Market Commentary: Small Caps Finding Support and Three Important Manufacturing Trends

President Biden Withdraws from Presidential Race

• The S&P 500 fell 1.9% last week after two weeks of gains but remains in a solid upward trend.
• Weakness was focused in the technology sector and some of the index’s largest stocks, but there was resilience beneath the surface and the small cap Russell 2000 Index climbed 1.7%.
• President Biden’s withdrawal from the 2024 presidential race does not change our view of the election’s impact that we presented in our Midyear Outlook.
• We see several signs that the sentiment toward small caps has shifted and believe small caps may be well set up for a strong second half.
• We’ve seen improving production trends in several key areas of the economy, including high tech equipment, automobiles, and defense.

Before we start this week, we want to briefly address yesterday’s news that President Joe Biden has withdrawn from the 2024 presidential race and has endorsed Vice President Kamala Harris as the Democratic nominee, although the endorsement does not necessarily mean she will win the nomination. The change in the Democratic ticket does not change our fundamental view of the election, which we discussed at length in our recently released Midyear Outlook 2024: Eyes on the Prize.

While the announcement may be an important political moment, there is a strong tendency to think party politics has a much larger near-term impact on markets than it has historically. As we wrote in the Midyear Outlook, “One important concept we want to stress regarding election years is politics and investments don’t mix.”

Based on the initial reaction in prediction markets, which absorb information more efficiently in real time than other estimates of election odds (although that doesn’t necessarily mean they are correct), the change in the Democratic ticket may move the presidential race slightly closer to being a toss-up but is still categorized as leaning in favor of former President Trump, and slightly decreases the odds of a Republican sweep. Of course, that could change, but even a much larger swing would not materially change our view of the election outcome’s impact on broad markets.

7 Reasons the Times Are A-Changin’ for Small Caps

“You’re killin’ me, Smalls!” Ham Porter in The Sandlot

We’ve liked small caps all year and we’ll be the first to admit they’ve been frustrating. But the times, they are a-changin’!

We will share a lot of charts and tables (in no particular order) as to why we think this underloved, underappreciated, and underowned area could be due for a big second half in ’24.

• • Let’s first remember the huge end-of-year rally for small caps in 2023. It was one of the best two-month rallies ever for small caps and history told us back then to expect better times over the coming year. Yes, the first six months of 2024 have been quite frustrating, but what if small caps were simply catching their breath the whole time and now are turning higher? Here’s the table we shared in December 2023 that looked at the ten best two-month periods for small caps ever. The next year? Higher 9 out of 10 times and up nearly 27% on average. Not bad.

• • In our just released Midyear Outlook, we noted why we like small caps (and midcaps). One of the better charts that shows this story highlights that small caps are historically cheap. This isn’t the only reason to be bullish, but once the other drivers are in place, buying things that are cheap can be a nice way to help your portfolio. In fact, the last time small caps were this cheap relative to large caps was in 1999, which kicked off a 13-year period of outpeformance for smalls.

• • Something most investors might not realize is small caps are expected to see explosive earnings growth going forward. Given we remain positive on the US economy, we think these overall earnings numbers could come in even better. Here are two nice charts showing this story.

Sources: Factset, Carson Investment Research 6/11/2024

• • Small caps like rate cuts. We’ve always been in the camp that inflation would improve and the Federal Reserve would cut this year, even if two months ago no one believed us. Well, now it is looking like two (or even three) rate cuts are coming and wouldn’t you know it, but small caps historically tend to do quite well once the Fed starts cutting.

• Speaking of inflation, our global macro strategist Sonu Varghese has been all over why better data was probably coming. The one sticky part of inflation has been shelter, but we finally saw some big improvement in the data. Lower inflation matters, as it opens the door for the Fed to cut, which historically has helped small caps.

• Small caps as a whole have not liked higher rates. Think about it. Smaller companies usually don’t have nearly as much fixed rate debt as large caps, so when rates rise their borrowing costs go up and it is harder for them to get financing, which limits their growth potential. In fact, large caps have locked in 90% of their debt (likely at very low rates from a few years ago), while small caps have only about half of their overall debt in fixed rate debt. Lower rates (even slightly lower) could be a big tailwind for small caps.

• The past week has been incredible for small caps, with the Russell 2000 up at least 1% five days in a row. The last time that happened was late April 2020, not the worst time to be bullish.

There isn’t a very large sample size of five-day streaks, so we looked at four-day win streaks of over 1% and the results were very impressive, higher a year later 11 out of 13 times and up a very strong 25.3% on average. It’s worth noting the worst of the 13 was fairly recent, in March 2022, and small caps were down about 20% three months later and 15% a year later. Still, we’d file the current streak in the bullish camp for small caps going forward.

Yes, we’ve liked small caps and midcaps all year. It has most definitely been frustrating, but we remain overweight these areas and expect the outperformance to continue the remainder of this year.

Three Big Things That Are Happening in the US Economy

The US economy mostly runs on the back of household spending, and so the manufacturing sector is usually a bit of an afterthought. Attention on manufacturing has increased recently amid the 2024 presidential election campaign, and especially former President’s Trump’s preference for a weaker dollar to boost the export sector. Still, the headline news from the manufacturing sector has been pessimistic, thanks to poor survey data. The ISM Purchasing Managers’ Index (PMI) —  which is one of the most popular leading economic indicators amongst investors, economists, and financial publications — has been below 50 for 19 out of the last 20 months, indicating that the manufacturing sector is contracting.

Well, there’s the survey data (of about 300 purchasing managers) and there’s the “hard” data that is collected from thousands of manufacturing establishments published by the Federal Reserve. This hard data has surprised to the upside recently. Manufacturing production ran at an annualized pace of 4% over the last quarter (Q2), upending the narrative from PMIs. While manufacturing production would ideally run faster, it’s far from in a slowdown, let alone contraction. Note that production declined in 2019 amid the trade war, and despite that the economy was doing quite well. The good news is that production is now 2% higher than where it was in December 2019 and running near early-2018 levels.

But there are some notable things happening behind the headline too. Heare are three areas people aren’t really talking about that we think are worth highlighting.

Motor Vehicle Production Is Rocking

Motor vehicle assemblies rose to a seasonally adjusted annualized pace of 11.6 million in June. That is well above the pre-pandemic pace of 11.1 million and the fastest pace in four years. The boost in vehicle assemblies has mostly come on the back of light truck assemblies, i.e. SUVs and minivans, which Americans can’t get enough of. Light truck assemblies are running a whopping 20% above the average 2018-2019 pace, whereas assemblies in the less preferred auto segment are running 39% below the pre-pandemic average.

Vehicle assemblies have come back strong since the auto industry strike last fall. This is a big deal for the economy as production came to a halt after the pandemic hit. It’s taken a long time to come back, especially as supply chain issues hampered the recovery. That’s also what sent vehicle prices higher. The good news is that the current pace should boost inventories, and sales, while pushing prices lower. Due to the production falloff amid the pandemic, we still have a massive deficit of 5-6 million vehicles. That will need to be made up, and so production is likely to continue running strong for a while, which will be a nice tailwind for the economy.

High-Tech Equipment Production Is Also Surging

High tech equipment production (computers, communication equipment, semiconductor chips) rose at an annualized pace of 13% in Q2. Production is now running a whopping 31% above December 2019 levels. This is likely a function of demand coming from artificial intelligence-related investment and the CHIPS/IRA Act. You can see the surge starting in early 2023, taking production well above the 2010-2019 trend.

An offshoot of this story is what we’re seeing in the electrical equipment space. Production has risen at an annualized pace of 20% over the past quarter and is running 18% above December 2019 levels (credit to our friends at Employ America for first flagging this data back in 2023). As you can see in the chart below, production looks to have broken out of a decade-long period of stagnation that began after the Great Financial Crisis in 2008. The current surge looks like what we saw back in the mid-1990s. This is another sign that there are major shifts happening under the surface for the economy, including the less talked about industrial side.

An Unexpected Boom: Defense Production

In some respects, this is more of a surprise than what we see on the high-tech equipment production side, given political constraints. Defense equipment production rose at an annualized pace of 10% over the last quarter and is currently running 4% above December 2019 levels. But as you can see in the chart below, the real surge has occurred over the past year. This is another area where government spending is boosting the economy, especially from the federal government. This trend is likely to continue even after November, irrespective of who is elected president. Contrast that to what happened after 2010, when defense equipment production fell amid budget cuts.

Together, all these pieces make up a significant portion of the US economy. It’s much smaller than the contribution from consumption, but it can provide an important cyclical boost, perhaps one that will continue as the Fed starts cutting interest rates. What we’re seeing in industrial production now is very different from the experience of the last decade and may be capturing an important hidden strength for the economy.

This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.

S&P 500 – A capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The NASDAQ 100 Index is a stock index of the 100 largest companies by market capitalization traded on NASDAQ Stock Market. The NASDAQ 100 Index includes publicly-traded companies from most sectors in the global economy, the major exception being financial services.

Russell 2000 Index – The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe and is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.

A diversified portfolio does not assure a profit or protect against loss in a declining market.

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