Rotation To Small-Cap From Tech Stocks Continues

With 136 S&P 500 companies reporting last week, the earnings season is 41% complete, and 78% have reported better-than-expected earnings for the quarter. The second-quarter earnings season enters its busiest reporting week, with 172 S&P 500 companies scheduled to report. A more detailed preview of the earnings season is available here. Among the companies scheduled include McDonald’s (MCD), Starbucks (SBUX), Microsoft (MSFT), Meta Platforms (META), Amazon.com (AMZN), Apple (AAPL), Chevron (CVX), Exxon Mobil (XOM), and Berkshire Hathaway (BRK/A, BRK/B).

The S&P 500 fell by 0.8% for the week. The Magnificent 7, consisting of Microsoft (MSFT), Meta Platforms (META), Amazon.com (AMZN), Apple (AAPL), NVIDIA
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(NVDA), Alphabet (GOOGL), and Tesla (TSLA), led the decline again with a loss of 3.9%. A deep dive into the characteristics of the Magnificent 7 is here. Tesla fell short of estimated earnings last week, but Alphabet’s earnings exceeded expectations. The worst laggards since July 9 has been Telsa (TSLA), taking over the spot after its poor earnings last week. Meta (META) and NVIDIA (NVDA) have the two highest expected year-over-year earnings growth rates and are the next two worst performers of Magnificent 7 since July 9.

The market rotation that began on July 9 continued with the mega-cap technology stocks falling despite better profit growth and weighing in the index while smaller companies outperformed. Small-cap stocks are 11.4% higher, while the Magnificent 7 and the S&P 500 declined by 10.9% and 2.1%, respectively. While not as strong as the smallest companies, midcap stocks have joined the rotation party with a 4.5% gain. The stock market’s breadth has markedly improved, with the average S&P 500 stock 2.2% higher since July 9 after the average stock lost value in the second quarter.

The less economically sensitive defensives slightly outperformed the more economically exposed cyclical stocks for the week. This move still looks more like a reversal in the spike of cyclical outperformance following the previous week’s rate-cut-friendly inflation report rather than a sign of impending economic woes. The outperformance of banks and small-cap stocks provides further evidence that this is not a sign of a rising risk of recession.

According to FactSet, several sectors, led by industrials and communication services, helped lift the earnings growth rate higher for the week. Higher-than-expected earnings from GE Aerospace (GE), Lockheed Martin (LMT), and RTX Corporation (RTX) were significant contributors within the industrials. Positive earnings surprises from Alphabet (GOOGL) and Comcast (CMCSA) drove the improvement for the communication services sector. These positive earnings surprises were p[partially offset by weakness in healthcare earnings. Earnings estimates were slashed for Vertex Pharmaceuticals (VRTX) relating to the accounting treatment of its acquisition of Alpine Immune Sciences.

Sales growth is closely tied to nominal GDP growth, combining after-inflation economic growth (real GDP) with inflation. Last week’s GDP report showed nominal GDP growth accelerating to 5.8% year-over-year for the second quarter, providing a tailwind to topline revenue growth for companies. At this point in the earnings season, sales growth has exceeded expectations.

So far, the blended earnings performance has outperformed expectations at the end of the quarter. Combining actual results with consensus estimates for companies yet to report, the blended earnings growth rate for the quarter improved to +9.8% year-over-year, above the expectation of +8.9% at the end of the quarter.

The second-quarter GDP report showed 2.8% annualized growth for the U.S. economy, which was well above the consensus of 1.9%.

Domestic demand looks robust, excluding the more volatile components of inventories and net exports. Real final sales to private domestic purchasers, which measures private demand in the domestic economy, remained healthy at 2.6 percent in the second quarter, continuing at the same pace as the first quarter.

The solid second-quarter GDP report should not lead to any concerns about economic growth, and the inflation component should provide some relief after the spike in the first quarter. The pace of inflation measured by the Federal Reserve’s preferred measure, core PCE, decelerated to 2.9% from 3.7% quarter-over-quarter annualized.

The Fed should make no rate changes at Wednesday’s meeting, but Chair Powell should provide hints that cuts could begin soon. The normalization of the job market and reinforcement of the better inflation trends make a September start to Federal Reserve rate cuts the most likely scenario. In addition, Friday’s monthly jobs report remains crucial as a softening of the job market is vital to cuts beginning in September. The total rate cuts expected in 2024 are between two and three, leaving room for three successive 25 basis point (0.25%) cuts in September, November, and December.

The earnings season kicks off its busiest week, with four of the Magnificent 7, Microsoft (MSFT), Meta Platforms (META), Amazon.com (AMZN), and Apple (AAPL), reporting earnings. While Wednesday’s Fed meeting won’t feature any rate cuts, markets will be disappointed if Chair Powell doesn’t provide some foreshadowing that the easing cycle could begin soon. Friday’s monthly jobs report caps the week with critical inflation about the health of the job market since it would be more challenging for the Fed to begin cutting rates with economic growth remaining solid unless the labor market continues to soften.