(Bloomberg) --Stocks hit all-time highs as bets the Federal Reserve will soon start cutting rates fueled a rush into riskier corners of the market.
Wall Street extended a pattern of money rotating into small caps and out of the megacap “safety” since last week’s soft inflation data. Over the past four sessions, the Russell 2000 has beaten the Nasdaq 100 by almost 12 percentage points — a feat not seen since 2011. An equal-weighted version of the S&P 500 — where the likes of Nvidia Corp. carry the same heft as Dollar Tree Inc. — outpaced the U.S. equity benchmark. That index is less sensitive to gains from the biggest companies — providing a glimpse of hope the rally will broaden out.
“Rotation is the name of the game,” said Andrew Brenner at NatAlliance Securities. “This is consistent with the increased perception of cutting rates.”
Brenner highlighted the fact that around 4 a.m. New York time, Russell 2000 futures spiked — while contracts on the Nasdaq 100 slipped. “This means that overseas money, big money, made a very large rotation trade overnight,” he said.
To Solita Marcelli, at UBS Global Wealth Management, if the Federal Reserve can cut rates significantly in the context of a soft landing, there will be better prospects for a re-acceleration in earnings growth for lower quality and cyclical segments of the market. At Interactive Brokers, Jose Torres cited another potential reason for the rally in smaller firms: they tend to be domestically oriented and perceived to benefit “disproportionately” if Donald Trump wins the election.
The S&P 500 rose to around 5,667, posting its 38th record this year. The Dow Jones Industrial Average climbed almost 2%. The Russell 2000 gained 3.5%, posting its biggest five-day run since April 2020. The Nasdaq 100 was little changed. Treasury 10-year yields fell seven basis points to 4.16%. Gold hit a record high.
Traders also waded through earnings. Bank of America Corp. rose after saying net interest income would climb by the end of the year. Morgan Stanley dropped as results from its wealth business fell short of estimates. Charles Schwab Corp. warned it will have to shrink itself in order to protect profits.
The S&P 500 Index is barreling toward its longest stretch without a 2% decline since the onset of the global financial crisis in 2007. The index’s current bull run has added US$18 trillion in market value since it touched its nadir in October 2022.
The strength of the equity market has been underpinned by optimism the economy has withstood the worst of Fed tightening. In this regard, Tuesday’s better-than-estimated retail sales report was a “healthy” development, according to Bret Kenwell at eToro. It’s better to see the Fed cutting rates on falling inflation than to see the central bank rushing to bolster a weakened economy, he noted
While the broadening out in the U.S. stock rally is seen as a positive sign, the surge in small caps in such a short span is showing signs of overheating. In only five days, the Russell 2000 has jumped over 10% — hitting the most-overbought level since December.
Matt Maley at Miller Tabak says the gauge has reached the kind of overbought condition that has been followed by declines over the past two years.
“Thus, this could be signaling that the small cap sector is due for some sort of short-term breather,” he noted. “At the very least, investors should be careful about chasing these stocks over the near-term.”
In such case, he says it will be interesting to see if there’s a reversal of the “rotation” move. Tech stocks are coming off their own overbought condition, so there’s no guarantee that they will advance during a pullback in the small cap names., he said.
The bottom line? If both tech stocks and the small caps decline at the same time, it could cause “some problems for the overall market,” he noted.
The move on the Russell 2000 is bullish, but investors should be ready for a potential potential profit-taking/consolidation in the sessions ahead, according to Dan Wantrobski at Janney Montgomery Scott.
“The longer-term monthly chart on the Russell shows a better picture of its potential,” he noted. “We believe the Russell 2000 can trade back toward its all-time highs as mean reversion in relative strength highlights further bandwidth for the sector against this year’s leadership (tech/AI/Mag7).”
Wantrobski also pointed out that broader market breadth/participation has been improving since the CPI rally last week, with the NYSE cumulative A/D line now close to making new highs.
“The battle between the broader markets and 2024 leadership is set to continue over the short run in our view, as relative strength disparities between these groups show the potential for more rotation ahead,” Wantrobski said. “This cannot be confirmed as a long-term trend/investment theme at this time. So for now, we continue to treat this as a trading opportunity (mean reversion move).”
Craig Johnson at Piper Sandler says it is too early to determine whether a sustainable rotation can be maintained. More time and technical evidence are needed to confirm sustainable broadening participation that can lift the market higher is underway.
“The current (and long-awaited) broadening of equity gains is welcome, but elevated valuations will limit further market upside to low single digits overall for the remainder of the year,” said Robert Teeter at Silvercrest Asset Management.
The relative performance of the Nasdaq versus the Russell 2000 has been on a wild ride since 2020, with each besting the other by more than 40 percentage points over different one-year holding periods since the pandemic crisis, according to Nicholas Colas at DataTrek Research. Dramatic small cap outperformance has only occurred after a tech stock crash or when retail investors created a small-cap bubble, he said.
“Neither setup is relevant now. We believe the Nasdaq will outperform the Russell by its 2003–2019 average of two points over the next year,” he noted.
As for whether the S&P 500 or Russell 2000 will outperform over the rest of the year, his view is that both will now do equally well but not at the same time due to their low correlation.
“For the moment, small caps have the better momentum because money managers cannot afford to stay as underweight as they have been forced to be over the last 18 months,” Colas said. “Once their reweighting is done, the S&P should be able to play catch up.”
Corporate Highlights:
· Goldman Sachs Group Inc. and Wells Fargo & Co. are joining rival JPMorgan Chase & Co. in tapping the US investment-grade bond market after reporting second-quarter earnings.
· PNC Financial Services Group Inc. notched its first increase in net interest income since the end of 2022, setting itself up for what it expects to be a record year of NII growth in 2025.
· Microsoft Corp.’s investment into Inflection AI will get a full-blown UK antitrust probe, after the watchdog said it needed to take a closer look at the hiring of former employees from the artificial intelligence startup.
· Philip Morris International Inc.is expanding production of Zyn in the U.S. as the popular oral nicotine pouch becomes increasingly hard to find because of soaring demand.
· Starboard Value became the third activist investor this year to take a stake in Match Group Inc., the owner of the dating app Tinder whose paying customer base has shrunk for six straight quarters.
· Adidas AG raised its annual profit target for the second time in three months amid soaring demand for classic sneakers like the Samba and more sales from the shrinking stockpile of Yeezy footwear.
Key events this week:
· Eurozone CPI, Wednesday
· U.S. housing starts, industrial production, Wednesday
· Fed Beige Book, Wednesday
· Fed’s Thomas Barkin speaks, Wednesday
· ECB rate decision, Thursday
· U.S. initial jobless claims, Philadelphia Fed manufacturing, Conference Board LEI, Thursday
· Fed’s Mary Daly, Lorie Logan and Michelle Bowman speak, Thursday
· Fed’s John Williams, Raphael Bostic speak, Friday
Some of the main moves in markets:
Stocks
· The S&P 500 rose 0.6% as of 4 p.m. New York time
· The Nasdaq 100 was little changed
· The Dow Jones Industrial Average rose 1.8%
· The MSCI World Index rose 0.4%
· The Russell 2000 Index rose 3.5%
Currencies
· The Bloomberg Dollar Spot Index was little changed
· The euro was little changed at $1.0901
· The British pound was little changed at $1.2974
· The Japanese yen fell 0.2% to 158.39 per dollar
Cryptocurrencies
· Bitcoin rose 2.2% to $65,153.51
· Ether rose 1.1% to $3,474.43
Bonds
· The yield on 10-year Treasuries declined seven basis points to 4.16%
· Germany’s 10-year yield declined five basis points to 2.43%
· Britain’s 10-year yield declined five basis points to 4.05%
Commodities
· West Texas Intermediate crude fell 1.3% to $80.87 a barrel
· Spot gold rose 1.9% to $2,468.56 an ounce
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