Is small beautiful?

Technology remains an unsolved problem at current weightings. In July, the only two sectors to underperform the S&P were Information Technology and Communication Services. Can the S&P move much higher if tech wrecks? Still, the equal-weighted S&P made a new high this week. And the S&P 500 itself is up about 15% year-to-date, which puts it right at the border between fourth and fifth quintile performance for January-July periods. Usually that’s a sign of positive returns for the balance of the year. The 50-day moving average for the S&P 500 is about 5,450. Below that, there appears to be support at 5,250 and further still at the 200-day, about 5,000. Trading has been volatile lately, with 10-year rates falling below 4%, presumably on recession worries. This even as nearly a quarter of the S&P 500 made a three-month high this week, a sign of strength. Anecdotally, it’s unusual for the S&P to peak for the year in July, having only occurred in 1957, 1975 and 1990. July was the worst month for the BBG commodity index since May 2023, yet this happened when the dollar was down for the month, suggesting that demand was the cause of commodity weakness. At the industry level this year, a trader who went long the previous month’s six worst performers and short the six best would have enjoyed a 40% return so far year-to-date, suggesting a mean reversion theme. Investors seem unhappy – puzzled by direction and wondering just how much consolidation is needed first.

Three-fifths of S&P 500 companies have now reported Q2 earnings and 75% of these are beating earnings estimates, in line with last quarter, while 56% have beaten on revenues, down from 60% last quarter. The season began with good reports from Financials, and this has now widened out to include Health Care (set to grow earnings 22%), Communication (24%) and Technology (18%). Overall earnings growth is at 12% y/y. S&P 500 companies face cost growth around 3.5%-4% (similar to pre-Covid), while revenue growth for Q2 is at 4.8% so far. If that roughly 1% differential between revenue and cost growth can be maintained, profit margins will be steady or better. And when margins hold up, the stock market can generally stay out of too much trouble. Analyst consensus calls for earnings growth of 6.8% in Q3 and 13.8% in Q4, followed by 14-15% in 2025.   

The big story the past month has been the violent rotation into value and, particularly, into smaller stocks. Large company earnings recovered from the pandemic faster than did their smaller brethren, and now smaller companies are expected to enjoy double-digit earnings growth next year. To give a sense of the rally’s strength so far, after making little progress since the beginning of the Fed’s tightening campaign two years ago, roughly 100 stocks in the S&P 1500 went up 20% in July. Multiples for small caps have expanded while those for large caps have contracted. And the rotation extends to value stocks and other members of the S&P 493. Some 70% of S&P 500 stocks outperformed the index over the past 20 days, which is a 2001-level rotation and a sign that at a time like this the index level doesn’t necessarily tell the full story of what’s happening within and around the S&P 500. As for the future, there are reasons to be bullish on small caps beyond a one-month trade. Rate cuts are on the way – this could be a windfall to their heavy floating rate debt burden relative to large caps. And small company earnings growth is forecast to be better than that of large companies by Q4. Also, mergers and acquisitions are the sixth-best on record, recession odds seem low and bond yields are coming down. Importantly, recession odds seem low with credit spreads still tight. Still, if a durable rotation is coming about, it isn’t painless: the Nasdaq 100 is down about 10% from recent highs while the S&P 500 is down about 5%. And yet I wonder. About 44% of Russell 2000 companies are unprofitable versus 6% for the S&P 500. It’s concerning that each cycle low this century has seen a higher percentage of unprofitable companies in the Russell, whereas the S&P has regularly had about 5-7% unprofitable companies once growth returns following recessions. There’s that “R” word again. Not beautiful.

Positives

• Consumers are confident – for now The Conference Board’s consumer confidence index rose to 100.3 in July, up 2.5 m/m and better than expectations of 99.7. The labor market differential, however, which compares those who say jobs are plentiful versus hard to get fell 1.7 points to 18.1. The expectations index rose 5.4 points to 78.2. That remains well below the level of 90, however, that historically indicates a recession will arrive within a year.
• Wage costs slow a bit The Employment Cost Index rose 0.9% versus the expected 1% in 2Q, yielding a 4.1% y/y increase. This is a level consistent with the beginning of Fed cuts, inasmuch as the Fed looks for a steady state where 3.5% wage inflation derives from 2% core inflation plus 1.5% productivity growth.
• It’s a start Pending home sales rose 4.8% m/m in June, well above consensus (1.5%) but still down 7.8% on the year. In this first such increase in three months, all four regions of the country showed growth. Mortgage applications remained sluggish. The S&P/Case-Shiller nationwide existing home price index rose 0.3% m/m in May, marking a 5.9% y/y increase.

Negatives

• A tough jobs report The economy added just 114K new jobs in July, far less than the expected 175K, while the unemployment rate jumped to 4.3%, triggering the Sahm rule, at least on a rounded basis. (The Sahm rule signals a recession if the 3-month unemployment rate exceeds the lowest 3-month period of the past year by more than 0.5%.) Prime age labor force participation grew to its highest level since 2001, suggesting a more benign cause to the rate increase. Another factor: temporary disruption owing to Hurricane Beryl.
• Manufacturing contracts The ISM manufacturing composite fell 1.7 points in July to 46.8; consensus was 48.8. This marked 20 months of contraction alleviated only by a brief move above 50 in March. The regional manufacturing indexes were mostly contractionary in July except for Philadelphia. Globally, growth was also weak, with five months of expansion coming to an end in July.
• Building slows Construction spending dropped 0.3% m/m in June versus expectations of a 0.2% increase. Residential fell 0.4% m/m while non-residential fell 0.2%. Two areas supported by fiscal stimulus were also weak: public construction spending fell 0.4% m/m while private manufacturing construction rose just 0.1%.

What Else

Now is not then At the peak of the tech bubble in 2000, Cisco had a PE of 200 times earnings and their net income was about $3 billion. In today’s money that might be worth twice as much. Nvidia’s net income for the past 12 months was $45 billion and it has a PE of about 60.

Productivity on the upswing Productivity rose at a 2.3% annual rate in Q2 and 2.7% y/y, helping keep inflation in check. This is well above the 2.1% average since the late 1940s. Experts say AI is not the yet the source of the uptick in productivity, which augurs well for continued gains ahead.

Planet of the apes Per the Wall Street Journal, zoos have grown concerned that gorillas are being given too much screen time. Visitors to the zoos have taken to showing the animals videos of themselves through the glass walls of their enclosures. The gorillas have even begun to change their behavior in response.