Rotation Trade Boosts Small Caps

Administrative Note: July is vacation month for myself at Signal Sigma; there will be one more period with no market updates (unless warranted by exceptional circumstances):

• 25-31 July

Meanwhile, the development team is working full time toward the production of the radical new version of the platform (see updates at the end of this article).

-Andrei

Last week caught most fund managers off-sides, as a spectacular rotation trade took off in the span of a couple of trading sessions. Beneficiaries included small and mid-capitalization companies (IWM and MDY ETFs), while this year’s biggest gainers were hit with a serious bout of profit taking. To sum up the last 5 sessions, the iShares Russell 2000 ETF (IWM) was up +1.09% on the week (hitting a peak of +5.23%), while the Nasdaq (QQQ) remained under continued selling pressure and lost -4.39%. The S&P 500 ETF (SPY) our general proxy for “the market” declined -2.37%.

It’s not the magnitude or the move itself that’s surprising, as small caps have been lagging their large capitalization peers for about 3 years. The speed at which this rotation has occurred was quite shocking for market participants. Various analysts (ourselves included) have, on occasion, touted small caps as a better value investment compared to the mega caps. In this issue of our Weekly Preview Newsletter, we’ll make the case for both the investment in small caps as well as buying large cap tech on the dip. But first, our usual technical analysis.

SPY managed to record an all-time-high of $564.84 last week, but has declined since then. The corrective action has pushed the benchmark ETF to below its key support level of $552-$556 (20-DMA & R1). This technical break now puts bulls on the back foot, with the focus shifting to regaining the 20-DMA. We’ll likely see a rally in the next couple of sessions - but a failure to close above this level would confirm the 20-DMA as resistance. In that case, downside to $527 (-3.8%) becomes much more likely. It is of paramount importance that the 20-DMA and R1 levels are regained, at least for short term trading.

The MACD signal has crossed over to a negative reading, suggesting that further weakness may lie ahead, despite any counter-rallies. Depending on how the market progresses, we may raise additional cash and hedge against further declines.

While there has been some angst on the part of some investors, this pullback remains remains rather ordinary, within a bull market trend. The drawdown is the largest one on record in 2024 besides the early spring episode:

For now, there is no indication that a more significant decline is in the books, with a fair amount of support at around $527 - $540. We’ll get more information on the direction of the market from the upcoming earnings releases, especially Alphabet (GOOG) on Tuesday after the close.

According to ZeroHedge “The de-grossing activity over the past 5 sessions is the largest since Nov ’22 and ranks in the 99th percentile on a 5-year lookback.”

Let’s explore the rotation theme that we mentioned at the start of the article. We’ll need to get a proper historical perspective first: IWM is still around -7% below its peak established in November 2021. SPY is up +17.5% since then, by comparison, resulting in a 24.5% performance differential.

IWM hasn’t even caught up with QQQ in the latest rally, starting in October 2023. Virtually all of the performance gap between the two ETFs during this time period was realized in 2.5 months (May 01 - Jul 10). Before that point in time, they were performing head-to-head mostly. This immense gap had to be closed sooner or later, as the chase into a handful of stocks couldn’t last indefinitely.

To be sure, the rally in QQQ was driven by only a handful of stocks (“Magnificent 7”), and this became a huge problem in terms of market breadth. We’ve written many times about this issue and regarded the weak breadth as a bearish indicator. A healthy market is not one where only 5-7 stocks get stellar performance while everything else is… “meh”.

Sentiment changed for small caps as soon as the weaker than expected inflation report was released on July 11. With inflation cooling and Jerome Powell stating he wants to act sooner rather than later, the odds of a rate cut by September surged. Naturally, yields retreated, a move which supported interest rate sensitive areas of the market (financials, real estate and … small-caps). At the moment, a rate cut in September is a foregone conclusion:

The drop in yields created a panic response, as traders dumped the “Magnificent 7”, along with close cousins Nasdaq (QQQ), Tech (XLK), Mega Cap Growth (MGK) and bought “everything else”. The move was exacerbated by short covering on the part of some hedge funds.

However, is this rotation sustainable? In the weeks and months ahead, are we to buy tech on the dip or should we rather chase the rally in small caps, given that the Russell 2000 is yet to surpass previous highs?

If lower yields are the only reason for buying into small caps, the current situation (where yields drop and small caps surge) is an anomaly. Longer term, the correlation between small caps and yields is positive, with the decline in yields not supportive of rallies in the Russell 2000. This occurs because lower yields usually reflect weakening economic conditions and vice-versa. Smaller capitalization companies depend on a strong economic environment that drives earnings growth.

As a consequence, investors who are bullish on IWM, should wish for higher rates, despite it sounding counter-intuitive.

From a technical perspective, the rally in IWM is close to becoming unsustainable, as it has now become the ETF with the highest deviation. While this doesn’t mean that buying can’t continue in the short term, there are limits to any price move. A correction or consolidation would be required before the rally can continue.

Longer term, even if the rally were to continue, it’s unclear exactly why IWM would outperform SPY or QQQ for that matter. Despite many short bursts of relative performance during the last decade, the trend clearly favors large caps. It’s possible to get a different outcome this time around (since anything is possible, after all), but there are numerous issues facing small caps.

The #1 issue being profitability. The following chart from Apollo shows the percent of companies in the Russell 2000 posting a negative 12-month trailing EPS. Today, that share of companies is a staggering 40%. These so called “zombie companies” need to issue debt in order to stay afloat, becoming highly susceptible to changes in the economic environment in the process.

Furthermore, small caps depend on a healthy consumer in order to generate revenue growth. As actual consumption decreases, company profitability slows as well, eventually weighting on share price performance.

Finally, companies in the Russell 2000 do not have the financial means to execute large scale buybacks or acquisitions in order to artificially support their slowing earnings growth.

Our Trading Strategy

We have discussed the need for large caps to correct for a while. Upside for SPY investors was becoming very limited from a fundamental perspective, and it still is (but to a lesser extent).

Our inclination would be to let the current correction episode run its course and buy the dip in large caps and momentum names. This doesn’t mean that a select number of small caps don’t have a well deserved spot in our portfolio - they do. But as far as chasing IWM, we’ll need to get a better entry point.

For now, technicals will dictate our next moves. It will be critical for SPY to maintain support at the 20-DMA. Absent this, we will likely use any rallies to raise cash and limit risk exposure.

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