With the summer Olympics in full swing in Paris and Tahiti (for surfing enthusiasts), we’re thrilled by the Herculean achievements of our favorite athletes who seem to defy the laws of physics. But there’s a special place in our hearts for the underdog who surprises everyone and rises to the pinnacle of success in their sport. Move over, giants, for July was the month of the little guy. Not necessarily in the world of the Olympics, at least as of the time of this writing, but certainly in the investing world.
As we’ve mentioned in previous market updates, the rally in the equity markets this year has been fueled by a handful of the largest companies, predominantly in the technology (i.e., growth) sector. But that dominance shifted in July with smaller and mid-sized companies, especially value stocks, powering ahead. Small cap stocks were up 10% in July, while large cap stocks were negative. Value stocks were up almost 5%, while growth stocks were negative.
Why the loss of love for the large cap leaders that have been driving market gains? There were several catalysts that stoked the stampede from the market favorites and into small cap and value stocks last month:
- The jobs report for June and second-quarter GDP were both better than expected, providing evidence that the economy is humming along.
- Inflation data has continued to move in the right direction to provide the all-clear signal for the Federal Reserve to begin cutting interest rates.
- While the Fed left rates unchanged at their end-of-July meeting, Chair Powell indicated we could expect the first rate cut in September if current conditions continued.
Since small cap stocks have underperformed their large cap cousins this year, investors see possible opportunities for the small cap space to play some catch-up. In last month’s market update, Ron Rough presented our concern about how few stocks were participating in the rally. Certainly, a broadening of the rally to include companies beyond a handful of stocks would be a welcomed and healthy sign for the markets.
Of course, there’s no guarantee that this rotation into small cap stocks will last. Smaller companies tend to thrive in an environment of solid economic growth combined with lower interest rates because they tend to have higher borrowing costs. But small companies will struggle more than their larger brethren in a recession, so any hint of economic weakness could send small cap stocks tumbling back down. The chart below shows that we’ve seen several fits and starts with a good amount of choppiness in that space over the past several years.
Changes to Portfolios in July
As a trend follower, FSA endeavors to have exposure to leading areas of the stock and bond markets. To that end, our equity-oriented strategies had leaned over to large cap growth stocks throughout the year. However, as signs of weakness began to show in July, we did reduce exposure to large cap growth stocks in our Core Equity and Tactical Growth strategies. We did the same in Conservative Growth, though to a lesser degree, given that this strategy has less exposure to growth stocks. On the buy side, we did initiate a small position in small cap stocks in some accounts within the Tactical Growth strategy since we tend to make first moves in our more aggressive strategies.
A sustained trend that lasts more than one month would suggest that the July rally in small caps has legs, and that is what the portfolio management team will be watching for before more broadly shifting the portfolios over into the small cap space. FSA tends not to react to sharp, sudden market actions to the upside, especially in our more conservative strategies, since such powerful moves often prove to be short-lived.
Volatility in the markets could very well ramp up as investors react to surprises and uncertainty surrounding the presidential election in the fall. Until then, we hope that you can enjoy the last days of summer.
Mary Ann Drucker
Assistant Portfolio Manager
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