(Bloomberg) — Stocks hit record highs as bets that the Federal Reserve would soon begin cutting rates fueled a rush into the riskiest parts of the market.
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Since last week’s inflation data, Wall Street has extended its capital rotation into small caps and outflow from mega caps, a trend that has continued. Over the past four sessions, the Russell 2000 has beaten the Nasdaq 100 by nearly 12 percentage points, a feat not seen since 2011. An equal-weighted version of the S&P 500, in which companies like Nvidia Corp. are equal in weight to Dollar Tree Inc., has outperformed the benchmark index of U.S. stocks. That index is less sensitive to gains in larger companies, raising hopes for a broader rally.
“Rotation is the name of the game,” said Andrew Brenner of NatAlliance Securities. “This is consistent with the growing perception of a rate cut.”
Brenner pointed to the fact that around 4 a.m. New York time, Russell 2000 futures soared, while Nasdaq 100 futures fell. “That means foreign money, big money, did a very big rotation overnight,” he said.
Solita Marcelli of UBS Global Wealth Management said that if the Federal Reserve can cut rates significantly amid a soft landing, the outlook for further acceleration in earnings growth for lower-quality and cyclical segments of the market would be brighter. Jose Torres at Interactive Brokers cited another possible reason for the recovery in smaller companies: They tend to be domestically oriented and are seen as benefiting “disproportionately” from a Donald Trump election victory.
The S&P 500 index climbed to 5,667 points, its 38th record this year. The Dow Jones Industrial Average climbed 1.85%. The Russell 2000 gained 3.5%, its biggest five-day gain since 2020. The Nasdaq 100 was little changed. U.S. 10-year yields fell seven basis points to 4.16%. Gold hit a record high.
Traders also looked at financial results. Bank of America Corp. reported a better-than-expected forecast for net interest income. Morgan Stanley traders joined the party on Wall Street in the second quarter, even though the company’s wealth management division missed expectations. Charles Schwab Corp. warned it will have to cut staff to protect profits.
While the broadening of the rally in U.S. stocks is seen as a positive sign, the surge in small caps in such a short period of time is showing signs of overheating. In just five days, the Russell 2000 has jumped nearly 12%, reaching the highest overbought level since 2017.
“A historic milestone was reached today as the Russell 2000 closed 4.4 standard deviations above its 50-day moving average,” according to Bespoke Investment Group. “No other major U.S. index (Dow since 1900, S&P 500 since 1928, and Nasdaq since 1971) has ever closed at such an extreme level.”
Miller Tabak’s Matt Maley says the indicator has reached the type of overbought condition that has been followed by declines over the past two years.
“So this could indicate that the small-cap sector is due for some sort of short-term respite,” he noted. “At the very least, investors should be cautious when looking for these stocks in the short term.”
In that case, it will be interesting to see if the “rotation” reverses. Tech stocks are coming out of their own overbought situation, so there’s no guarantee they’ll move higher if small-cap stocks pull back, he said.
In conclusion, if technology stocks and small caps fall at the same time, it could cause “problems for the entire market,” he noted.
The Russell 2000 is bullish, but investors should prepare for potential profit-taking or consolidation in the coming sessions, according to Dan Wantrobski of Janney Montgomery Scott.
“The Russell’s long-term monthly chart gives a better sense of its potential,” he noted. “We believe the Russell 2000 can return to its all-time highs as the mean reversion in relative strength highlights further room for the sector to run from this year’s leadership (tech/AI/Mag7).”
Wantrobski also noted that broader market breadth and participation had improved since last week’s CPI increase.
“The battle between broader markets and leadership in 2024 is likely to continue in the near term in our view, as the disparities in relative strength between these groups show the potential for further rotation going forward,” Wantrobski said. “This cannot be confirmed as a long-term investment trend/theme at this time. So for now, we continue to treat this as a trading opportunity (mean reversion move).”
Piper Sandler’s Craig Johnson says it’s too early to tell whether a sustainable rotation can be sustained. More time and technical evidence will be needed to confirm that a sustainable broadening of participation that could drive the market higher is underway.
“The current (and long-awaited) broadening of equity gains is welcome, but lofty valuations will limit the market’s upside to low single digits overall for the remainder of the year,” said Robert Teeter of Silvercrest Asset Management.
For Lori Calvasina of RBC Capital Markets, earnings season will be a “key test” for the rotation sector. She added that valuations and positioning have set the stage for a potential change in direction, but there have been several false starts.
The Nasdaq’s relative performance versus the Russell 2000 has been on a tear since 2020, with each index outperforming the other by more than 40 percentage points over different one-year holding periods since the pandemic hit, according to Nicholas Colas of DataTrek Research. Dramatic small-cap outperformance has only occurred after a tech market crash or when retail investors created a small-cap bubble, he said.
“Neither of these patterns are relevant today. We believe the Nasdaq will outperform the Russell by two points, its 2003-2019 average, over the next year,” he noted.
As for whether the S&P 500 or the Russell 2000 will outperform over the rest of the year, he believes both will now do equally well, but not at the same time because of their low correlation.
“For now, small caps are enjoying better momentum because fund managers can’t afford to stay underweight as they’ve been forced to do over the last 18 months,” Colas said. “Once they reweight, the S&P should be able to catch up.”
The S&P 500 has gone 351 trading days without a 2% decline through Tuesday. If the stock index reaches 352 by Wednesday’s close, it will be the longest stretch since the start of the global financial crisis in 2007. The index went about 950 trading days between May 2003 and February 2007 without such a decline.
The stock market’s strength has been buoyed by optimism that the economy has weathered the worst of the Fed’s tightening. In that regard, Tuesday’s better-than-expected retail sales report is a “healthy” development, according to eToro’s Bret Kenwell. It’s better to see the Fed cut rates because of falling inflation than to see the central bank rush to support a weakened economy, he noted.
The Dow also had a “banner day” on hopes of lower interest rates and tax and regulatory relief — which could be on the horizon, according to Chris Zaccarelli of Independent Advisor Alliance. He also cited hopes that the market’s recovery will extend from a narrow group of tech stocks to “a range of companies.”
Company Highlights:
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Goldman Sachs Group Inc. and Wells Fargo & Co. joined rival JPMorgan Chase & Co. in tapping the U.S. investment-grade securities market after reporting second-quarter results.
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PNC Financial Services Group Inc. reported its first increase in net interest income since late 2022, setting itself up for what it expects to be a record year of net interest income growth in 2025.
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Microsoft Corp.’s investment in Inflection AI will face a full antitrust investigation in the United Kingdom, after the watchdog said it needed to take a closer look at the hiring of former employees of the artificial intelligence startup.
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Philip Morris International Inc. is expanding its production of Zyn in the United States as the popular oral nicotine pouch becomes harder to find due to growing demand.
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Starboard Value became the third activist investor this year to take a stake in Match Group Inc., the owner of the dating app Tinder whose paying customer base has declined for six straight quarters.
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Adidas AG raised its annual profit target for the second time in three months, citing strong demand for classic sneakers like the Samba and increased sales from dwindling inventory of Yeezy shoes.
Main events of the week:
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Eurozone CPI, Wednesday
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U.S. Housing Starts, Industrial Production, Wednesday
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Fed Beige Book, Wednesday
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Fed Chairman Thomas Barkin Speaks Wednesday
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ECB interest rate decision on Thursday
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U.S. Initial Jobless Claims, Philadelphia Fed Manufacturing, Conference Board LEI, Thursday
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Fed members Mary Daly, Lorie Logan and Michelle Bowman speak Thursday
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Fed members John Williams and Raphael Bostic speak Friday
Some of the main movements in the markets:
Actions
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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 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%
Currencies
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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 pound was little changed at $1.2974.
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The Japanese yen fell 0.2 percent to 158.39 per dollar.
Cryptocurrencies
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Bitcoin rose 2.2% to $65,153.51
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Ether rose 1.1% to $3,474.43
Obligations
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The yield on 10-year Treasury notes fell seven basis points to 4.16%
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Germany’s 10-year yield fell five basis points to 2.43%
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The UK 10-year yield fell five basis points to 4.05%
Raw materials
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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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