Closing Market Update

Small Caps Again Lead the Way as Rotation Continues

July 15, 2024 Joe Mazzola
Rotation out of tech and into cyclical and small-cap stocks amid rate cut hopes continued, and stocks gained despite late selling. Volatility rose after the tragic weekend shooting.

Published as of: July 15, 2024, 4:40 p.m. ET 

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(Monday market close) Last week's healthier theme continued Monday amid fresh signs of the rally broadening, not depending on a few highly capitalized names while everyone else hunkers down. Major indexes advanced, led by small caps, but ran into late selling pressure similar to Friday.

Remarks by Federal Reserve Chairman Jerome Powell at midday sounded somewhat encouraging, with Powell indicating the Fed won't wait until inflation falls all the way to its 2% target to cut rates. He was mum, however, on the timing of a cut.

"During Chair Powell's Q&A, he reiterated that the economy continues to be strong, and inflation is trending toward the Fed’s 2% goal, but the Fed will take it slow on the timing of rate cuts," said Cooper Howard, director of fixed income strategy at the Schwab Center for Financial Research. "The Fed's dual mandate has come into better balance, which means the path of the labor market will gain greater importance. We expect the first of a series of rate cuts this year to begin in September. Odds of a September rate cut are near 100%."

Besides rate cuts and the broadening rally, lots of discussion today centered on the dynamics of the tragic events over the weekend and how that affects the election odds. Earnings also play a key role in coming days, competing with the Republican convention and other outside news for investor attention.

Banks dominate this week's earnings calendar but are joined by other heavy hitters including Johnson & Johnson (JNJ), United Airlines (UAL), UnitedHealth (UNH), and American Express (AXP). Info tech earnings are thin, but Taiwan Semiconductor (TSM) on Thursday is an important one to watch for chip market investors. ASML (ASML), a company that manufactures machines used for chip-making, is worth a look for signs of underlying industry demand when it reports Wednesday.

Here's where the major benchmarks ended:

  • The S&P 500® index (SPX) rose 15.87 points (0.28%) to 5,631.22; the Dow Jones Industrial Average® ($DJI) climbed 210.82 points (0.53%) to 40,211.72, a new record-high close; the Nasdaq Composite® ($COMP) added 74.12 points (0.4%) to 18,472.57. 
  • The 10-year Treasury note yield (TNX) gained four basis points to just below 4.23%.
  • The Cboe Volatility Index® (VIX) increased to 13.14, its highest close since June 24.

Read all our market commentary on our Insights & Education page, and you can follow us at @SchwabResearch.

Read all our market commentary on our Insights & Education page, and you can follow us at @SchwabResearch.

Stocks on the move

By late Monday, the session's leading sectors on the S&P 500 were all cyclical ones like energy, financials, and industrials, which tend to perform well when the economy grows. Communication services and info tech, the first-half leaders, fell into the middle of the pack. 

In fact, communication services, a sector that includes notable names like Alphabet (GOOGL) and Meta Platforms (META), is by far the worst-performing sector over the last week, down more than 2%. Both companies report earnings next week. Info tech is also lower over the last week.

Meanwhile, money pours into small caps. The percentage of names trading above their respective 50-day moving averages in the small-cap Russell 2000® (RUT) reached 69% early this week, up from 39% a week ago. That's a dramatic weekly increase for an index that was basically ignored most of the year's first half. 

Small-cap strength sometimes reflects more optimism about the U.S. economy, as their sales often have less international exposure compared with larger companies. Lower borrowing costs also typically help smaller firms that rely more on debt. The RUT rose nearly 2% Monday and is up nearly 8% from a week ago. At its intraday peak Monday, the RUT reached its highest level since January 2022.

Recent cooling U.S. inflation data that led to rate cuts hopes sent Treasury yields to four-month lows and led to the sector rotation currently underway. Still, tech results stand out this earnings season considering how much that sector has supported the overall market and the strong expectations going in. Any signs of disappointing or slowing growth from the biggest players could chip away at sentiment, which right now is extraordinarily bullish.

The following companies had stock price moves driven by analyst ratings, quarterly earnings, or other news:

  • Tesla (TSLA) rose 1.8% following a USA Today report that Tesla's Cybertruck outsold Ford's (F) F-150 Lightning in the second quarter. 
  • Apple (AAPL) added 1.7% following an upgrade from Loop Capital (LOOP) to buy from hold with a $300 price target. The firm had positive comments on AAPL's AI initiatives.
  • Ralph Lauren (RL) dropped nearly 6% amid continued softness in the luxury market. The weakness came as London-listed shares of Burberry (BURBY) dropped 16% on news it was replacing its CEO and halting dividend payments amid falling profits. Weak consumer demand from China is hurting luxury sales in general, according to Barron's.
  • Goldman Sachs (GS) gained 2.5% after exceeding analysts' earnings and revenue expectations. Strong fixed income trading as Wall Street action picked up last quarter helped Goldman and other large banks.
  • Macy's (M) fell almost 12% after the department store confirmed its ending buyout talks with Arkhouse Management and Brigade Capital Management, media reports said.

From a technical perspective, the SPX is overbought, possibly setting it up for consolidation if prices keep rising. This would arguably be positive, and last week's rotation out of tech and into value and cyclical sectors was quite positive because it eased the market's top-heavy nature. Late day selling both Friday and Monday could be a sign of investor exhaustion that's sometimes seen when the market continually makes new highs. The SPX finished more than 35 points below its intraday high. This is a pattern worth watching.

The Relative Strength Indicator (RSI)for the Nasdaq Composite, a measure of market momentum, dropped to 67 by late last week, below the 70 level typically thought of as overbought. At the same time, the RSI for the small-cap RUT index rose to 75 from 48 in just a week, a dramatic move.

Earnings resume early tomorrow as Bank of America (BAC) and Morgan Stanley (MS) become the latest U.S. investment banking firms to report. Several major regional banks post earnings in the coming days as well, and about 60% of all regional banks report this week.

A 21% jump in investment-banking fees driven by higher debt underwriting gave Goldman Sachs' earnings some extra power. Its quarterly earnings per share (EPS) beat the average Wall Street estimate by $0.27. Revenues rose 16.8% year over year to $12.73 billion, above the $12.35 billion consensus from FactSet. The increase in debt underwriting could be read as a sign of overall economic strength because it reflects companies seeking help from banks to raise capital.

UnitedHealth's (UNH) earnings tomorrow put the focus squarely on UNH's medical cost ratio (MCR), or the amount of every premium dollar going toward medical costs. A lower number indicates better profitability. The figure was 84.3% for UNH in its prior quarter. That was down slightly, which is a positive sign as the company and health insurance industry grapples with rising costs. 

Climbing the yield curve ladder as rate cuts eyed

Yield curve steepening, which began last week as shorter-term Treasury yields fell on growing hopes of a Federal Reserve rate cut, extended into the new week. Longer-term yields went the opposite way, rising in what some analysts said could be a reaction to market perception of Republican strength as the election nears. 

The best-known indicator of yield spreads is the 10/2, which focuses on the divergence between 10-year and 2-year Treasury note yields. It's been "inverted" for well over a year, meaning the 2-year yield holds a premium to the 10-year yield. Historically, longer-dated Treasuries have higher yields than shorter-dated ones. At times, the yield of the 2-year outweighed the 10-year yield by 100 basis points or more. Well, it's down to 23 basis points now, the lowest since early this year. 

"We expect the yield curve to continue to dis-invert led by lower short-term yields as the Fed begins to cut rates," Schwab's Howard said. "For investors who have been waiting on the sidelines in cash, we think there's still an opportunity to extend duration but it's fleeting."

Data this week with potential yield curve impact include tomorrow's June retail sales and import and export prices, along with Wednesday's Industrial Production report.

For retail sales, due at 8:30 a.m. CT Tuesday, analysts expect a flat reading following May's 0.1% increase, according to Trading Economics. Excluding autos, analysts expect retail sales to rise 0.1%, up from –0.1% in May. 

Import and export prices typically don't have much influence on trading, but with so much focus now on the inflation picture, they've grown in stature. Both fell moderately in May, and the June readings are due at the same time as retail sales tomorrow.

Despite some talk about a possible July rate cut, the market continues to price in virtually no chance of that at less than 10%, according to the CME FedWatch Tool. Investors place odds at 100% that rates will fall at least 25 basis points by the September Federal Open Market Committee (FOMC) meeting.

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