Weekly Market Prep - 7/15/2024
Small-caps, the magnificent 7, Treasuries. Where does it go from here after last week's massive shift?
Welcome back to ETF Focus!
It’s Sunday! That means it’s time to get prepped and ready for the week ahead!
What We’re Talking About This Week!
+ Weekly Market Reset
+ Key Economic Reports This Week
+ Dividend Landscape
+ Market Outlook
Weekly Market Reset
Last week, the U.S. market saw one of the biggest rotations in recent memory, marking a massive shift away from recent winners and towards unloved and undervalued names. I posted on Twitter/X this week that this is the first time that the S&P 500 equal weight index beat the S&P 500 by at least 2% since 2020 and only the 29th time this has happened in the past half century. Almost every other time this happened occurred around one of four major market events - the COVID recession, the financial crisis, the tech bubble and the stagflation ‘70s. I don’t need to tell you that these were some of the worst times to be an equity investor in history!
The question now becomes: is this a one-time reaction to a cooler than expected inflation report or is this a genuine change in sentiment that could last for an extended period of time? One could certainly make an argument either way. The past 18 months has been marked by a near uninterrupted rally for tech, growth, mega-caps and AI. Everything else has struggled for scraps in terms of market gains. We’ve seen these quick bursts over this time frame where small-caps or utilities or Treasuries pop because of an economic report or market event. In each case, the pop has been short-lived and tech has returned to leadership. In each case, the catalyst failed to usher in a broad change in market sentiment. The only exception might be Powell’s Fed pivot announcement in the 4th quarter of last year. That led to a 2-3 month run where small-caps and some cyclical sectors, including industrials and financials, did particularly well, but that faded once the market started dialing back rate cut expectations.
This time might, in my opinion, favor the sentiment change argument. The reason is that the longer-term underlying macro conditions are in place to support this rotation as opposed to just a single economic report or event. Another lower-than-expected inflation report might be the initial catalyst, but the Fed has already shifted its rhetoric from worrying about inflation to worrying about growth (his recent quote was “reducing policy restraint too late or too little could unduly weaken economic activity and employment”). If that’s the Fed’s new stance and you take that in consideration of the facts that GDP growth has already been slowing, the labor market is starting to show weakness and credit delinquencies, defaults and bankruptcies have already risen to concerning levels, there’s a strong case to be made that at least an economic slowdown and maybe a recession is headed our way.
When that starts to become the base case scenario, investors start abandoning expensive stocks & sectors and begin rotating into value stocks in order to protect themselves, which is what happened last week. You could point to the huge rally in small-caps last week as a sign that market conditions are still good because small-caps tend to outperform in true bull markets. I’d counter that argument with the fact that small-caps trade at about 16 times earnings vs. 22 for large-caps. This was also more of a rotation into value than anything. This is similar to the phenomenon we saw in 2022 when small-caps outperformed large-caps even though there was a 20% correction. The value-oriented nature of small-caps actually helped.
As is almost always the case, we need to give this time to play out. One day doesn’t change the direction of the markets, but if we see this trend of cyclicals, defensives and small-caps take the lead and hold it, we might need to adjust our outlook. I don’t believe now is the time to overtrade and overreact. For the time being, remain aware that market conditions may be changing in real time and the time of tech, growth and the magnificent 7 may be coming to an end.
Key Economic Reports This Week
With last week’s CPI and PPI reports now out of the way, the economic calendar largely gives way to the start of the Q2 earnings season, but there are some numbers in the U.S. to watch. In particular, retail sales could help confirm the idea that the consumer is getting exhausted and running out of gas. Last month’s tepid reading combined with this month’s expected tepid reading would be in line with the effects of a slowing jobs market and rapidly falling inflation due to lower demand. The economic signals have been mixed for months, but it feels like they’re finally starting to line up to tell the same story.
Additionally, building permits and housing starts have suggested that perhaps the U.S. residential housing market is slowing as well. Home prices may be elevated, but high interest rates not only stifle demand and the universe of potential buyers in this market, but it also makes the cost of construction more expensive. A number that misses expectations this month could help signal that the peak has been reached and a reversal might be near.
Also worth watching is Powell’s speech on Monday will be his first chance to publicly address the changing landscape of inflation and Fed policy following last week’s CPI report and market shift. His tone is unlikely to change much, but I’ll be curious if he reiterates the fact that the central bank is concerned about growth. If so, that could extend last week’s rotation well into this week and beyond. The ECB also meets this week, but is unlikely to change rates and it takes a slow and steady approach to policy changes.
Dividend Landscape
It was finally a better week for dividend investors as the rotation away from tech benefited most of the biggest sources of dividend payers (save for consumer staples, which continue to struggle). The market theme of migrating from growth to value would feed into the idea of dividend stocks as a defensive alternative, so it’ll be worth watching to see if that sentiment carries into this week as well. High yielders outperformed dividend growth by a wide margin. Since that group tends to be more value-oriented, it’s not surprising to see it perform well. An extension of the value trade would be good news for high yielders, but really all dividend stocks.
Market Outlook
Over the past year, these pivots away from tech rarely last, so it’d be unwise to assume that the value trade has legs. But the fact that Powell is talking about weakening economic activity & employment and CPI is starting to fall off a cliff can’t be ignored. This feels like we could be in the very early stages of a change in conditions that could be longer-term, but we need to give it more time to play out. No need to overreact here.
The range of market returns could be wide, so it would be wise to approach the week with some caution. I do believe Treasuries have some value built into them and feel like a better option this week than equities. If Treasury yields fall, that probably means good things also for gold and real estate, but a negative for the dollar.
Looking better for: Treasuries, dividend stocks, international, gold
Looking worse for: tech, mega-caps, TIPS
Though I'm not sure that I can point to any specific grammatical or punctuation errors, I did find some of the complex sentences to be very hard to read and posssibly confusing. Keep up the good work, but please don't hesitate to have a qualified associate proodread your future postings. - All th' e-Best - Rusty Tyson