After a 4% surge higher during the first half of July, The S&P 500 rolled over during the last half. Mega Cap tech rolled over a week earlier and took the brunt of the damage with a peak to end of month drawdown nearly 10%.
The S&P 500 still closed the month with a 1% gain, while the NASDAQ shed close to 1%. The DOW and S&P 500 equal weight (RSP) gained over 3%, while small caps (IWM) rallied 7.5%. Value advanced 3% on the month while bonds rallied over 2%. Foreign stocks (CWI) outperformed the U.S. with a 2% gain.
WHAT MOVED THE MARKETS
There was a sizable rotation halfway through the month which notably shifted investor positioning. June inflation data came in much softer than expectations. In fact, inflation declined month over month (the first such decline in three years). This sets the stage nicely for a
September Fed rate cut. Growth stocks sold off on the news, and small caps ripped higher.
Investors also appeared to become impatient with the AI-related spend. While the spend on AI is notably huge, the monetization of said spend remains uncertain. The high-flying tech stocks sold off hard on this perceived impatience, and most of the money had begun to shift to small caps and other cyclical/value-oriented areas of the market.
The softer inflation data that supports the end of the rate hike cycle and pulls forward the beginning of an easing cycle theoretically benefits smaller companies more, as they are much more dependent on borrowing, thus impacted by higher (or lower) rates to a much greater extent than mega cap companies. This seems to be the reason that small caps rallied when mega caps sold off, particularly when rate cuts are predicated on inflation normalizing as opposed to rates being cut to relieve a quickly deteriorating economy. Second quarter GDP came in at over 2% – much higher than expectations, implying that economic output continues to grow.
With the substantial weighting of mega cap stocks in the broad market indexes, it was no surprise to us that the S&P 500 and the NASDAQ encountered declines during the back half of the month as tech was sold off, while small caps handily outperformed. Plus, with the advance of RSP equal weight, upside participation is broadening out to more members beyond the Magnificent 7. The concentration of the market that has led the index higher is not normal nor healthy, so a broadening out is a welcome sign that companies outside of tech are expected to see their earnings grow.
Furthermore, as earnings growth typically supports higher stock prices, small caps appear to have turned a corner from the prior five quarters of flat to negative earnings growth as the street expects small caps earnings to grow over the upcoming quarters, while at the same time Mega cap tech stocks earnings are expected to decelerate in the upcoming quarters given the AI spend. As such, the rotation on paper makes sense to us.
Finally, to close the month, the Federal Reserve held its open market committee meeting, at which they kept rates steady. There was a more dovish tone to Powell’s press conference, declaring that they are now equally watching the labor market and inflation, implying acknowledgement of a weakening labor force. This sets up a higher probability that they will cut rates at their next meeting in September, providing much needed (and hopefully not too late) relief to the lending markets.
PORTFOLIO POSITIONING
We entered July with a substantial position in mega cap growth and participated from what appears to be a blow off top as the market peaked on July 10th . Over the ensuing sessions, as tech was sold off and small caps rallied, our process began to unwind the large position in QQQ starting on July 18th . The first three sizable reductions from QQQ occurred within 4% off its all-time high reached on July 10 th . Subsequent reductions occurred a little farther down, but each trade resulted in taking profit from the significant run up in QQQ over the prior year. By the end of the month, our exposure to QQQ was systematically reduced from being 65% of the equity sleeve to around 20%, a pretty quick reduction in risk.
Proceeds from the QQQ trims during the month were allocated to small caps, large cap value, as well as the S&P 500. Such moves had the effect of reducing the risk and volatility of the portfolios due to mega cap growth exhibiting characteristics of being up AND down more than the broad market. The ideal relative strength relationship is up more/down less, and as the month unfolded the characteristics of value were decidedly responding in a down less mode. Thus, compressing the standard deviation of the portfolio can be viewed as a risk reduction measure as the market exhibited heightened volatility and the future became more uncertain.
Unfortunately, as the selling pressure accelerated into the end of the month, the once high-flying small caps also succumbed to the market’s skittishness. As a result, leaning into small caps was a detractor in stabilizing the portfolios, and didn’t help reduce the overall risk profile. Small caps should require not just a rate cut to sustain their ascent, but also a strong economy. The worse than expected jobless claims data put the strength of the economy into question and impacted small companies in an adverse manner. We will likely lean out of small caps in the upcoming weeks should this trend reversal continue.
LOOKING AHEAD
As we look ahead and recognize we have entered a seasonally weak period as well as a more uncertain future given the recent change in investor sentiment, unemployment trends, and other company confirmed signs of a struggling consumer being more discerning in their purchases, the attendant risks in the stock market have increased.
We are not concerned about the recent volatility, as drawdowns are still within range of normal pullbacks in the market, which normally happen a couple of times a year. However, acknowledging a more uncertain immediate-term future which will likely lead to heightened volatility, we find comfort in how quickly we have repositioned the portfolio to areas of the market that are historically lower risk.
As of now, recent data only suggests a temporary slowdown and not an imminent recession and a spiraling stock market. However, should the market deteriorate further we are well prepared to move money to the sidelines to preserve principle if a more sustained down trend evolves. In our experience, our process generally does not start raising cash until the markets have experienced the 10% plus decline. We are not quite there yet but should this occur, we will respond accordingly. For now, we continue to be fully invested but in a lower overall risk profile than where we when the market peaked on July 10th .
Periods of dramatic trend changes like we experienced in July often briefly throw us out of sync as we adjust to inter market rotations. Just as we outperformed our benchmarks while the Q’s were surging, we lagged our benchmarks on the unwind. We are positioned now to relieve some of the anticipated volatility as the market adjusts to a period of greater uncertainty. We are not of the opinion that the market will decline significantly but reducing exposure to the worst performing areas of the market provides some insulation from further drawdowns. As rates decline, earnings should improve, particularly in those sectors that are likely to play catch up. At the same time, if earnings decelerate in tech, then the market will likely find more opportunity in other areas where earnings are expected to grow faster, which is where we find ourselves positioned to end the month.
Of course, if and when growth and tech begin to show outperformance, and volatility abates, we will likely return when appropriate relative strength once again favors growth stocks. For now, we will continue to monitor the market and position your risk assets in a prudent manner as we navigate through cloudy skies.
Be well.
