- The S&P 500 fell 0.8% last week, declining for the second consecutive week, but there’s still a lot of strength under the surface, as the small cap Russell 2000 Index climbed 3.5%.
- While we do expect continued outperformance by small caps, recent small cap strength also suggests the bull market in the S&P 500 will continue.
- Second quarter real GDP growth surprised to the upside coming in at 2.8% compared to a consensus expectation of 2.0%.
- Consumer strength, especially a rebound in goods spending, supported the upside surprise, while transportation equipment and defense spending investment were also strong.
Why We Think This Bull Market Still Has Plenty of Life Left
The Russell 2000 (R2k) is comprised of small cap names and it soared after the much better than expected inflation data two weeks ago. How much did it rally? The R2k gained 11.5% in 10 trading days, for one of the best 10-day rallies ever and best since after the election in November 2020.
We found 23 other times the R2k gained at least 10% in 10 trading days (taking the first signal in a cluster) and the returns going forward were extremely strong. The R2k was higher a year later more than 86% of the time and up nearly 27% on average, which should have many long-suffering small cap bulls smiling.
We saw small caps (R2k) outperform the Russell 1000 Index of large caps (R1k) by more than 5% in a five-day period recently. This is another not so subtle clue that small caps could continue to lead, as when this has happened in the past the R2k was higher a year later eight out of 10 times and up an average of more than 16%.
Why This Is Bullish for Large Caps
Yes, we think small caps will outperform large caps the rest of this year, but that doesn’t mean large caps can’t have some more fun too. In fact, we think it is quite likely. The R2k outperformed the R1k by more than 8% in a 10-day period recently, which is extremely rare. We found only four other instances and the S&P 500 was up 20% on average a year later and higher three times. The one time it didn’t work? March 2000 at the peak of the tech bubble. Still, this combined with the other studies in this blog continues to suggest a solid second half of the year when all is said and done.
Recently more than half of the components in the S&P 500 hit a new 20-day high, which is a buying thrust and shows there is broad participation in this bull market. Once again, future returns are strong, with the S&P 500 up close to 15% a year later, on average, and higher nearly 89% of the time.
Lastly, an “overbought” market can be a good thing. When you hear overbought you might think that it’s bad, but it turns out overbought conditions are how nearly all major bull market start and it can be good plenty of other times too. More than 28% of all the components in the S&P 500 were recently overbought, as measured by the Relative Strength Index (RSI) indicator. This tends to happen in bullish trends and rarely has major trouble been right around the corner. When we’ve seen this level of overbought stocks, the S&P 500 has been higher 25 out of 28 times a year later and up nearly 12% on average.
Let’s be honest though, September and October are historically poor months in an election year and I think we could see some rocky times once again this year. We’ve been quite spoiled with such a strong start to ’24 and this was on the heels of the huge year last year. Buckle up, as we likely will see some scary headlines and red days ahead of the election, but let’s not lose perspective if this happens.
Q2 GDP Growth Confirms Economic Resilience
The economy grew at an annualized pace of 2.8% in the second quarter, after adjusting for inflation. This was well above expectations of a 2.0% increase and acceleration from last quarter’s 1.4%. It’s a very solid, but not spectacular, number, just in the top half of all quarters since 2010, but looking at it in the context of the rate environment shows just how resilient the economy has been. Remember, an upper bound on the fed funds rate target of just 2.5% almost broke the economy in 2019. The current economy has powered through the most aggressive rate hiking regime in over 40 years with the top of the fed funds target rate sitting at 5.5% for almost a year now.
Overall, this was a “goldilocks” GDP report, with enough strength to be reassuring but not so much that it weighed on the likelihood of a September rate cut.
For markets, GDP is typically one of the least important economic data points because the numbers are relatively stale. Markets aren’t taking their bearings from what happened in April and May. At the same time, it’s the best broad measure of economic activity we have. The positive surprise also tells us the economy was running a little stronger than what might have already been “baked in” to market prices. Plus, looking at what’s going on under the hood can highlight areas of economic momentum.
Key Takeaways from the GDP Report
We’ve seen some comments dismissing the report because of the contribution from inventories (+0.8%-points), which tends to be mean reverting. But this was offset by net exports, another number less reflective of core economic strength that also tends to be mean reverting. Final sales to domestic purchasers, which is GDP without trade and inventories, came in at 2.7%, almost identical to the headline GDP number.
As has been the case for much of the expansion, consumer spending led the way, including a big rebound in goods spending from Q1, when goods spending had actually contracted.
There was a big jump in equipment investment, bolstered by transportation spending (most notably aircraft). Housing spending continues to see a headwind from interest rates and fell for the first time in four quarters. This should get a boost once rates come down.
Government spending made a solid contribution, with the main contributing factor the investment side of federal defense spending.
Overall, the report does not change our outlook for the economy. While economic risks have risen, we still see a lot of underlying strength. However, with interest rates still restrictive and disinflation continuing, we think the Fed needs to be more focused on risks to employment now, even with the strong GDP report. It would probably be appropriate to cut in July, but that’s very unlikely given current messaging and the strong GDP report, we think we’ll need to wait until September.
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.
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A diversified portfolio does not assure a profit or protect against loss in a declining market.
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