- Small caps primed for correction
- Despite inflation fears, data and soaring company profit margins should propel stocks higher
Ongoing optimism that the economic rebound remains on track pushed most stocks higher on Friday, for at least the third day and for some indices for the fourth straight month, as May trading came to a close. The positive sentiment should linger into the upcoming, holiday-shortened trading week.
Investor bullishness overshadowed off-again-on-again concerns that inflation will upend growth, but not all assets performed as well as equities. On Saturday, Bitcoin extended its selloff.
The climbed for a third day on Friday, finishing just 0.7% below its May 4 record close. It was also the broad benchmark’s fourth straight monthly gain. The also advanced for the third day on the final day of last week’s trading, closing 0.75% below its May 4 highest close.
The climbed 0.25% on Friday, finishing 2.6% below its record. It was the tech-heavy benchmark’s third monthly uptick. Conversely, the small cap was the only major gauge that closed lower on Friday, 3.8% below its Mar. 15 record. Still, the small cap index notched its eighth monthly gain in a row, for the first time since 1995.
Note that the last two indices we mentioned—which represent the opposite sides of the reflation trade—are each considerably further from their respective records than the other two major indices. That, however, doesn’t necessarily mean they’re underperforming. They may have simply jumped higher, creating loftier records, than the other two.
Actually, that only provides a partial picture. While the Dow Jones and S&P 500 have risen 12.7% and 11.8% respectively so far this year, the NASDAQ 100 gained considerably less, with only a 7.2% boost. The Russell, however, has been the biggest gainer so far in 2021, adding 15.6% YTD.
What this means: there is an argument to be made that technology stocks, normally characterized as growth stocks, might be providing more value than shares designated ‘value stocks,’ best represented by the Russell 2000 index, which lists smaller cap American domestic firms. Those smaller caps were the companies that suffered the most during lockdowns, and are therefore also expected to benefit the most from a restarting economy, at least in our proposed time frame.
That is partly why we think the Russell 2000 may be entering a .
The small cap benchmark formed a shooting star as it neared an H&S top.
Even after rose the most in two decades, traders remained focused on the outlook for higher spending that could boost growth. The perception that the latest figures won’t be enough to prompt any change in policy by Federal Reserve officials also helped sentiment remain strong.
The topic of has remained a point of contention for investors and economists alike, with some arguing that price increases are temporary and others anxious about the potential for escalating costs in the longer-term. US President Joseph Biden released his first, full-year last week. It details his ambitions to expand the size and scope of the federal government with more than $6 trillion in spending over the coming fiscal year.
If so much data has been less buoyant than expected and high-profile investors like Warren Buffett continue warning about inflation, why are stocks appreciating? Though the debate continues raging, companies are booking profits and momentum is accelerating.
Indeed, with 97% of S&P 500 firms having already released earnings for their most recent quarters, corporate results are on course to grow by 50% from a year ago, making it the biggest boost for this metric since 2010.
Remember, however, we’ve warned about making this comparison to last year, given that the frame of reference is an economic shutdown, so any growth will come in artificially higher. However, consensus estimates took into consideration the economic lockdown, and results still beat estimates by a record 23%.
In fact, compared to the prior three quarters, when better-than-expected numbers were a consequence of low expectations, this quarter’s results were a function of loftier earnings, projecting economic strength. Demand rebounded as the number of COVID cases decreased, with vaccinations on the rise and social restrictions loosening. As last week’s and data showed, there’s pent up demand fueled by a significant amount of excess savings consumers could deploy as normal activities begin to resume.
Putting all this into context—while putting aside for now questions about unprecedented fiscal and monetary policy—the performance of the stock market and corporate earnings are completely in sync, which should provide some comfort to investors. But, if forward, 12-month corporate earnings are already expected to exceed their pre-pandemic level by +11%, is there any more room for growth?
We believe so, based on our expectations for a durable expansion. Following the previous two recessions, corporate earnings continued to grow by an average of 65% once they reclaimed their prior peaks.
Forward SPX EPS 1997-2021
But it’s more than just plain ole’ earnings that are boosting optimism…it’s record profit margins as well. Automakers, financials, materials—reflation sectors all—have led stocks to surging profit margins.
Then why are we expecting a potential pullback for the Russell 2000, the index that has proven to be most related to the reflation trade? Because it is primed for profit-taking before it continues higher.
Yields, including for the Treasury note have been consolidating in the same timeframe the Russell 2000 has been.
UST 10Y Daily
A downside breakout of the congestion within the falling channel may signal a retreat of the reflation trade, and along with it, the Russell 2000.
Will falling yields pull down the ?
On Friday, the USD attempted an upside breakout of a falling wedge but failed at its first attempt. The greenback has been congesting for 9 sessions, as buyers and sellers struggle at the base of the previous, rising wedge, which followed the massive wedge since the 2020 peak.
While climbed for the second day, it remained congested.
The yellow metal has been struggling to advance once it hit the top of its rising channel on May 17. If the precious metal were to retreat, support would be both at the bottom of its fast, rising channel, as well as by its falling channel since the 2020 record peak.
has completed a bearish wedge after realizing the implied target of an H&S top.
This is challenging our . However the $29,000 level would be our red flag.
A combination of fundamental themes are weighing on the price of , including green activism, US negotiations with Iran threatening to bring more supply to the market and the upcoming on June 1 where talk of increasing output is on the agenda. As well, a surprising surge in shareholder activism could upend the old business models for oil supermajors.
On the other hand, a robust economic recovery requires energy. Plus, the summer driving season begins this weekend.
WTI’s conflicting drivers have formed an ascending triangle, which has been struggling to complete. An upside breakout would signal a $76 target.
The Week Ahead
All times listed are EDT
21:00: China – : anticipated to remain flat at 51.1.
Markets closed for the Memorial Day holiday in the US, Bank Holiday in the UK.
21:45: China – : expected to edge down to 51.7 from 51.9.
00:30: Australia – : forecast to remain at 0.10%.
3:55: Germany – : seen to remain flat at 64.0.
3:55: Germany – : likely sank to -9K from 9K.
4:30: UK – : to have remained unchanged at 66.1.
5:00: Eurozone – : expected to rise to 1.9% from 1.6%.
8:30: Canada – : predicted to jump to 1.0% MoM from 0.4%.
10:00: US – : forecast to have remained steady at 60.7.
11:00: UK –
21:30: Australia – : anticipated to drop to 2.5% from 3.1%.
21:30: Australia – : previously printed at 1.1%.
4:30: UK – : expected to remain flat at 61.8.
8:15: US – : forecast to retreat to 650K from 742K.
8:30: US – : to edge down to 395K from 406K.
10:00: US – : to rise to 63.0 from 62.7.
11:00: US – : previously came in at -1.662M bbl.
2:15: India – : anticipated to remain at 4.00%.
4:30: UK – : seen to tick up to 62.0 from 61.6.
7:00: US –
7:00: Eurozone –
8:30: US – : predicted to surge to 650K from 266K.
8:30: US – : forecast drop to 5.9% from 6.1%.
8:30: Canada – : to jump to -22.5K from -207.1K.
10:00: Canada – : previous release came in at 60.6.