Inflation’s continuing decline and the cooling labor market are having profound effects. Recent data and interest rate projections indicate that a big rotation is unfolding in stocks and bonds, and it could deliver historic positive gains.
The astonishingly low June CPI gave the green light for both a broadening of the market rally into small-cap stocks and a fresh bid in the bond markets. Also, the odds for a September interest rate cut by the Federal Reserve jumped to 95% from 70% in the past week:
This matters because some investors may still view a 70% chance as not high enough due to volatile reactions from past economic and inflation data. But the June CPI was the third consecutive good inflation report. It was enough to convince interest rate futures markets to move up to a 95% probability and remove most (maybe all) potential doubt from investors’ minds.
As a result, we offer five reasons to be bullish about the market rally broadening to small-cap equities:
- The 95% probability of a Fed rate cut in September.
- Last year from October to December, small-cap stocks rallied 27% merely on a Fed pause – with an actual cut, we could see a larger and longer rally.
- Small- and mid-cap stocks (especially regional banks) are breaking out based on earnings and rate cut expectations – remember smaller stocks’ performance and interest rates are intertwined:
- Investor inflation expectations were way too high, so the reversal will likely be even more significant.
- Small-cap valuations (i.e., low price-to-earnings ratios) relative to larger S&P 500* stocks provide significant bandwidth for a “catch up” trade.
Putting it all together, there's ample data that the changing narrative supports a continuation of the small-cap rally that began nearly two weeks ago. It could even eclipse last year’s 27% gain:
As of this writing, small-cap stocks are up 10.2% in barely more than a week (using the iShares Core S&P Small-Cap ETF (IJR) as a proxy):
Furthermore, that 2023 jump of 27% is not even in the top 20 of the 25 largest 10-week moves for small-cap stocks in the Russell 2000# since 1978:
In other words, the potential runway is much longer. With the tailwind of actual rate cuts, this year’s small-cap rally could end up being even bigger.
It helps that inflation continues to fall:
Plus, median inflation is already below the pre-pandemic average:
Thus, it’s not crazy to expect the current small-cap rally to surpass last year’s 27% gain.
More support for this phenomenon is seen in the bond markets.
The two-year Treasury yield is 4.461% (as of this writing):
The 10-year yield is 4.178% (as of this writing):
Since the encouraging inflation report, the spread between two-year and 10-year Treasury is now only -0.283%:
While the yield curve is inverted, it’s beginning to normalize with the Fed not even having started actual rate cuts yet. This implies the bond market is on track for long-term rates to finally get back above short-term rates, which points to a bullish bond market in the intermediate term.
Fuel To the Fire
The impending decrease in interest rates could be the pin to finally prick the largest cash bubble in history. Remember, there is over $6.5 trillion sitting on the sidelines that will begin to collect significantly less interest as this plays out:
Per data from our friends at MAPsignals, the move out of cash may already be taking place. The recent run up in small-cap stocks added about $93 billion in value that couldn't have all come from a rotation out of other holdings.
Viewing through the lens of the Big Money Index, a 25-day moving average of netted “big money” buys and sells, you can see how significant this breakout is on the far right of the chart:
Digging deeper, when “big money” buying and selling is thrown into the mix, the upswing is obvious:
A move of this magnitude within small-cap stocks has only happened 145 times since 2000, or just 2.4% of all trading days in the last 24 years. The following analysis from MAPsignals shows an excellent future for these stocks after such occurrences:
Keep in mind that markets look forward. The moves occurring now are unfolding before rates are actually cut.
As rates drop, it should add fuel to the fire, especially in equities of smaller companies that will benefit from a more favorable debt financing landscape. And judging by the table above, it’s possible this current small-cap run could deliver historic positive gains in the second half of 2024.
So, with inflation cooling, Fed Chair Jerome Powell sounding encouraged, and rates falling, there’s plenty of support for this equity market broadening and bullish bond boost to continue.
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* The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.
# The Russell 2000 Index is a stock market index measuring the performance of 2,000 smaller companies included in the Russell 3000 Index and is widely regarded as a bellwether of the U.S. economy.
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