Category: Markets

Why the Fitch Downgrade is Better for Investors

Posted on by phoffman@channelchek.com

With a Longer Time Horizon, The US Credit Downgrade Helps the Market

Providing third-party research and analysis that then ranks an entity’s debt or equity outlook, including companies and sovereign nations, requires extremely high integrity. The mostly negative news headlines responding to the Fitch Ratings downgrade of the United States Long-Term issuance to AA+ from AAA is an indication of how much pressure analysts must be under to avoid issuing a downgrade. This is true whether the rating impacts the entire free world, or the stakeholders and their families of a small public company through company-sponsored research.

Most high-caliber analysts have built a model that gives them little room for pressure from the outside, either from the ranked entity, the investors, or even the financial media. It is undoubtedly easier to do nothing and cross your fingers as an analyst, but that doesn’t actually serve anyone well, including investors or the entity.

Background

In late May, while investors and other market watchers were trying to determine on which day in June the US Treasury would run out of money, Fitch, a securities rating service, placed a ratings watch on US debt which they had held at triple-A, the highest rating, indicating the lowest default risk for the issuer.

On July 31, the US Treasury unveiled an overview of its third-quarter debt issuance needs. At $1.007 trillion, it would be the largest third quarter on record. I have experience as an issuer ranked by Fitch and Moody’s while CIO of two funds that held a rating in order to meet specific investor guidelines.  Rating agencies are the first to be made aware of any changes being considered. So I suspect that Fitch, Moody’s, and S&P analysts were all aware of the details of what the Treasury planned and projected going forward. Moody’s downgraded the US back in 2011 from its lowest default risk rating. Its treatment back then was also not one of appreciation from the markets, investors, or the issuer.

This clip from the movie The Big Short attempts to show the movie-goer all the relevant pressures an analyst may be under, and why integrity is critical.

Thoughts on Ratings Move

Cathie Wood had a conversation on (Twitter) Spaces this morning with Pension & Investments’ Jennifer Ablan in an exclusive mid-year interview. Ms. Ablan asked Ms. Wood’s thoughts on the US downgrade. The Ark Invest founder didn’t hesitate to say that there is “a side that is happy to see it.” She went on to explain that it helps those managing the organization, in this case Washington, to do a better job. She explained that it  says, “legislature, let’s get your act together.” Wood, added “government spending is taxation.”

While Cathie Wood was discussing the most powerful nation in the world, the same concept should be applied to a company she holds, or you own that experiences a downgrade. It serves to help management discover weak areas they could pay more attention to and gives the investor the understanding and confidence that a third party is looking on and even consulting with management before they make any moves that may alter the rating.

Michael Kupinski, the Director of Research at Noble Capital Markets, is a veteran analyst that has undoubtedly had to ignore pressure from the outside and follow models he’s created to the path they help provide. Mr. Kupinski says, “Ratings and earnings revisions are a function of the dynamics of new, and, likely extreme, inputs on the investing continuum.” He then explained how all could benefit,  “Such revisions then present management a roadmap for the new baseline in expectations or for a course correction. As such, ratings provide a valuable currency to determine investment merits, set investment expectations, and for investors to determine risk,” said Michael Kupinski.

Take Away

Don’t shoot the messenger – instead, thank them.

A negative change in ratings, whether it be on debt issuance, equity issuance, or frankly ones own credit rating could serve to preserve something before it goes further down a bad path, and can be used as a guide to adjust and do better. While there was a lot of criticism for Fitch placing the USA on credit watch for a downgrade back in May, if they had not issued a downgrade as US Treasury issuance climbed even higher, it would cause investors to think that no one is paying attention. The outcome of not having another trusted set of eyes, on any security issuance, is weaker pricing.

Paul Hoffman

Managing Editor, Channelchek

Meet the top management and hear the compelling stories of less talked about opportunities, while mingling with analysts and knowledgeable investors at this year’s NobleCon19

Sources

Fitch US Downgrade Press Release

Cathie Wood Jennifer Ablan

Michael Kupinski

An Increased Need for Treasury Borrowing Will Impact All Markets

Posted on by phoffman@channelchek.com

Stocks, Bonds, and Real Estate Markets are All Impacted By U.S. Debt Levels

Who will buy all the U.S. Treasury debt issuance? This week the Treasury Department hinted at its borrowing needs estimate for the third quarter. Its estimated need is $1 trillion-plus, the largest third-quarter need ever. At the same time, the Federal Reserve is reducing its holdings of U.S. debt by a cumulative $90 billion each month, and the U.S. dollar is on a weakening trend which reduces demand for dollar-denominated assets. There are now concerns being raised about the extent to which domestic and foreign demand for U.S. debt issuance will be able to grow to match issuance.

More details surrounding the Treasuries financing needs will be released at 8:30 on Wednesday August 2nd. The large estimate already shared in advance, $1.007 trillion, has analysts beginning to conclude that the U.S. could become hampered with a deteriorating fiscal deficit outlook amid continuing pressure to borrow more.

Two months ago, analysts at Fitch Ratings, a bond credit rating company, put the United States on Rating Watch Negative (RWN) citing, among other things, “fiscal and debt trajectories.” The initial ratings watch came at a time when there was uncertainty about whether the U.S. debt ceiling would be raised. It was not only increased, on June 2nd President Biden signed Congresses bill removing any upper limit on debt issuance until January 2025. The increase in debt, reduced number of buyers, lack of fiscal guardrails, and already higher interest rates on rollover debt could have consequences for all markets. Fitch may be prompted to replace the AAA rating on US Treasuries by assigning a lower rating.

At stake for the broader fixed-income market is that most corporate debt issuance is spread to U.S. Treasury rates of similar duration bonds. If large ongoing auctions over the third quarter deplete demand at market levels Treasury yields would have to trade higher, or government debt would face being illiquid or even default.

In the past U.S. Treasury borrowing need has been met by the perceived safety in the country’s ability to prosper and pay its debts, as well as the reliability of the U.S. dollar as a reserve currency. It’s unclear with less stable relations with China (a large holder of U.S. debt) and the BRICS nations plans to create a gold-based fiat currency, if demand will shrink or grow while U.S. debt issuance climbs.

At stake for the broader real estate market, which is heavily leveraged and therefore greatly impacted by interest rate expenses, is for the cost of borrowing to rise should demand for Treasuries not meet new issuance levels. Thirty-year residential loans are spread off ten-year Treasuries. Further increases in mortgage rates would serve to slow down real estate transactions.

The stock market would likely become bifurcated with stocks tied to big ticket items, typically bought by securing financing, weakening, and stocks that benefit from a strong dollar (higher comparative rates strengthen a native currency) could also do well. These stocks include companies that don’t have a large overseas customer base — if they are net importers, they may benefit even more. Companies that have large borrowing needs, will find their cost of capital has increased as they compete with U.S. Treasury rates. This is why small cap companies, that have very little borrowing needs, tend to perform better than large-cap companies with high debt levels in similar industries.

Source: St Louis Federal Reserve

One Federal government expense that it can’t exercise immediate control over is the interest rate expense of its debt. Over $32 trillion in debt, spread out to mature through 30 years, now holds an average rate of near 2.50%. New debt is issued with almost double that interest rate. This is evident in the chart above that shows interest on debt from 2020 until today increased by $400 billion – with no expected change in its growth rate.

In a Tuesday note title “Treasury Tsunami,” rates strategists at Barclays Anshul Pradhan and Andres Mok wrote, the “Treasury’s latest financing estimates point to a worsening fiscal profile” and “the fiscal picture has worsened significantly since last year.” They point to the likelihood of “a sharp increase in the supply of notes and bonds over the coming quarters,” and cautioned investors against expecting “a typical end-of-cycle bond market rally.”

Whether or not the Fed continues to remain hawkish, if this recipe of greater U.S. debt issuance need continues on its trajectory, with fewer buyers, interest rates will rise. For investors with the common 60/40 portfolios, that is to say 40% in bonds, higher rates will mathematically cause prices of their fixed income holdings to decline. They may receive interest payments every six months, but if interest rates keep increasing, what others are willing to pay for that payment stream declines. In this way, bonds and other fixed income is only the place to hide if you want to be certain of declining values of your holdings.

Take Away

The Fed could stop tightening, and still there would be upward pressure on Treasury rates because of increased supply. Interestingly, this would serve to create a normally sloped yield curve (not inverted) which, according to many that were saying this year’s inverted yield curve is an unmistakable sign of impending recession, they would have another chance at being wrong again by saying an upwardly sloping yield curve is signs the market expects robust growth. Taken in the context of all of 2023s market dynamics and manipulations, neither textbook simplification fits.

If the scenario of higher rates out on the curve unfolds, a higher cost of capital will impact some industries more than others, and international companies differently than pure domestic operations. Consider this as you make your own interest rate and economic projections and adjust your holdings accordingly.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.fitchratings.com/research/sovereigns/despite-debt-limit-agreement-us-aaa-rating-remains-on-negative-watch-02-06-2023#:~:text=Fitch%20Ratings%2DNew%20York%2D02,and%20the%20outlook%20for%20medium%2D

https://fiscaldata.treasury.gov/datasets/average-interest-rates-treasury-securities/average-interest-rates-on-u-s-treasury-securities

https://www.morningstar.com/news/marketwatch/20230801306/eye-popping-borrowing-need-from-us-treasury-raises-risk-of-buyers-fatigue

What Investors Learned in July That They Can Use in August

Posted on by phoffman@channelchek.com

Looking Back at the Markets in July and Forward to August

Enthusiasm for the overall stock market remained strong in July. The major indices were all up, and every S&P sector closed in positive territory. Despite the Federal Reserve which continued its monetary policy tightening, and suggestion that it is not finished, markets looked at waning inflation and still strong employment and began to believe a soft landing is now more likely. During the month Nasdaq decided to rebalance the Nasdaq 100, this was completed as of the market open on July 31. The purpose was to allow the index to better reflect price movements in the top 100 Nasdaq stocks. As with the S&P 500, the weighting of the five largest companies represented in the index, has been a concern for many investors that don’t believe the index represents the overall market moves well. On the other side of the scale, for the second month in a row, the small cap Russell 2000 index led the other popular market indexes by a wide margin.

Earnings season or second quarter reporting, which kicked off mid-July, has so far exceeded estimates for many highly followed companies; this has also kept the markets rising in July.  Whether the strong market momentum continues through August may depend on if inflation continues to show signs of coming down toward the Fed’s 2% target.

Image Credit: Koyfin

Look Back

Four broad stock market indices were positive in June. In order, the Russell 2000 Small Caps, Nasdaq 100 Large Caps, the Dow Jones Industrials, and S&P 500 Large Caps.

Small cap stocks are the big winner in June as investors went looking for value. The Russell 2000 rose 6.11%, which follows a large 8.07% gain the previous month. The smaller stocks may now have more positive impetus that could carry over into August. Just prior to the beginning of July, Goldman Sachs had estimated that based on their models, small cap stocks could rise 14% over the next 12 months.  This helped small cap stocks continue their outperformance as more investors begin to exercise caution toward the high P/E ratios in larger companies and recognize the historical value still represented in small cap company valuations.

The Nasdaq maintained its growth as big tech retained its appeal despite individual company market caps that have exceeded those of developed countries. The Nasdaq 100 was up 3.81%, following 6.49% in June. The Dow 30 Industrials made headlines for a week as it had a 13 day winning streak. It returned 3.35% during July after a 4.56% increase in June. The S&P 500 was the worst performing index at 3.11% after rising 6.47% the previous month.  All major indices are off their all time highs that were reached in Winter 2021.

Source: Koyfin

Market Sector Lookback

Of the 11 S&P market sectors (SPDRs), even the lowest performer had an above-average one-month return. The chart above reflects the three best-performing sectors and the three worst. The top performer demonstrated the strength of energy during the month as oil and natural gas prices rose.  

The energy sector had the best return at 7.77% during July.  Continued disruption as countries work toward renewables, the war in Ukraine, and even a coup in Niger all helped the sector attract investors.

Communications was second with a 5.70% return. On June 26, the White House announced internet infrastructure spending plans that helped support and should continue to help many companies in this sector.

Investors began returning to companies in the financial sector as a rebound from March and April when investors became leary after a few bank failures. Bank earnings in July showed better-than-expected performance on many of the large banks. This helped the move back into financials. The sector returned 4.81% in July.

The three worst-performing sectors also indicate the month was very positive. Consumer Staples which was third from the bottom returned a respectable 2.13%. Investors view this sector as a defensive play in times of economic uncertainty. Its move shows less interest as investors become more positive on the economic outlook.

The second to weakest performer is Real Estate. The sector has held up fairly well considering how closely its performance can be tied to interest rates. The 1.33% return in June is indicative of the entire market’s resilience yet lower probability of the sector in light of a still hawkish Fed.

Health Care is still out of favor. Investors had a lower level of interest in healthcare stocks, which are also considered defensive. Lower market volatility and a brighter economic outlook have investors less interested in defensive stocks. Also, interest rates could be affecting big pharma as dividends on the stocks become less appealing as bond yields rise.

Looking Forward

The job market is strong, inflation is tapering,  and consumers are more confident. Analysts are now expecting that companies that have been waiting for a more friendly market to go public are considering now as a good time for their IPO.

Bitcoin and other cryptocurrencies, along with stocks of crypto exchanges, are still faced with uncertain legal outcomes and regulatory positioning. Artificial intelligence as a growing component of many industries, is driving interest as investors look to uncover those companies that will benefit the most both directly (ie: selling chips) or indirectly (ie: gain efficiency).

The rotation to small caps and sectors that perform better when the economy improves has a lot of momentum heading into August. This sector has a long way to run before it catches up with the large cap sectors that it historically surpasses over time.

Take-Away

The market showed more signs of relief in July as the conversation changed from an upcoming recession to a likely soft landing. With five more months in 2023, the markets have rallied and are not showing signs of retrenching. This is especially true of small cap stocks that for the second month have handily outperformed large caps.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.barrons.com/livecoverage/stock-market-today-072723/card/dow-ends-13-day-winning-streak-as-markets-slide-E6vt9Ow8tIPvRB87SWNQ

https://www.whitehouse.gov/briefing-room/statements-releases/2023/06/26/fact-sheet-biden-harris-administration-announces-over-40-billion-to-connect-everyone-in-america-to-affordable-reliable-high-speed-internet/

The Week Ahead – Earnings, Interest Rates, and US Dollar

Posted on by phoffman@channelchek.com

This Trading Week – Earnings Reports are Likely to Set the Tone

Just over half of the companies in the S&P 500 have now reported second-quarter earnings. Of these companies, 80% have surprised on the high side with actual EPS above the average estimate – 4% have reported earnings equal to the average expectations. The reporting sectors beating estimates by the most are Information Technology at 93%, and Communication Services, which beat average estimates 92% of the time. Of sectors that beat the least often, Utilities and Financials were at the bottom of the list at 67% and 70%, respectively, surpassing average estimates. These are also above 50%, supporting strong stock markets.

The weaker US dollar has helped companies with more international exposure as these have had improved year-over-year earnings above those companies with a higher percentage of domestic revenue.

The markets are likely to focus on the earnings reports this week as economic releases will be slow. Stocks may also take its cue from interest rates that have been rising for longer duration US Treasuries.

Monday 7/31

•             9:45 AM ET, The Chicago Purchasing Managers Report is expected to improve 2 points in July to a still very weak 43.5 versus 41.5 in June, which was the tenth straight month of sub-50 contraction. Readings above 50 indicate an expanding business sector.

•             10:30 AM ET, The Dallas Fed Manufacturing Survey is expected to post a 15th straight negative score, at a consensus minus 22.5 in July versus minus 23.2 in June. The Dallas Survey gives a detailed look at Texas’ manufacturing sector, how busy it is, and where it is headed. Since manufacturing is a major sector of the economy, this report can greatly influence the markets.

Tuesday 8/1

•             9:45 AM ET, the final Purchasing Managers Index (PMI) for manufacturing for July is expected to come in at 49.0, unchanged from the mid-month flash to indicate marginal contraction (above 50 indicates expansion).

•             10:00 AM ET, Construction Spending for June is expected to rise a further 0.6 percent following May’s 0.9 percent increase that benefited from a sharp jump in residential spending.

•             10:00 AM ET, JOLTS (Job Openings and Labor Turnover Survey) still strong but slowing is the consensus for June as it is expected to ease 9.650 million from 9.824 million.

Wednesday 8/2

•             10:00 AM ET, New Home Sales are expected to slow after a much higher-than-expected 763,000 annualized rate in May. Junes are expected to have slowed to 727,000.

•             10:30 AM ET,  The Energy Information Administration (EIA) provides weekly information on petroleum inventories in the US, whether produced here or abroad. The inventory level impacts prices for petroleum products.

Thursday 8/3

•             8:30 AM ET, Jobless Claims for the week ended July 30, 2023, are expected to come in at 225,000 versus 221,000 in the prior week. Claims have been moving lower in recent weeks. This is a classic case of where what might otherwise be considered worsening news (increased jobless claims) may be taken well by the market as tight labor markets are considered additive to inflation pressures.

•             8:30 AM ET, Productivity and Costs (nonfarm) is expected to rise at a 1.3 percent annualized rate in the second quarter versus 2.1 percent contraction in the first quarter. Unit labor costs, which rose 4.2 percent in the first quarter, are expected to rise to a 2.6 percent rate in the second quarter.

•             9:45 AM ET, PMI Services. Following Tuesday’s PMI Composite Final for manufacturing, which has been contracting, the Services Purchasing Managers Index is expected to indicate no change at 52.4 as the July final.

•             10:00 AM ET, Factory Orders are expected to rise 1.7 percent in June versus May’s 0.3 percent gain. Factory Orders is a leading indicator that economists and investors watch as it has been a fairly reliable indicator of future economic activity.

•             10:00 AM ET, The Institute for Supply Management (ISM) gauge is expected to have slowed to 53 from June’s 53.9 level. An ISM reading above 50 percent indicates that the services economy is generally expanding; below 50 percent indicates that it is generally declining.

•             4:30 AM ET, The Fed’s Balance Sheet is expected to have decreased by $31.208 billion to $8.243 trillion. Market participants and Fed watchers look to this weekly set of numbers to determine, among other things if the Fed is on track with its stated quantitative tightening (QT) plan.

Friday 8/4

•             8:30 AM ET, Employment Situation is expected to show that the unemployment rate unchanged at 3.6%, with a consensus for payrolls at 200,000 versus the 209,000 reported in June.

What Else

On Thursday quarterly results will be reported on Apple (AAPL) and Amazon (AMZN). The week will be the busiest one of the earnings season. About 30% of the S&P 500 will give their financial updates during the week, including Alphabet (GOOGL), Microsoft (MSFT), Meta (META), and Robinhood (HOOD). Several big pharma companies are getting ready to report, and it’s a big week for industrial companies and big oil as well.

We’re near the halfway point for Summer 2023. Have you signed up to receive Channelchek market-related news and analysis in your inbox?  Now is a good time to make sure you don’t miss anything!

Paul Hoffman

Managing Editor, Channelchek

Learn more about NobleCon19 here

Sources

https://tradingeconomics.com/calendar

https://us.econoday.com/byweek.asp?cust=us

https://advantage.factset.com/hubfs/Website/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_072823.pdf

Mismatches Between a Company’s Words and Actions

Posted on by phoffman@channelchek.com

Investors Especially Hate Companies that Say They’re Good Then Behave Badly – Unless the Money is Good

The Big Idea

Stock investors punish companies caught doing something unethical a lot more when these businesses also have a record of portraying themselves as virtuous. This hypocrisy penalty is the main finding of a study we recently published in the Journal of Management.

Companies often espouse their supposed virtue – known as “virtue signaling” – usually with the aim of getting benefits, such as higher sales, positive investor sentiment or better employees. We wanted to know what happens when such companies then do something wrong.

This article was republished with permission from The Conversation, a news site dedicated to sharing ideas from academic experts. It represents the research-based findings and thoughts of, Brian L. Connelly, Professor of Management and Entrepreneurship, Auburn University, Lori Trudell, Assistant Professor of Entrepreneurship, Clemson University.

So we examined corporate communications and media coverage for every company in the Standard & Poor’s 500 to develop a comprehensive database of both virtue signaling and misconduct.

To gauge virtue signaling, we conducted linguistic analysis of each company’s letters to shareholders. This is a form of computer-aided text analysis that identifies and categorizes language to draw inferences. For example, we looked for words and patterns to identify conscientiousness, empathy and integrity and considered how language patterns developed over time. Each company received a score that reflected how much of their corporate communication was devoted to virtue rhetoric.

We then examined over half a million news articles to identify unethical behavior, such as egregious events like a CEO’s being fired for sexual misconduct, but also less severe transgressions, like not treating employees fairly.

Finally, our study considered how shareholders respond. Specifically, we looked at price swings the day after the media initially reported the misbehavior.

We found that share prices fell 1.5% overnight in response to unethical behavior when companies had engaged in lots of virtue signaling, compared with 0.4% for those that did less virtue signaling or none at all. For an average company, that difference amounts to over half a billion dollars in lost value.

Keep in mind, too, that these ethical violations are not uncommon events. About a quarter of companies in our sample engaged in this kind of behavior in any given year. Stated simply, bad things happen, and when they do the stock market will clobber those who do not seem to be walking their talk.

Well, with one critical exception related to a company’s expected future performance. If investors anticipate that a company will perform well in the future, there is no hypocrisy penalty – the consequences of misconduct are the same for those that use virtue signaling and those that do not.

Apparently, shareholders are very concerned about executives who say one thing and do another – unless the company is expected to make lots of money, in which case there is little or no penalty for unethical behavior.

Why it Matters

Many companies, and the CEOs who run them, publicly say they care a lot about their people, the environment and the communities around them, among other virtuous signals.

For example, ice cream maker Ben & Jerry’s proudly declares that it seeks to “advance human rights and dignity, support social and economic justice for historically marginalized communities, and protect and restore the Earth’s natural systems.” At the other end of the political spectrum, restaurant chain Chick-fil-A proclaims that it is “about more than just selling chicken”; its corporate purpose: “To glorify God by being a faithful steward of all that is entrusted to us.”

Whether from the right or the left, this virtue signaling establishes, and implicitly promises adherence to, a set of ethical standards. What happens, though, when behavior does not align with virtuous talk?

Academics have two decidedly different views about how to answer this question. Some contend that virtue signaling buffers companies from the negative ramifications of misconduct. Another perspective suggests that there’s a more severe adverse reaction whenever anyone deviates from expectations. Think, for example, of the special vehemence reserved for the priest who pilfers from the church coffers.

Our study confirms that the latter – a hypocrisy penalty – is more likely what is happening.

What’s Next

We are now exploring different types of shareholders and how they respond to organizational behavior – and misbehavior. For example, social activist funds could be especially put off when companies in which they invest behave badly, whereas the most powerful institutional investors are less likely to be concerned about a mismatch between a company’s words and deeds.

Stock Market Imbalance Has Fastest Increase in 60 Years

Posted on by phoffman@channelchek.com

The Warning Signs that the Mega-Cap Era Is Coming to an End are Growing

By Monday of next week, the Nasdaq 100 will be rebalanced to reduce the weighting of its top holdings and add weight to the smaller companies represented. This event can be grouped with the number of experts and outlets waving yellow and red flags warning U.S. stock market investors about the reliance on mega-caps for continued performance. The number of warnings has been increasing. The original purpose of any index is to measure overall market or sector performance. Currently reported performance in the most popular indexes is dependent on five to ten mega-cap names – this trend is not sustainable through time.  JP Morgan (JPM) is the most recent firm to warn about an extreme concentration of a few stocks.

JPMorgan Chase & Co.’s equity analysts, led by Chief Global Markets Strategist Marko Kolanovic, warn that overweighting towards very few companies of extremely large-cap stocks could spell trouble ahead. In a research note published on July 24, the firm writes historically, such periods of extreme concentration have often led to negative outcomes. In fact, the current level of concentration is growing at the fastest pace since the 1960s, surpassing even the extremes seen during the infamous dot-com bubble in March 2000.

To illustrate the stark divergence between the largest U.S.-listed companies and the rest of the market, the JPM team compared the six-month change in the index weighting of the ten largest stocks in the S&P 500 with that of the next 40. This analysis revealed that over the past six months, the divergence has widened in favor of the biggest companies, reaching levels comparable to the “Nifty 50” era of the 1960s—a period when large-cap stocks were highly favored by investors.

JPM Chase, July 24, 2023

Crowding in growth stocks represented in the S&P 500 is currently at the 97th percentile historically. This is a level not seen since the dot-com bubble period. While the team provided extensive data and analysis to support their concerns about overconcentration, they were less definitive about the timing or specific implications for the market.

JPM Chase, July 24, 2023

A selloff is expected and appears likely according to JPM; predicting its timing is more challenging. The team pointed out several potential catalysts, such as a deep recession or a sudden resurgence of inflationary pressures, but it remains uncertain when the downturn may begin. Nonetheless, the JPM team believes that the peak in concentration will coincide with waning investor interest in the generative AI/large-language model theme, a trend that has contributed this year to the significant divergence in equity performance.

In light of Monday’s special rebalancing of the Nasdaq-100, the JPMorgan team suggested that this move could potentially mitigate concentration risk by easing the outperformance of mega-cap technology stocks, including Apple Inc., Microsoft Corp., Nvidia Corp., and Alphabet Inc., which have been major beneficiaries of the AI boom. If a larger percentage of dollars entering large-cap funds find their way to the ticker symbols below the giants at the top, the pace at which the markets have become unbalanced may slow or correct without a major problem.

The JPM team pointed out that if correct, speculators may capitalize on this by considering that the S&P 500 equal weight may be in a position to outperform the S&P 500 traditional weight methodology products over the next three to six months.

Interestingly, there are already signs that the overconcentration problem highlighted by JPMorgan are beginning to ease. Over the last month, the S&P 500 equal-weighted index has outperformed its market-cap-weighted counterpart by 2 percentage points, according to FactSet data.

Despite these concerns, the U.S. stock market closed higher on Monday, with the Dow Jones Industrial Average booking its 11th consecutive daily gain, marking its longest winning streak in nearly six years. The performance of the value-heavy Dow, which has been catching up, while the year-to-date rally of mega-cap tech stocks has stalled, highlights the ongoing dynamics in the market.

Take Away

While some market gurus like Michael Burry have been warning of a bubble brought about by index funds, since 2019, the weighting in indexes have only increased. By the last day in July, the Nasdaq 100 will have taken steps to relieve some of the pressure by shrinking the weighting of the top holdings. JP Morgan analysts are still concerned that the trend is strong and can end with a catalyst triggering an unwinding and move away from the larger high P/E names.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://insight.factset.com/topic/companies-and-markets?_ga=2.236820420.453682497.1690312070-153117876.1690312070&_gac=1.92287727.1690312086.Cj0KCQjw5f2lBhCkARIsAHeTvlgwKsM2zr6tQTIKuToXNk5q7Ukbankb732U4FD1PQ7yHveCJjDgyA0aAkF9EALw_wcB&_gl=1*3sxwh5*_ga*MTUzMTE3ODc2LjE2OTAzMTIwNzA.*_ga_2Q3PTT96M8*MTY5MDMxMjA3MS4xLjEuMTY5MDMxMjA5MC4wLjAuMA..

https://www.marketwatch.com/story/overconcentration-in-u-s-stock-market-has-reached-highest-level-in-60-years-jpmorgan-warns-6f8a0766?mod=hp_LATEST&adobe_mc=MCMID%3D04828691964107368544310185344499067435%7CMCORGID%3DCB68E4BA55144CAA0A4C98A5%2540AdobeOrg%7CTS%3D1690290760

The Week Ahead –  FOMC Meeting and Earnings Reports Will Shape the Mood

Posted on by phoffman@channelchek.com

This Trading Week May be Pivotal in the Push and Pull Between Bulls and Bears

The overwhelming focus this week is on the FOMC meeting Tuesday and Wednesday. There is widespread expectation that after skipping a chance to raise rates in June, the Federal Reserve will bump the overnight lending rate up by 25 bp. This would push the target to 5.25%-5.50%. Policymakers have been clear that they don’t believe they are finished in their battle against inflation but have always maintained their actions are data-dependent. Data on inflation over the past month indicate previous moves could be having the desired impact. If the FOMC determines inflation is trending toward its goal of 2% and is expected to stay on the path, it may not find another hike prudent. However, the Fed won’t see a June reading on its preferred inflation indicator, the PCE deflator, until after the FOMC meeting.

Monday 7/24

•             8:30 AM ET, The Chicago Fed National Activity Index in June is expected to have risen to just above neutral at 0.03 (zero equals historical average growth). This would be up from a lower-than-expected minus 0.15 in May.

•             9:45 AM ET, The Purchasing Managers Index Composite flash reading has been above 50 in the last five reports with the consensus for July at 54.0 versus June’s 54.4. A reading above (below) 50 signals rising (falling) output versus the previous month and the closer to 100 (zero) the faster output is growing (contracting).

Tuesday 7/25

•             9:00 AM ET, The Federal Open Market Committee meeting to decide the direction of monetary policy begins.

•             1:00 PM ET, Money Supply is forecast to show that M2 for the month of June rose 0.6% to $20,805.5 billion. The markets resumed focusing on money supply as a way to view the progress and impact of quantitative easing. It helps decipher how the Fed’s actions are filtering through the economy.

Wednesday 7/26

•             10:00 AM ET, New Home Sales are expected to slow after a much higher-than-expected 763,000 annualized rate in May. Junes are expected to have slowed to 727,000.

•             10:30 AM ET,  The Energy Information Administration (EIA) provides weekly information on petroleum inventories in the US, whether produced here or abroad. The inventory level impacts prices for petroleum products.

•             2:00 PM ET, The FOMC announcement. After holding steady in June, the Fed is expected to raise its policy rate by 25 basis points to a range of 5.25 to 5.50 percent.

•             2:30 PM ET, The post FOMC Chair Powell press conference helps market participants understand the Fed’s decision(s), if any, during their two-day meeting.

Thursday 7/27

•             8:30 AM ET, Durable Goods Orders are forecast to have risen 0.5 percent in July following June’s 1.8 percent jump. Ex-transportation orders are expected to edge 0.1 percent lower as are core capital goods orders, after also coming in high the previous reporting period.

•             8:30 AM ET, Second-quarter GDP is expected to slow to 1.5 percent annualized growth versus first-quarter growth of 2.0 percent. Personal consumption expenditures, after the first quarter’s burst higher to plus 4.2 percent, are again expected to rise but by only 1.5 percent. Whether or not the US has entered a recession is substantially hinged on whether GDP is negative for a prolonged period (typically two quarters).

•             4:30 AM ET, The Fed’s Balance Sheet is expected to have decreased by $22.371 billion to $8.275 trillion. Market participants and Fed watchers look to this weekly set of numbers to determine, among other things if the Fed is on track with its stated quantitative tightening (QT) plan.

Friday 7/28

•             8:30 AM ET, Jobless Claims Jobless for the week ended July 22 are expected to come in at 235,000 versus 228,000 in the prior week.

•             8:30 AM ET, Wholesale Inventories are expected to increase 0.1 percent (advance report) for June, it was unchanged in May.  

 •            10:00 AM ET, Consumer Sentiment is expected to end July at 72.6, unchanged from July’s mid-month flash and more than 8 points higher from June. Year-ahead inflation expectations are expected to hold at the mid-month’s 3.4 percent which was one tenth higher than June.

What Else

The week ahead is also set to be the busiest one of earnings season. Thursday will be the most intense day. About 30% of the S&P 500 will give their financial updates during the week, including Alphabet, Microsoft and Meta. Several big pharma companies are getting ready to report and it’s a big week for industrial companies and big oil as well.

Sign up for Channelchek updates on this week’s FOMC meeting as announcements unfold, and to be updated on other critical information.

There will be a number of Roadshows held during the week in South Florida and St. Louis. Learn more about who’s presenting and how to attend by clicking here.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.federalreserve.gov/newsevents/calendar.htm

https://us.econoday.com/byweek.asp?cust=us

Why, When, and How to Rebalance Your Portfolio 

Posted on by phoffman@channelchek.com

There are More Reasons to Balance Your Investments than to Let Them Ride

Performance differences of varied allocations in an investment portfolio over time will disrupt the original balance. It doesn’t take long for the portfolio to be overweighted in some sectors and underweighted in others. This can add unintended risk not included in the original plan. One tried and true method of resetting the risk to its original setting, is regular portfolio rebalancing. Below, we’ll highlight why investors rebalance their portfolios, how to know how often is prudent, and the importance of reviewing and maybe revising allocations during the rebalancing process.

Why Do Investors Rebalance Their Portfolios?

Rebalancing helps to retain the characteristics of a decided upon asset allocation. This enforces the mix in sot not veering too far from an allocation that takes into consideration the expected risk adjusted return characteristics of the portfolio, and supports the individuals investment policy statement (IPS)

Asset allocation refers to the distribution of investments across different asset classes, such as stocks, bonds, crypto, real estate and cash. A well thought out portfolio may also consider market capitalization of the securities in the stock portion of their investments as these too have different performance characteristics.

Over time, market movements cause the value of the portfolio assets to fluctuate, as one segment grows faster, or loses value faster than other assets. This unbalances the original asset allocation. Because this is portfolios lose their balance, investors will mark their calendars to, at set intervals, rebalance their portfolios to bring it back in line with the intended allocation.

Bringing a portfolio back to the original decided upon helps with two main important goals.

Risk Management: Different asset classes carry varying levels of risk. By rebalancing, investors can ensure that their portfolios remain aligned with their risk tolerance. For instance, if stocks have performed exceptionally well, their increased value could lead to a higher proportion in the portfolio. Rebalancing allows investors to sell some stocks and allocate the proceeds to other assets to manage risk effectively. Over time this can have the effect of selling off securities as they become overvalued, and buying others when they are undervalued.

Long-Term Strategy: Regular rebalancing forces investors to maintain their long-term investment strategy. It prevents the portfolio from becoming overly skewed towards one asset class, which could result in excessive exposure to specific market conditions. Regularly rebalancing ensures that the investment strategy remains intact, even during periods of market volatility.

How Often Should Investors Rebalance Their Portfolios

The frequency of portfolio rebalancing depends on individual preferences, investment goals, and market conditions. While there’s no one-size-fits-all approach, common rebalancing strategies include:

Time-Based: Investors can rebalance their portfolios on a predetermined schedule, such as quarterly, semi-annually, or annually. This approach ensures regular monitoring and adjustment of the portfolio.

Threshold-Based: Investors can set predetermined thresholds for asset allocation. When the allocation deviates beyond these thresholds, rebalancing is triggered. For example, if the target allocation for large-cap stocks is 30% and it exceed 35%, the entire portfolio would be rebalanced to the original desired mix.

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Reviewing Allocation Changes when Rebalancing

Isn’t selling your winners and increasing your losers a bad strategy? When rebalancing a portfolio, investors should review and carefully consider allocation changes. This is risky because the purpose of rebalancing and doing it at set trigger points is to make sure emotion doesn’t prevent the investor from thinking that a particular allocation will rise, fall, or move sideways forever. If one is reviewing changes to the allocation, they should start with their stated investment objectives and assess the performance and expectations of each asset class against the objectives.

Key points to consider include:

Diversification: Rebalancing presents an opportunity to reassess the diversification of the portfolio. Ensure that investments are spread across multiple sectors, regions, or asset types to mitigate risks associated with concentration.

Investment Objectives: Investors should review whether their investment objectives have changed over time. If so, they may need to adjust their target asset allocation accordingly. If the portfolio is retirement money, as one approaches retirement, conventional wisdom suggests they should reduce assets that expose them to the most uncertain returns.

Market Conditions: Assess the performance and outlook of different market-caps, industries, and overall asset classes. For example, if rates are expected to rise, reducing the weighting in dividend stocks could be a historically-supported wise decision. Allocate resources to areas that demonstrate growth potential while considering expected risk factors.

Take Away

Time-tested wisdom says investors should, at regular intervals or triggers, rebalance their investment portfolio. This helps them take some profits and invest in securities that haven’t yet risen, or perhaps have gotten cheaper.

By rebalancing, investors can manage risk, align their portfolios with their investment goals, and prevent overexposure to assets that have already had their big run and may be ready to retrace their rise. The frequency of rebalancing should be based on individual circumstances and preferences, while careful review and consideration of allocation changes are crucial for optimal portfolio management. Regularly monitoring and adjusting portfolios through rebalancing can help

Paul Hoffman

Managing Editor, Channelchek

The Week Ahead –  With Few Economic Stats, Earnings Reports Will Take on Added Importance

Posted on by phoffman@channelchek.com

The Trading Week is Light on Data and Heavy On Quarterly Earnings Reports

After last week’s lower-than-expected CPI and PPI inflation readings, the markets are far less certain what the FOMC will decide at their policy meeting July 25-26. Clarity is not going to come from addresses by any Fed Presidents as they enter a blackout period where they are forbidden to speak on the subject between July 15 and July 27. One report that the markets will be focused on during the week involves unemployment, which, if up, may cause the markets to rally – remember we are still in a period where bad economic news causes a positive stock market reaction.

Investors looking for direction may find it in the earnings reports as major banks, metals producers, and closely followed tech companies will be releasing their quarterly earnings reports.

Monday 7/17

•             8:30 AM ET, The New York State Manufacturing Index is expected to drop to negative 7 for June after unexpectedly climbing 38 points to +6.6 in May 2023, from a four-month low of -31.8 in May.

Tuesday 7/18

•             8:30 AM ET, The consensus for Retail Sales for June is up 0.4% after unexpectedly rising 0.3% month-over-month in May, following a 0.4% increase in April, which beat forecasts of a 0.1% decline. It’s clear the ability to forecast has been economic numbers, especially consumer activity has been difficult.

•             8:55 AM ET, The Johnson Redbook Index is forecast to show a year-over-year, same week, increase of 1.1%, for the week ending July 15. This would follow a 1.6% increase the prior reading. The Redbook is a sample of large US general merchandise retailers representing about 9,000 stores. By dollar value, the Index represents over 80% of the equivalent ‘official’ retail sales series collected and published by the US Department of Commerce.

•             9:15 AM ET, Industrial Production is expected to have risen by 0.1% in June, after declining by 0.2% from a month earlier in May.

•             9:15 AM ET, Manufacturing Production is expected to be flat month over month for June after rising 0.1% in May.

•             9:15 AM ET, Capacity Utilization is expected to have remained in a non-inflationary low 79.5% rate during June. When industries are bumping up against capacity, costs will increase as operations become less efficient because less effective resources are called on to produce, thus increasing the cost of each unit of production.

•             10:00 AM ET, Federal Reserve Vice Chair for Supervision Michael S. Barr will be speaking on fair lending practices at the National Fair Housing Alliance National Conference. The Fed is in a blackout period this week, so it is expected that there will be no discussion of monetary policy.

Wednesday 7/19

•             8:30 AM ET, Building permits consensus forecast for June is for 1.505 million after May’s strong 1.486 million.

•             8:30 AM ET, Housing Starts month over month for May increased by 21.7%, the forecast is for a decline of 10.2% for June.

•             10:30 AM ET,  The Energy Information Administration (EIA) provides weekly information on petroleum inventories in the US, whether produced here or abroad. The inventory level impacts prices for petroleum products.

Thursday 7/20

•             8:30 AM ET, Initial Jobless Claims are expected to have increased the week ended July 15 to 245,000 from 237,000 the prior week. Employment data ahead of the July 25-26 FOMC meeting, in the absence of any fresh inflation data until the 28th has the potential to move markets.

•             10:00 AM ET, Existing home sales in the US, which include completed transactions of single-family homes, townhomes, condominiums, and co-ops, is expected to decline by 1.2% month over month for June. This would follow a small increase of 0,2% the previous reading.

Friday 7/21

•             No major economic releases scheduled.

What Else

The FOMC meeting is Tuesday and Wednesday during the last full week in July. The Fed can do one of three things, lower rates, raise rates, keep rates unchanged. Like all good multiple choice questions, one of these answers can be eliminated. On Thursday of last week (July 13), Federal Reserve Board Gov. Christopher Waller said he was not swayed by June’s benign consumer inflation data and said he wants the central bank to go ahead with two more 25-basis-point rate hikes this year. “I see two more 25-basis-point hikes in the target range over the four remaining meetings this year as necessary to keep inflation moving toward our target,” Waller said this in an address to The Money Marketeers on NYU, a bond market club with some of the most powerful fixed income professionals as members. If the Fed is data dependent and there is little new data since the last inflation readings, Waller’s position is not likely to change.

Paul Hoffman

Managing Editor, Channelchek

How the US and the UK Intend to Improve Capital Markets

Posted on by phoffman@channelchek.com

Why Issuer-Sponsored Research Has Become a Priority in the UK (and US)

Why are the United Kingdom, The United States, and other countries providing an atmosphere that helps promote company-sponsored research?

Last year the SEC issued a report that was required by Congress on issues affecting the investment research of small companies. Last week the UK accepted, in its entirety, a recommendation on issuer-sponsored research. Both countries recognize the needs of investors, issuers, and the overall economy. Investors and issuers ought to be particularly interested in these changes and how they’ll improve the financial system.

Investment Research

Research is like the grease in the capital markets that keeps money from being stuck. It can be categorized into three types: sell-side research, buy-side research, and independent research.

Sell-side research is provided by full-service broker-dealers for clients to consume.

Buy-side research is created by institutional money managers for in-house use to help them make investment decisions on the money they manage.

Independent research is provided by firms that are neither broker-dealers nor institutional money managers, this service is paid for by investors or at no cost to investors as the company that has issued the security has sponsored the analysis.

Analysts often specialize in a specific industry and will regularly provide research on companies within that industry. This research includes written reports that discuss market developments, financial projections, target prices, and overall ratings or recommendations (such as buy, hold, or sell). The specific content and terminology used in research reports will vary.

These research reports can be published at any time, especially in response to important corporate events like earnings releases. While sell-side and buy-side research may have limited distribution, independent research is more widely available to money management firms and individual investors.

Research helps investors gain clarity about a company and its prospects. It can provide interpretations of significant events related to the company, such as media coverage or predictions from other analysts. Individual investors can also benefit from research reports by using them as part of their overall investment decision-making process.

In addition to producing written research reports, research providers may also assist issuers by arranging meetings or conference calls between investors and the senior management of companies. These roadshows help allow better understanding and communication between investors and the companies they may be interested in.

Overall, research is essential in the capital markets, it provides valuable information and insights that help investors make informed decisions about their investments. It helps reduce uncertainty and allows investors to assess the potential risks and rewards associated with different investment opportunities.

Analysts can also introduce or express their opinions about specific of covered companies using other forums such as video interviews, print media, or investor/issuer conferences. Additionally, sell-side analysts who work for broker-dealers that offer investment banking services may, within regulatory guidelines, be involved in investment banking transactions.

Benefits to Issuer

Research helps investors by discovering and delivering important information about companies. Well-rounded investors consider research an important part of the information they use to make investment decisions, including staying up to date on analyst forecasts for the company and industry, management forecasts, earnings announcements, and SEC filings. This fosters improved liquidity, which benefits price discovery and execution on demand.

According to the Congressionally mandated SEC report titled Staff Report on the Issues Affecting the Provision of and Reliance Upon Investment Research Into Small Issuers, research coverage of a company positively affects the liquidity of its stocks. When a company loses analyst coverage, its stock liquidity can decrease. This decrease in liquidity is more pronounced for smaller companies with fewer analysts covering them. Research coverage also helps investors recognize and pay attention to companies, which affects their value. Investor attention can be gained by engaging research and analysis firms to initiate coverage to gain investor attention.

Excerpt from the Securities and Exchange Committee Report, February 2022, (page 11):

“Studies have shown that research coverage of an issuer is positively related to its stock liquidity and that a reduction in research coverage of an issuer may reduce its stock liquidity. For instance, one study found that issuers that lose analyst coverage for at least one year suffer a ‘significant deterioration in bid-ask spreads, trading volumes, and institutional presence.’

Other studies have found that the reason for this deterioration is that decreases in analyst coverage increases information asymmetry, which can cause issuers to switch to financing that is less sensitive to information asymmetry, including decreasing their use of equity and long-term debt, or cause issuers to decrease their total investment (e.g., capital, research and development and acquisition expenditures) and financing. This decline in liquidity was shown in one study to be more significantly pronounced for smaller issuers, issuers with relatively less analyst coverage, and issuers with a bigger increase in information asymmetry resulting from the loss of an analyst.”

According to the SEC report, research analysts also serve as a comfortable third-party mechanism by monitoring a company’s management. Their scrutiny increases transparency and makes it harder for managers to engage in self-dealing activities. Analysts monitor financial statements, ask questions during earnings announcement conference calls, and distribute information to investors, helping detect any misconduct by management.

When a company loses analyst coverage, according to an SEC review, markets anticipate an increase in agency costs, such as the misuse of cash reserves by managers. The number of analysts covering a company is related to the compensation of chief executive officers and the likelihood of value-destructive corporate acquisitions. Decreased analyst monitoring is also associated with increased earnings management by companies.

The UK Goes All In

On July 10, 2023, the UK formally announced they are on a mission to improve capital markets. A large segment of the new, self-imposed mandate includes the consensus that investment research is an important part of the UK public capital markets and that the availability and quality of expert analyst research is significant in attracting (and retaining) issuers and investors. The Chancellor of the Exchequer is adopting seven action items aimed at “protecting and developing the UK as a centre of excellence for investment research.”

Source: UK Investment Research Review , July 10, 2023 (page 5)

The report states that introducing a research platform to help generate research would help improve research coverage and would help promote a greater interest in smaller cap companies where there is currently a scarcity of research coverage.

The plan is to allow additional optionality for paying for investment research. And would address some of the unintended consequences of the MiFID II unbundling requirements, this aims to increase choices regarding payment for research to permit asset managers to pay for research on a bundled basis and to ensure that UK investment managers remain able to procure research from elsewhere, particularly from the US.

Retail investors have always been at a disadvantage, the UK mission supports greater access to investment research for retail investors, helping to level the playing field.

In developing a research platform open to all, the UK wishes to involve academic institutions and explore situations to strengthen the collaboration between universities and the capital markets ecosystem.  

By providing rules, boundaries, and guidelines, the UK believes it can support issuer-sponsored research by implementing a code of conduct.

The Uk wishes to clarify aspects of the UK regulatory regime for investment analysis or better define it to help simplify access to investment research.

And the last on the UK’s “To Do” list is to review the rules relating to investment research in the context of IPOs with the following points to consider:

  • Changing the FCA Conduct of Business Rules, introduced in 2018, designed to encourage unconnected research analysts to produce research in connection with IPOs. These rules have not had the desired effect of increasing IPO coverage by unconnected analysts but have consequentially extended the UK IPO timetable, putting the UK at a competitive disadvantage.
  • Making IPO-connected analyst research available on a basis similar to the prospectus so that all investors can access the same information.
  • Lower the current restrictions on analysts meeting potential IPO candidates prior to an investment bank being mandated on the IPO are also seen as putting the UK at a disadvantage to other listing venues.

Take Away

Investor access to investment research is important to the capital markets system as it helps money to flow much more easily where needed. Offerings that are better understood and have an additional layer of third-party oversight can attract more needed capital. This reality has been echoed by the SEC and the UK regulatory bodies.

Third-party investment analysis particularly helps smaller companies that may be less understood, as studies show, research coverage improves liquidity among small cap stocks. Investors, particularly retail, benefit from unbiased research and are more likely to make decisions on companies they believe they have a firm understanding of.

All in all, the UK and US authorities understand research provides valuable benefits to investors and the market as a whole. It enhances stock liquidity, increases investor recognition of companies, and serves as an external governance mechanism by monitoring and deterring managerial misconduct.

To have free access to small and microcap company research from the veteran equity analysts at Noble Capital Markets, sign-up here. If you are responsible for the investor relations of a company that may benefit from well-respected coverage, please contact Channelchek here for more information on company-sponsored research.  

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.cfainstitute.org/-/media/documents/code/other-codes-standards/analyst-issuer-guidelines.ashx

https://www.sec.gov/files/staff-report-investment-research-small-issuers.pdf

https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1168719/UK_INVESTMENT_RESEARCH_REVIEW_-_RACHEL_KENT_10.7.23.pdf

https://www.lexology.com/library/detail.aspx?g=d36aa9a5-d058-4ddc-93d1-ef430dbe3fe7

Reasons to Be Even More Positive on Small Caps in the Second Half

Posted on by phoffman@channelchek.com

Statistically, 2023 Should Finally Be the Year for Small Caps

It has been six months since I shared the hard data and a graphic from Royce Investment Partners. In the firms most recent letter to investors, the firm reiterated the reality that after any consecutive five-year period where small-cap stocks had returned less than five percent, the following year, returns averaged 14.9%. Senior management of Royce again stated in its July newsletter, that a five-year low-performing period occurred 81 times in history, 81 times small caps had a sixth year with very good returns.

Source: Koyfin

Are Small Cap Stocks on Track to Make it 82 Times in a Row?

The five-year period 12/31/83 through 6/30/23, was below 5% for each year. January kicked off the sixth year return was up over 5%.  Since the strong January, we have had a strong June, and so far July. Year-to-date, the Russell 2000 index is up 9.4%, which is a strong six months – with six months to go. If it stays on course, small caps will keep the “100% of the time history.”

What is even more exciting is that in the month of June alone, the small cap index was up 6.9% and so far in July is up on the month and outperforming large cap indexes, which are all down on the month.   

Source: Koyfin

While a 100% of the time track record is comforting, the idea that so far only months that start with the letter “J” have been up, and after this month, we run out of “J” months, is concerning. The Royce newsletter dated July 7th has pointed out another positive statistic for where we are now.

Co-CIO Francis Gannon recognized, “It’s true that January and June were the only months so far in 2023 when the Russel 2000 had positive returns. There were four straight down months in between.” Gannon explained that this is also a rare occurrence that has occurred only nine times since the start of the Russell 2000 on the last day of 1978. The Co-CIO said, “For the eight periods for which we have data, subsequent one-year returns averaged 24.7%; subsequent three-year returns averaged 21.0%; and subsequent five-year returns averaged 16.8%.”

Source: Royce Capital Partners

These numbers work on a simple, buy-the-dip phenomenom, but quantify it in a way that gives investors confidence that at a minimum there is a rationale behind expanding holdings in small cap stocks.

Take Away

Investing, at it’s core, is putting statistics on your side, expecting that it is not different this time, then letting historical probabilities play out.  Large cap stocks are expensive compared to small caps. This may not be the only reason the two scenarios discussed in newsletters from Royce Capital Partners have played out. But other factors, including a rebalancing of the Nasdaq 100 Index this summer, strongly favor a more competitive performance of small cap stocks in 2023 than we have experienced in five years.

Paul Hoffman

Managing Editor, Channelchek

Sources

Bullish for the Long Run—Royce (royceinvest.com)

Nasdaq Tells Investors, “We’re Taking a Little Off the Top”

Posted on by phoffman@channelchek.com

Nasdaq Special Rebalance Will Create Winners and Losers

The Nasdaq press release didn’t provide much information, but index investors have been talking about the need to reweight large-cap funds for years. Later this month, the Nasdaq 100 will be rebalanced. Unlike the Russell Indexes, which have an annual rebalance process, this will be only the third time in history. The last Nasdaq 100 reweighting was in 2011. This will affect stock prices, potentially, by quite a bit.

The seven big tech stocks like Apple (AAPL), Microsoft (MSFT), and Meta (META) have market caps that rival entire stock exchanges outside of the US. The popular stock indexes, including the Nasdaq 100, weights stocks with a larger market cap more heavily than those with lower market caps. The result is the movement of these indexes don’t necessarily reflect the movement of the stocks within the index. In the case of the Nasdaq 100, ninety-three other stocks taken together are weighted by only 44.5%.

The rebalancing is expected to trim the weighting of at least six of the seven largest stocks in the index and increase the weighting somewhat of many others. Similar to what occurs each June during the Russell Index Reconstitution, index fund managers will have to sell those stocks that experience reduced weight and buy those stocks that have increased weighting in the benchmark index.

The Big Seven that Are Likely to be Trimmed

Microsoft (MSFT)………..12.9%

Apple (AAPL)………..12.5%

NVIDIA (NVDA)……….7.0%

AMAZON (AMZN)……….6.9%

Alphabet (GOOG)……….3.7%

Alphabet (GOOGL)……….3.7%

Tesla (TSLA)……….5.5%

Meta Platforms  (META)……….4.3%

The seven-largest companies in the Nasdaq 100 impact 55.5% of the index’s movement. This combined weighting will be lowered. Investors can also expect relative weighting shifts within these upper echelons.

Current Weighting and Methodology

The Nasdaq 100 index is a modified market-cap-weighted index. Overall Market valuation is the largest factor, but with oversight and review of concentration to help benefit users of the index.

Currently, MSFT has the largest weight. AAPL, which has a larger market cap than MSFT has a lower weight. Alphabet has the next highest weighting with the GOOGL and GOOG share classes combined. NVDA recently jumped to a 7% Nasdaq 100 weight, just ahead of AMZN. Tech/car company TSLA, and META are the final two represented in the top seven that are expected to end the month with some of their current weighting being added to stocks with smaller market values.

Key Dates and New Methodology

The Nasdaq 100 includes the 100 largest non-financial Nasdaq components.

The weighting changes will be announced on Friday, July 14, after the market close. The current 100 tickers will all still be intact. 

The Nasdaq 100 special rebalance will take place before the Nasdaq open on Monday, July 24, to “address overconcentration in the index by redistributing the weights.” This has only happened twice before, in December 1998 and May 2011.

The combined weight of the five companies with the largest market caps, will be set to 38.5. The top four alone, have a combined weight of 46.7%. So these company’s can expect meaningful reductions. Nasdaq has also adjusted its methodology to state that no company outside the top five can have a market cap exceeding 4.4%. This implies that Tesla will also experience a little trim in its weighting.

Why it’s Important

With 17% additional weighting to be shared down the line in the Nasdaq 100 index, there may be a huge shift in individual stocks. The official new weightings are to be released Friday July 14, based on July 3 market data. This will include companies that see an increase in weighing.

According to Nasdaq, more than $300 billion in exchange-traded funds tracked the index as of the end of 2021, that number has since risen considerably. Currently, QQQ, the Invesco Nasdaq 100 ETF (QQQ), by itself, has over $200 billion in assets. Index fund managers using the benchmark will need to sell some of their holdings in the largest constituents of the index, and add to their positions in other stocks, based on the Nasdaq readjustments that we will learn about after the close on Friday July 14.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.nasdaq.com/press-release/the-nasdaq-100-index-special-rebalance-to-be-effective-july-24-2023-2023-07-07

https://www.barrons.com/articles/nasdaq-100-special-rebalance-apple-stock-price-98515240

The Week Ahead –  Beige Book, Inflation Numbers, FOMC Minutes, Employment

Posted on by phoffman@channelchek.com

This Full Trading Week May Decide the Direction of the Markets for the Rest of 2023

Inflation will be a big focus this week as the CPI, PPI, and import and export prices for June will be released in this order at 8:30 on the last three days of the week. These economic reports are the final inflation readings the Federal Reserve will get before its July 25-26 meeting. The Beige Book also has the ability to alter market sentiment as this is a large part of the data and discussions used at the FOMC meeting. The Beige Book, which is information from each Fed reporting district, is released on Wednesday afternoon.

Monday 7/10

•             10:00 AM ET, The second estimate of Wholesale Inventories is a 0.1 percent draw, unchanged from the first estimate.

•             10:00 AM ET, Mary Daley the President of the San Francisco Fed, will be speaking.

•             3:00 PM ET, Consumer Credit is expected to show that consumers borrowed $20 billion more in May. This compares to a $23 billion increase in April.

Tuesday 7/11

•             6:00 AM ET, The National Federation of Independent Business (NFIB) optimism index has been below, and often far below, the historical average of 98 for the past 17 months. June’s consensus is 89.8 versus 89.4 in May.

Wednesday 7/12

•             8:30 AM ET, The Consumer Price Index, or CPI, is expected to show that core prices in June are slowed to a modest 0.3 percent on the month versus May’s 0.4 percent. Overall prices are also expected to rise 0.3 percent. Annual rates are expected to slow sharply at the headline level, to 3.1 from 4.0 percent, and also for the core, to 5.0 from 5.3 percent.

•             10:00 AM ET, The Atlanta Fed Business Inflation Expectations is not one of the more widely watched inflation reports. But in these times of the markets grasping on anything that may foretell where inflation is headed, this number has the potential to be impactful.

•             10:30 AM ET,  The Energy Information Administration (EIA) provides weekly information on petroleum inventories in the US, whether produced here or abroad. The inventory level impacts prices for petroleum products.

•             2:00 PM ET,  The Beige Book is a report on economic conditions used at FOMC meetings. This publication is produced roughly two weeks before the monetary policy meetings of the FOMC.

Thursday 7/13

•             8:30 AM ET, Employment numbers seemed to be the new razor-sharp focus among Fed watchers. Initial claims for the prior week are expected to be at the 248,000 level.

•             8:30 AM ET, Producer prices in June are expected to rise 0.2 percent on the month versus a 0.3 percent fall in May. The annual rate in June is seen at plus 0.4 percent versus May’s plus 1.1 percent. June’s ex-food ex-energy rate is seen at 0.2 percent on the month and 2.8 percent on the year which would exactly match May’s results.

•             4:00 PM ET, Fed’s Balance Sheet data is expected to show that the Fed holds $8.98 trillion in US debt. The total assets are forecast to drop by $42,602 billion.

Friday 7/14

•             10:00 AM ET, the Consumer SentIment first indication for July, is expected to rise to 65.0 from June’s surprisingly high 64.4.

What Else

Last week the BLS reported the US economy added 209,000 jobs in June. This helped cause the unemployment rate to fall to 3.6%, near its 50-year low. This spurred inflation worries and spooked the bond market, which in turn impacted the broader stock market. Looking at the make-up of the numbers may be less worrisome. It seems the US government has been the last to begin hiring after the pandemic. Excluding government hiring, private sector payrolls grew by only 149,000 in June. This is the slowest since December 2019 and below the 166,000 monthly average in 2017-19.

So the reaction may have been more of a reason for the market to take a breather after a strong June, than increased concern over a hot job market.  

Paul Hoffman

Managing Editor, Channelchek