPX, the small-cap index is poised for its best outperformance since February 2000.The S&P 500 equal-weighted index XX:SP500EW is on pace to outperform the S&P 500 by 2.8 percentage points, its widest monthly margin since February 2021.The Russell 1000 Value index RLV is poised to outperform the Russell 1000 Growth index RLG by 7 percentage points, its widest margin since March 2001. The S&P 500 value index is on track to outperform the growth index by the widest margin since October 2022. The Dow Jones Industrial Average DJIA is outperforming the S&P 500 by 3.64 percentage points, on pace for its best month, relatively speaking, since October 2022.
Of course, these corners of the market still have a long way to go to close the gap with more growth-oriented sectors like information technology and communications services, home to most members of the group of tech stocks known as the Magnificent Seven.
Shift in leadership was long overdue
To strategists like Richard Bernstein, who had been recommending for much of the past year that clients risked missing out on a "once in a generation" opportunity in cheap corners of the market, the catch-up seen in July seemed long overdue.
"When overall profits accelerate, as they are now doing, investors historically have become comparison shoppers for earnings growth," Bernstein told MarketWatch. "Why pay a lot for something that is everywhere?"
Whether the trend can continue during the coming months was less clear. "I'm not smart enough to tell you about the short-term," he said. However, over time, he said he expected these corners of the market would outperform the leading AI names.
Catch-up trade will depend on the economy, not just rates
Others said a lot still needs to go right in 2024 for the rotation trade to continue.
Small-caps and value stocks remain attractive based on their valuations relative to their Big Tech peers, suggesting there is scope for them to continue narrowing the performance gap, said Ross Mayfield, an investment strategist at Baird. But ultimately, whether they succeed could hinge on the fate of the U.S. economy.
If the Federal Reserve fails to guide the U.S. economy toward a soft landing, small-caps and many cyclical sectors like financials, industrials and materials could see their recent gains reverse, even if the central bank does cut interest rates as investors expect, Mayfield said. Investors are expecting more guidance about the prospect of rate cuts from the Fed on Wednesday.
"Small-caps have a lot of floating-rate debt and big exposure to regional banks. Those trades don't work if the economy is headed for a recession," Mayfield said.
Some economists, including former New York Fed chief Bill Dudley and Renaissance Macro's Neil Dutta, have argued that the Fed should cut rates on Wednesday to avoid risking a recession. Mayfield said he tends to agree with this view due to recent softness in labor-market data.
Others expect July's rotation will ultimately be remembered as a brief blip before Big Tech stocks retake the lead.
Confidence in AI could help Big Tech retake the lead
Sentiment and position likely played a bigger role in driving this month's shift than any other factor, said Michael Lebowitz, portfolio manager at RIA Advisors. Popular trades like bullish bets on megacap stocks had simply become too crowded. Now that they have taken a beat to unwind, investors can start piling in once again.
"We currently think this is more of a technical trade. There were too many people short small-cap value, and too many people long and overleveraged high-growth stuff," Lebowitz told MarketWatch during an interview.
When it comes to markets, fundamentals like earnings take a back seat to intangibles like investor confidence, Lebowitz said. Confidence about the transformative impact of AI has done more to fuel the rally than Nvidia Corp.'s $(NVDA)$ earnings and sales growth, as impressive as they might be.
Investors might ultimately be disappointed by AI's ability to boost workers' productivity growth. But for now, their confidence remains undimmed, he said.
-Joseph Adinolfi
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(END) Dow Jones Newswires
July 31, 2024 14:01 ET (18:01 GMT)
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