by Jeremy Bryan, CFA, Gradient Investments, LLC
The stock market saw a dramatic reversion in July, as small-cap stocks significantly outperformed their large-cap counterparts for the month. Our opinion is that this rotation was based on a resilient economy paired with a higher potential for the US Federal Reserve (Fed) to begin their widely anticipated interest rate cuts.
Let us begin with the Fed. Based on CME probabilities, investors have begun to anticipate cuts beginning in September with the highest probability now being 0.75% (75 basis points) of interest rate cuts by year end (based on three cuts of 25 basis points each). Just one month ago, the probability of this magnitude of cuts was less than 20%. Now, the market is “pricing in” a 60% probability of three cuts by year end. The Fed also met at the end of July, and while no actions were undertaken, Fed Chair Jerome Powell said in his press conference that a rate cut in September is “on the table”.
The rising expectations of interest rate cuts have driven bond yields lower, which had a positive influence on bond prices. The 10-year US Treasury rate ended the month at 4.09%, falling from the 4.70% year-to-date high set in April. As a result, the US Aggregate Bond Index was higher for the month and is now in positive territory year to date.
The S&P 500 is up 22% in the past 12 months, mostly driven by a few number of stocks in the artificial intelligence (AI) field. Companies like Nvidia, Microsoft, Apple, Amazon, Alphabet, and Meta have become very large components of the S&P 500 index and their significantly positive year-to-date performance drove the index higher. What was experienced in July, however, was a significant rotation to the “other” stocks in the market – with one significant beneficiary being small-cap US stocks (like the Russell 2000 index).
Small-cap stocks were up over 10% for the month of July, significantly outperforming the large-cap-influenced indexes like the S&P 500 and Nasdaq. In our opinion, the small-cap rally has been led by the prevailing thought of lower interest rates and relative resiliency of the economy. Small-cap stocks tend to be more US focused and many of them are reliant on debt to grow their businesses. So, if economic data continues to reflect growth, and debt expenses are less due to lower interest rates, small-cap stocks could continue to perform well.
As with any change in market trend, it is important to understand whether the trends are sustainable or a temporary “head fake.” Regarding investing in small-cap stocks, it is incredibly important to understand that owning small caps on a broad basis (like an ETF) is a very different company exposure than a large-cap index like the S&P 500. Many smallcap companies are not currently profitable and for those that do earn a profit, a large percentage are in small regional banks that may have exposure to items like commercial real estate. In our opinion, while this trend of small-cap outperformance could continue, we would caution investors to know what they own before making that decision.
On the other hand, we welcome stock performance that has a broader level of participation of companies that are outside the sphere of AI. While we believe in the secular growth of AI, we do advocate for greater diversification in portfolios that include AI beneficiaries but also include companies outside that space that are still growing but trading at much more reasonable valuations.
Lastly, we are advocating a “bring an umbrella” approach to the markets right now. S&P 500 performance has been significant year to date and the corrections experienced thus far have been relatively mild. With an expected contested and contentious election still ahead, as well as growing evidence of slowing spending among lower income consumers, we believe it is prudent to maintain a balance of safe and growth assets and not chase excessive risk at current levels.
Sources:
https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html
https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html)
https://www.cnbc.com/2024/07/31/powell-says-september-rate-cut-on-the-table-ifinflation-data-continues-to-cool.html https://www.cnbc.com/2024/07/31/powell-saysseptember-rate-cut-on-the-table-if-inflation-data-continues-to-cool.html)
Gradient Investments and Retirement Income Planning, LLC operate independently of each other. Please consult your independent investment advisor before making any investment decisions. The information herein is for informational purposes only and should not be used as the sole basis for making an investment decision. Investing involves risk including the potential loss of principal. For more information, please request a copy of Gradient Investments’ ADV Part 2A. Gradient Investments, LLC is an SEC Registered Investment Advisor.