Stocks rallied sharply through the first 8 days with the Magnificent Seven stocks up over 10% and the Nasdaq-100 Index up over 5%. On July 10, the Magnificent Seven were trading 36% above its 200-day moving average and the Nasdaq was trading 20% above its 200-day moving average as investor bullishness started to take on extreme levels.
Markets were Overextended Heading into Earnings
Since then markets have taken a decidedly different direction with a violent rotation out of the high flying Magnificent Seven stocks and into beaten down small caps. This rotation seems to have started with short covering on some of the market’s junkiest names and then fueled by strong flows into the largest small cap ETF. As the month progressed, this rotation persisted thanks to disappointing earnings from the mega caps.
Markets took another turn for the worse after lackluster results from Tesla and Alphabet on July 23. While Tesla’s report highlighted the challenges the company faces in an EV winter, Alphabet’s release had broader implications as its capex spending plans were not well received by the market. Investors face the reality that the AI investment cycle remains in spend mode. Alphabet noted that they plan to spend $24 billion more in capex for the rest of 2024. This would put full year spending at $49 billion, which is 84% greater than its 5-year annual average. In an interview with the Wall Street Journal, Chief Executive Officer Sundar Pichai stated “The risk of underinvesting is dramatically greater than the risk of overinvesting for us here.” Meanwhile, Microsoft reported a $5 billion quarter-over-quarter increase in capex to $19 billion, with CFO Amy Hood saying that number will increase next fiscal year as well. Meta expects to increase outlays on AI infrastructure in 2025. Amazon CEO Andy Jassy plans to spend heavily on AI, saying it represents a “multibillion-dollar revenue run rate business.” Tim Cook reported Apple will “continue to invest significantly in the innovations that will enrich” customer lives. Taken together, the Magnificent Seven appears to be in the thick of an AI spending cycle with profit growth not increasing at the same pace.
While we expected this earnings season to have a high bar, especially for the Magnificent Seven, post Alphabet Inc. and Microsoft’s reports, it appears that margins, with all of the current AI spending, are going to play an outsized story this earnings season on what is next for markets.
The Magnificent Seven continue to deliver outsized margin growth, but they are declining. With that being a key driver of their outsized gains over recent years, any cracks in this story are cause for concern considering their current valuations. However, the recent soft economic data does not necessarily offer an all clear signal for smaller companies, making the setup for stocks tricky heading into the election. The challenge we see for a continued long-term rotation is that we are already in the late cycle with economic data showing signs of softness. On the flip side, small caps are inexpensively valued and remain so relative to large caps. Companies outside of mega caps will need to deliver.
Margin Growth Remains Superior for Large Caps
However, we believe the election is playing a prominent role in market moves. Based on the latest polls, Vice President Kamala Harris has quickly put together a credible campaign to challenge Donald Trump. The tighter race equates to possibly greater volatility as investors attempt to handicap how close of a race this will be after investors initially priced in a Trump landslide. They also need to assess how a Harris presidency would differ from Biden’s.
What is Next for the Market?
Looking ahead, we expect to see softness throughout the summer months, especially on the back of strong gains to start the year and the election remaining front and center. Historically, July has been a strong month on average for the S&P 500. That seasonal tailwind could wane going forward, as August and September tend to be a tougher stretch for stocks. When considered in the context of a contentious election cycle and the uncertainty that accompanies it, a consolidation and rotation for U.S. stocks seems reasonable.
That said, whether we rotate or not does not necessarily mean investors need to get outright “bearish.” While frothy sentiment and heavy price action from the Magnificent Seven weigh on the S&P 500, the percentage of S&P 500 stocks making a one-month high hit 50% in mid-July, a signal that is emblematic of improving breadth. While it is natural for this type of momentum to mean revert in the short term, the forward three, six, and twelve months forward tend to see above historical average returns.
Of course, one cannot comment on the market outlook without touching on the potential for rate cuts. With the U.S. Federal Reserve passing on a July rate cut last week, a September cut appears to be fully priced in. The data from Friday’s job report will likely beg the question of whether the Fed has been caught flat-footed. Nonfarm payrolls were softer than expected and unemployment rose to 4.3% from 4.1%. Time will tell if the Fed has remained consistent with its historical track record of tending to cut too late with the economy already in trouble. While we believe the ultimate path for markets is higher and with broader participation, we are cautious for the time being.
Not an offer: This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only and on the understanding that the recipient has sufficient knowledge and experience to be able to understand and make their own evaluation of the proposals and services described herein, any risks associated therewith and any related legal, tax, accounting or other material considerations. To the extent that the reader has any questions regarding the applicability of any specific issue discussed above to their specific portfolio or situation, prospective investors are encouraged to contact 1-855-561-5728 or consult with the professional advisor of their choosing.
Forward-looking statements: Certain information contained herein constitutes “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events, results or actual performance may differ materially from those reflected or contemplated in such forward-looking statements. Nothing contained herein
Use of Third-party Information: Certain information contained herein has been obtained from third party sources and such information has not been independently verified by Roundhill Financial Inc. No representation, warranty, or undertaking, expressed or implied, is given to the accuracy or completeness of such information by Roundhill Financial Inc. or any other person. While such sources are believed to be reliable, Roundhill Financial Inc. does not assume any responsibility for the accuracy or completeness of such information. Roundhill Financial Inc. does not undertake any obligation to update the information contained herein as of any future date.
Any indices and other financial benchmarks shown are provided for illustrative purposes only. Investors cannot invest directly in an index. Comparisons to indexes have limitations because indexes have volatility and other material characteristics that may differ from a particular hedge fund. For example, a hedge fund may typically hold substantially fewer securities than are contained in an index.
Except where otherwise indicated, the information contained in this presentation is based on matters as they exist as of the date of preparation of such material and not as of the date of distribution or any future date. Recipients should not rely on this material in making any future investment decision.
