The Fed, Trump, Biden…and a Violent Market Rotation

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The Fed has got more and more ammunition now to begin its rate cutting process. I could go into the litany of economic reports that are softening but suffice it to say it appears that Fed Chairman Powell simply speaking in "dovish" tones has been enough to have the desired effect?on interest rates, but now he has gotten the help of some economic indicators as well.

On top of this we have more drama in the US Presidential election process as Biden has dropped out of the race and is endorsing his VP. It is still yet to be seen if this is the person the party chooses, but I guess this will be even more election drama to deal with over the next few weeks.? The last point is that of the general market action. For the last couple of weeks, I have brought up the point of market breadth and a broadening of the market performers has in fact occurred. It appeared violent in that the fearless leaders, better known as the "Magnificent Seven" got firmly kicked in the shins and in a rather aggressive swap, the money appeared to move directly into the Small-Caps (Small-Cap companies are companies that have a market capitalization of under $2 Billion). This selloff in the leading technology stocks seemed to have exhausted itself come Monday of this week so now we wait to see if the Small and Mid can continue their ascent.?

In that Wall Street Journal last week, James Mackintosh penned an article, "The Momentum Stock Trade Falters." He says there are two basic explanations for the moves. The first is economic. A slowdown in inflation?means a greater chance of rate cuts, and that brings down bond yields. That's good for stocks that had been suffering from higher rates. These tend to be smaller companies that borrow from banks at floating rates rather than from the bond market. Cheaper financing is also good for struggling firms, which are usually value stocks. It should also be known that almost 40% of the Russell 2000 index are unprofitable companies. So, if the cost of capital declines smaller companies seem to benefit much more. It should also be noted that this broad group of smaller companies trades at a much cheaper valuation as compared to the S&P 500. This could also provide added fire power should this sleeping index come to life. Thomas Lee of FundStrat put out a great graphic showing this:

In looking at the relative price to book ratio of the Russell relative to the S&P and seeing what it did the last time these smaller companies got this cheap, a similar rotation could prove to be quite impressive indeed:

Historically, Small-Caps have outperformed during the early phases of slow easing cycles. The Russell 2000's 10.3% surge since the CPI report last week illustrates how beholden smaller companies are to the bond market and central bank policy.

Focusing a bit more on the increased easing visibility?from the Fed makes me take a look at what the broad market tends to do at the start of a Fed easing cycle. The stock market in general tends to rally once the Fed has cut, gaining an average of 14.5% in the year after the first rate cut. Although not all easing cycles are equal. The rally has actually been stronger when the Fed has moved slowly (four or fewer cuts in a year) than when it has cut quickly. Historically, the Fed has cut aggressively when there is a high level of concern of an impending recessionary slowdown whereas today it is appearing to be a case where the Fed is trying to “normalize”?rates after an overly aggressive tightening cycle. This Friday we will get another quite important economic indicator in the case of the PCE. So, we will stay tuned to this. Tying this together with the Small-Cap market advance, they tend to do well when the outlook on interest rates is such that the future for rates will be lower.?

The most recent time that the Russell 2000 had an increase was its rally of almost 30% last October, when the Fed stated that they were done raising rates. At the time, there was also a great amount of short selling going on in the Small-Caps due to expected earnings implosions. According to Thomas Lee, the huge difference this time is that not only is the same percentage of the Russell short, but we are probably going to experience a rate cut in short order. This, according to Lee, could mean an even more explosive move up by the small company group. He put together the chart below where he shows that this last week started very similar to the move that went from October to December of 2023, yet this one could have the true fuel of a cut to catalyze the move.?

Since 1978, the last 25 major moves higher in the Russell occurred within 10 weeks. What's interesting about such phenomena is the first 2 weeks of the move typically result in a?+9% gain. The current move originated a little over 8 days ago and has resulted in a?+10% gain. The next 8 weeks could complete the move higher by an additional?+17% on average. It's important to note that the last major move in the Index was still rooted in speculation that the Fed was finished raising rates. There have so far been 6 new inflation reports confirming lower inflation. So, we need to ask ourselves, in the last 25 times that the Russell has had this kind of a move, where does the current move stand in relation to what has normally happened? As can be seen below, this is only the 21rst best start of a move! Even though a 10% move in an index is a huge one in such a short time period, there could still be significantly more room to run.?

Bottom Line:

• We are seeing evidence that the market is rotating, rather than outright selling.
• General market breadth has remained quite supportive, as evidenced by advancers outpacing decliners at a healthy clip on these days.
• While Large-Cap tech selling will make a dent in the headline index level, this is purely a function of the weighting of these companies in the Index.
• And because we have seen other sectors outside of tech put up healthy returns in the wake of previous tech-driven profit taking sessions, we remain encouraged that the market can tread water at the index level, while generating gains in other segments of the market beneath the surface should we see tech leadership starting to cool.?
• Rotations have historically been the lifeblood of a healthy market as it allows leaders to rest and recharge their batteries while other sectors lead the charge.?
• What is important is that this selling of the Magnificent Seven has driven money into other parts of the market, the money hasn't simply gone into cash or bonds, which would indicate general market weakness.?

I will admit, after the Magnificent Seven leading in most all cases for so long, it does feel quite strange to have other, less well-known companies and indexes join the party. But in the end, this is the healthiest thing that could happen to a bull market- broadening of breadth. The move that is expected by Thomas Lee and his team is really quite a bold expectation on a percentage basis, but it must be remembered that the Russell 2000 is really not that large of a total financial value. If one were to sell every share of the market leader, Nvidia, this could purchase the entire Russell 2000 index.

Time will tell, but we have positioned ourselves appropriately, we believe. Should things change, we will be quick to adjust as well. Should you have any questions, please don’t hesitate to reach out.

-Ken South, Newport Beach Financial Advisor

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.

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The Standard & Poor's 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

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The Nasdaq-100 is a large-cap growth index. It includes 100 of the largest domestic and international non-financial companies listed on the Nasdaq Stock Market based on market capitalization.

The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

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