(Bloomberg) Stocks hit record highs as investors expected the Federal Reserve would soon start cutting interest rates, driving capital into riskier parts of the market.
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Wall Street has continued its pattern of moving money into small caps and out of the “safe haven” large caps following weak inflation data last week. Over the past four sessions, the Russell 2000 has outperformed the Nasdaq 100 by nearly 12 percentage points, the first time that has been the case since 2011. An equal-weighted version of the S&P 500, where companies like Nvidia Corp. share the same weighting as Dollar Tree Inc., has outperformed the U.S. stock benchmark, offering hope that the rally could extend because the index is less dependent on the profits of large companies.
“The rotation is what’s important,” said Andrew Brenner of NatAlliance Securities. “This coincides with the growing perception of interest rate cuts.”
Brenner highlighted the fact that around 4 a.m. New York time, Russell 2000 futures surged while Nasdaq 100 futures fell. “This means that overseas funds, large cap funds, did a very large rotational trade overnight,” he said.
Solita Marcelli of UBS Global Wealth Management believes that if the Fed can deliver significant rate cuts in the context of a soft landing, it could brighten the outlook for earnings growth to pick up again in lower-quality, cyclical segments of the market. Another reason for the rise in small-company stocks is that smaller companies tend to be domestically oriented and would be seen as “disproportionately” benefiting from a Donald Trump election, said Jose Torres of Interactive Brokers.
The S&P 500 rose to 5,667, its 38th highest close this year. The Dow Jones Industrial Average rose 1.85%. The Russell 2000 rose 3.5%, its biggest five-day gain since 2020. The Nasdaq 100 was little changed. The 10-year U.S. Treasury yield fell 7 basis points to 4.16%. Gold hit a record high.
Traders also scrutinized earnings. Bank of America Corp. gave a better-than-expected outlook for net interest income. Traders at Morgan Stanley joined the Wall Street party in the second quarter even as its larger asset-management business missed expectations. Charles Schwab & Co. warned it needs to downsize to protect profits.
While the broadening rally in U.S. stocks is seen as a positive sign, the surge in small-cap stocks in such a short period of time is a sign of overheating: In just five days, the Russell 2000 has risen nearly 12%, hitting its most overbought level since 2017.
“Today, the Russell 2000 Index made history by closing 4.4 standard deviations above its 50-day moving average,” Bespoke Investment Group said. “No other major U.S. index has ever seen such an extreme closing price (the Dow since 1900, the S&P 500 since 1928, or the Nasdaq since 1971).”
Miller Tabak’s Matt Murray said the stock index has reached an overbought state that has seen it trend lower for the past two years.
“So this could signal that it’s time for the small-cap sector to take a breather in the short term,” he said. “At the very least, investors should be cautious about chasing these stocks in the short term.”
If that happens, he said, it will be interesting to see whether the “rotation” moves reverse.Tech stocks are trying to get out of overbought conditions, so there’s no guarantee they’ll rise while small-cap stocks fall, he said.
After all, if both tech and small-cap stocks were to fall at the same time, it could cause “some problems across the market,” he noted.
Dan Wantrobski of Janney Montgomery Scott said the Russell 2000 Index’s performance is bullish, but investors should prepare for possible profit-taking and consolidation in coming sessions.
“The long-term monthly chart of the Russell gives a better picture of its potential,” he noted. “We believe the Russell 2000 can trade back towards all-time highs as mean reversion of relative strength highlights the sector’s further room for leadership (Tech/AI/Mag7) this year.”
Wantrobski also noted that broader market breadth and participation has improved since last week’s CPI increase.
“We believe the battle between the broader market and 2024 leaders will continue in the near term as the relative strength differences between these groups indicate the possibility of further rotation going forward,” Wandrobski said. “At this point, we are unable to confirm this as a long-term trend/investment theme, so for now we will continue to treat this as a trading opportunity (mean reversion move).”
Piper Sandler’s Craig Johnson said it’s too early to tell if the rotation can be sustained: “We need more time and technical evidence to be sure that a sustainable expansion in participation that will lift the market is underway.”
“While the current (and much-needed) extension of the equity rally is welcome, rising valuations will likely limit further market gains overall to low single digits for the remainder of the year,” said Robert Teeter of SilverCrest Asset Management.
For RBC Capital Markets’ Lori Calvasina, earnings season will be a “key test” for the rotation trade, adding that valuations and positioning are poised for an eventual transition to new management, but there have been some missteps.
The relative performance of the Nasdaq and Russell 2000 has fluctuated wildly since 2020, with each outperforming the other by more than 40 percentage points over various one-year holding periods since the pandemic crisis, according to Nicholas Colas of DataTrek Research. Dramatic outperformance of small caps has only occurred after tech stocks crashed or after retail investors created a small-cap bubble, he said.
“Either setting is irrelevant now. Over the next 12 months, we expect the Nasdaq to beat the Russell by 2 percentage points above its 2003-2019 average,” he noted.
As for whether the S&P 500 or the Russell 2000 will perform better for the rest of the year, he believes that both indexes will perform equally well so far, but not at the same time due to their low correlation.
“For now, small caps are outperforming because money managers can’t afford to remain underweight them as they have been for the last 18 months,” Colas said. “Once the small cap reweighting is over, the S&P should be able to catch up.”
The S&P 500 had gone 351 sessions into Tuesday without a 2% drop. If the index reaches 352 by Wednesday’s close, it would be its longest period of decline since the start of the global financial crisis in 2007. The index had not experienced such a decline in about 950 sessions between May 2003 and February 2007.
The stock market’s strength is being buoyed by optimism that the economy has withstood the worst of the Fed’s tightening. In that respect, Tuesday’s better-than-expected retail sales figure is a “healthy” development, eToro’s Brett Kenwell said. It’s better for the Fed to cut interest rates in response to falling inflation than to rush to shore up a weakened economy, he said.
The Dow Jones Industrial Average also had a “great day” on hopes of interest rate cuts, tax cuts and deregulation, according to Chris Zaccarelli of Independent Advisor Alliance, who also cited hopes that the market rally will spread from a narrow focus on technology stocks to “a variety of companies.”
Company Highlights:
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After reporting second-quarter results, Goldman Sachs Group Inc. and Wells Fargo & Co. followed rival JPMorgan Chase & Co. in making inroads in the U.S. investment-grade bond market.
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PNC Financial Services Group Inc. expects its net interest income to increase for the first time since the end of 2022 and to record its highest ever growth in net interest income in 2025.
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Microsoft’s investment in Inflection AI is facing a full investigation in the UK after the UK’s antitrust regulator said it needed to look more closely at the artificial intelligence startup’s hiring of former employees.
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Philip Morris International Inc. is expanding production of Zyn in the United States as a surge in demand for the popular oral nicotine pouches makes them hard to find.
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Starboard Value has become the third activist investor this year to take a stake in Match Group, owner of dating app Tinder, whose paying customer base has shrunk for six consecutive quarters.
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Adidas AG raised its annual profit target for the second time in three months as sales continue to rise due to surging demand for classic sneakers such as the Samba and dwindling inventories of Yeezy shoes.
Major events this week:
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Eurozone Consumer Price Index, Wednesday
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US housing starts, industrial production Wednesday
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Fed Beige Book, Wednesday
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Fed President Thomas Barkin to speak Wednesday
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ECB interest rate decision Thursday
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US initial jobless claims, Philadelphia Fed manufacturing index, Conference Board LEI, Thursday
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Federal Reserve Board members Mary Daly, Laurie Logan and Michelle Bowman to speak Thursday
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Fed’s John Williams and Raphael Bostic to speak on Friday
Some of the key market developments:
stock
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The S&P 500 was up 0.6% as of 4 p.m. New York time.
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The Nasdaq 100 index was little changed
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The Dow Jones Industrial Average rose 1.85%.
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The MSCI World Index rose 0.4%.
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The Russell 2000 Index rose 3.5%.
currency
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The Bloomberg Dollar Spot Index was little changed.
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The euro was little changed at $1.0901
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The British pound was little changed at 1.2974 to the dollar
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The Japanese yen weakened 0.2% to 158.39 yen to the dollar.
Cryptocurrency
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Bitcoin rose 2.2% to $65,153.51.
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Ether rose 1.1% to $3,474.43.
Bonds
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The yield on the 10-year Treasury note fell 7 basis points to 4.16%.
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German 10-year bund yields fell 5 basis points to 2.43%.
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UK 10-year government bond yields fell 5 basis points to 4.05%.
merchandise
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West Texas Intermediate crude fell 1.3% to $80.87 a barrel.
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Spot gold rose 1.9% to $2,468.56 an ounce.
This story was produced with assistance from Bloomberg Automation.
–With assistance from Lu Wang, Esha Dey, Jessica Menton, and Sophie Caronello.
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