Are Markets Peaking?

Will the Small Cap Stampede Continue?

KR Opinion

The recent surge in the small-cap asset class is impossible to ignore. Over the last several days, we've seen it move from essentially unchanged for the year to a gain of over 11%.. This stampede is astonishing, as traders and the FOMO (Fear Of Missing Out) mentality drive them to pay virtually any price to avoid being left behind.

 One significant advantage of being a quant for several decades is the ability to focus on data rather than emotions. Despite small caps lagging significantly earlier this year, our wave tech models identified the beginnings of this trend back in November of last year.

Throughout this year, we've faced various crises, from banking issues to CRE, and I've discussed in great detail the continued presence of zombie companies within the Russell Index. Despite this, market participants are now eagerly buying everything resembling IWM (iShares Russell 2000 ETF), contrary to the market sentiment of rising employment numbers and an impending economic slowdown.

I have advocated for the small-cap sector for years, especially during mature market cycles. The trend, arguably in early 2023, saw the market bottom slightly before January, followed by a brief retracement in October and a significant rally this year. Algorithms suggest that this trend may continue, extending into September, October, and possibly beyond.

However, many traders' dilemma lies in the timing of their investments in small caps. While substantial moves are happening within the indexes, individual stocks also show significant activity. Small caps, typically represented by the Russell 2000 and Russell 3000, often provide a more accurate view of the economy.

Reflecting on the paradigm shift discussed in yesterday's commentary, we'll likely see more of this trend. With expectations of a pro-business environment under potential future political scenarios, such as making the 2017 tax cuts permanent, sentiment towards small caps may continue to rise. This shift aligns with my earlier discussions about yield curve restructuring in 2025 and the anticipated productivity gains from AI implementation.

AI's impact on smaller and mid-sized companies will likely drive significant productivity improvements, making businesses more efficient and financially robust. This innovation, crucial for long-term economic opportunities, often occurs in smaller companies. However, these companies face challenges such as limited access to credit compared to larger firms, making interest rates a critical factor.

As we navigate the next few weeks, I plan to develop a theme around this emerging paradigm shift in the United States and globally. Considering the potential for consolidation after such a significant rally is crucial, as it will set the tone for future market movements.

This paradigm shift goes beyond just market movements. It encompasses broader economic and technological changes that reshape businesses' operations and growth. With the rise of AI and its integration into various sectors, I expect to create massive productivity gains. Smaller companies, often at the forefront of innovation, are poised to benefit significantly from these advancements.

The small-cap sector, which includes technology, healthcare, and biotech companies, is vital for driving innovation. These companies often lead the development of new technologies and medical advancements, contributing to long-term economic growth. However, their limited access to credit and financing compared to larger companies makes them more vulnerable to interest rate fluctuations.

The recent rally in small caps indicates a shift in market sentiment and expectations about the economy's future. With potential changes in tax policies and other economic reforms, we could see a more favorable environment for these companies. This shift is not just about short-term gains but represents a fundamental change in how the economy operates and grows.

The graphic below shows that the wave tech models had repurchased the IWM in November and are up about 25% already. Virtually half of the gain has been in the last five sessions, but the trend is still very much intact. Some seem concerned about whether we'll make it to all-time highs, and the algorithms forecast that this is likely. My 2024 outlook suggested that the small-cap sector would explode in 2025 and 2026, driven by the AI revolution and the resulting productivity gains.

The prominent players in the market have already embraced AI and are reaping the benefits. However, the actual productivity boost will come from smaller and mid-sized companies integrating AI into their operations. This will make these companies more competitive and efficient, helping to drive overall economic growth.

Looking at the broader picture, the small-cap sector's performance reflects the economy's health and prospects. These companies are often more agile and innovative, making them better positioned to capitalize on new technologies and market trends. As such, the current rally in small caps suggests investors are optimistic about the future, expecting significant economic growth driven by technological advancements and favorable economic policies.

In conclusion, we are witnessing a profound shift from the trends that began in early 2023. These shifts can lead to a multi-year bull market driven by AI productivity, economic reconfiguration, and favorable tax policies. While some may argue that the market is overbought, I believe we are entering a new era, a hypothesis I outlined in my annual report. I will share this report on Twitter so that all can see and revisit these ideas that continue to shape my market outlook.

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Looking Back on Tuesday’s Action

The Dow Jones Industrial Average surged by 1.9% today, gaining more than 700 points and moving further into record territory. The S&P 500 also hit another record high, closing with a 0.6% gain. Meanwhile, the Russell 2000 jumped 3.5%, continuing its recent outperformance.

With today's gain, the Russell 2000 is up 10.6% since the start of July. Over the same period, the S&P 500 and Nasdaq Composite have increased by 3.8% and 4.4%, respectively.

Today's trading continued the broadening trend observed in recent sessions, driven by momentum and a drop in market rates. The 10-year note yield settled at 4.17%, down six basis points from yesterday, while the 2-year note yield settled at 4.44%, down one basis point from yesterday.

Losses in the mega-cap space limited the gains for the major indices. Notable losers included NVIDIA (NVDA 126.36, -2.08, -1.6%), Meta Platforms (META 489.79, -6.37, -1.3%), and Microsoft (MSFT 449.52, -4.44, -1.0%).

Despite this, buying activity was robust elsewhere. The equal-weighted S&P 500 registered a 1.7% gain. Advancers outnumbered decliners by a 4-to-1 margin at the NYSE and a 7-to-2 margin at the Nasdaq.

Positive earnings news also supported today's upside bias. Dow component UnitedHealth (UNH 548.87, +33.50, +6.5%) posted a sharp gain following its earnings report.

In the financial sector, Bank of America (BAC 44.13, +2.24, +5.4%) and PNC Financials (PNC 176.98, +7.96, +4.7%) were top performers following pleasing earnings reports. Morgan Stanley (MS 106.22, +0.96, +0.9%) also posted an earnings-related gain.

Six other sectors jumped at least 1.0% today in addition to the financial sector. The industrial sector (+2.5%) registered the most significant gain by a considerable margin, followed by materials (+2.0%). The heavily weighted information technology (-0.4%) and communication services (-0.6%) sectors were the only ones to close in negative territory.

• Nasdaq Composite: +23.3% YTD

• S&P 500: +18.8% YTD

• S&P Midcap 400: +12.0% YTD

• Russell 2000: +11.7% YTD

• Dow Jones Industrial Average: +8.7% YTD

Reviewing today's economic data:

- June Retail Sales: 0.0% (KR Forecast consensus -0.1%); Prior was revised to 0.3% from 0.1%. June retail sales ex-auto were 0.4% (KR forecast consensus 0.2%); prior sales were revised to 0.1% from -0.1%.

  The key takeaway from the report is that it conveyed some rather solid levels of discretionary spending on goods in June, which belies any hard landing tracking for the economy.

- June Import Prices: 0.0%; Prior was revised to -0.3% from -0.4%.

- June Import Prices ex-oil: 0.2%; Prior -0.3%.

- June Export Prices: -0.5%; Prior was revised to -0.7% from -0.6%.

- June Export Prices ex-ag.: -0.6%; Prior -0.8%.

- May Business Inventories: 0.5% (KR Forecast consensus 0.3%); Prior 0.3%.

- July NAHB Housing Market Index: 42 (KR Forecast consensus 44); Prior 43.

Wednesday Economic Releases:

- 7:00 ET: Weekly MBA Mortgage Index (prior -0.2%).

- 8:30 ET: June Housing Starts (KR Forecast consensus 1.310 million; prior 1.277 million) and Building Permits (KR Forecast consensus 1.391 million; prior 1.386 million).

- 9:15 ET: June Industrial Production (KR Forecast consensus 0.3%; prior 0.9%) and Capacity Utilization (KR Forecast consensus 78.6%; prior 78.7%).

- 10:30 ET: Weekly crude oil inventories (prior -3.44 million).

WaveTech Database

Once again, we are witnessing strong market movements. The bullish percent on the short-term models has increased to 70.44%, indicating a robust upward trend. Notably, there were 7,132 new entries and only 96 exits, reflecting significant market participation.

We are currently in 10 sectors. The graphic below shows that every sector is profitable, with only two sectors out of play at this moment. The sectors we invest in include basic materials, conglomerates, non-cyclical consumers, financial companies, healthcare companies, services, technology, transportation, and utilities.

Most of these trades have been initiated over the past three days, indicating a stronger market rotation. This aligns with our earlier discussions that such movements would continue the current trend.

S&P 500

Over the past several days, I have discussed that we are likely to start some sort of move down to test the 10-day moving average, which is currently at 5654. Overnight, we're seeing a fair amount of weakness after yesterday's move into an all-time high (ATH) once again.

We're finally seeing some response overnight, and I expect we will test this 5654 level.