Small Caps Are Catching Up Fast

Summary

• The major market averages down ahead of earnings reports from tech giants.

• The Magnificent Seven is expected to show slower earnings growth and potential rotation out of tech stocks.

• Small caps are expected to outperform tech giants in the third quarter, indicating an improving macroeconomic landscape and a potential soft landing for the economy.
  

It was not a great day for the major market averages in front of critical earnings reports from the mega-cap technology names that have been leading this bull market since its beginning. I have been advising investors to brace for what may be disappointing guidance from the Magnificent Seven due to very difficult comparisons with prior quarters, which should reveal that earnings growth rates for this group peaked in the first quarter. Tesla, Inc. (TSLA) was the first of the seven to report last night, and the company fell short on earnings, margins, and free cash flow. The shares were down 8% after hours, but that should come as no surprise for a name trading at nearly 100 times this year's expected earnings. Alphabet Inc. (GOOG), (GOOGL) modestly beat revenue and earnings estimates, but its shares were still trading lower by approximately 2% after its CEO cautioned to be patient for profits from the wave of investments in artificial intelligence.

Analysts expect the magnificent ones to produce year-over-year earnings growth of 29% for the second quarter. While that may be impressive on an absolute basis, it would be a slower rate of annualized growth than what was reported in the prior three quarters. That is a negative rate of change, which I think current valuations do not justify. These companies need to spend some time growing into their current valuations. That doesn't mean their stock prices must drop dramatically, but I think it does mean that the prior year's degree of outperformance will not repeat.

Earlier this year, I thought the market would begin pricing in this development well in advance of July, but I also thought the Fed would be more proactive in easing monetary policy before September. Its delay kept investors hiding in the perceived safety of these tech giants. Regardless, I expected the result to be a rotation out of these behemoths of technology and into just about everything else, which has lagged dramatically. That is happening seemingly overnight because we have a combination of slowing profit growth for the bull market's leaders while we have an improving macroeconomic landscape for the laggards through a pending rate-cut cycle. The iShares Russell 2000 ETF (NYSEARCA:IWM) has closed the gap between its performance and that of the Nasdaq 100 rapidly over the past two weeks. It should outperform at some point during the third quarter. Small caps are expected to realize an increase in annualized profit growth each quarter through year-end, which is the opposite of what is expected for the Magnificent 7.

From my viewpoint, this market action also affirms that the economy is on track for a soft landing. If the expansion was at risk, we would not be seeing this improvement in breadth. I think it also means that any pullback in the major market indexes this summer will be just that pullback. It will also be aggressively bought by those who have been underinvested in stocks this year.