Indiana Trust Wealth Management
Investment Advisory Services
by Clayton T. Bill, CFA
Vice President, Director of Investment Advisory Services
- The U.S. equity market, represented by the S&P 500 index, rose 3.3% this week.
- The stock market has rallied strongly from its June lows. The S&P 500 is now down less than 10% on the year.
- The U.S. economy is slowing. However, if the slowdown is of the “soft landing”-variety versus a deep recession, small caps stand to do well.
Over the last month, the U.S. stock market has staged an impressive rally. The S&P 500 is now down 9.5% year-to-date, coming back over 15% from its mid-June low.
The market had turned extremely bearish over the first six months of the year. To fight high inflation, the Federal Reserve began a historically fast interest rate hiking cycle into a widely predicted U.S. economic slowdown. This is not a good combination. The odds of a deep recession were rising in the minds of investors.
Over the last several weeks, however, the odds of a “soft landing” for the U.S. economy have improved. Employment remains robust, corporate earnings have been solid, and, most importantly, signs of easing inflation have appeared in the data. The headline CPI print for the month of July was zero. The PPI (Producer Price Index) data released this week also pointed to softening price pressures.
A trend of muted inflation readings could lead to a pause in the Fed’s hiking cycle, which would be good for economic growth and stocks, generally. While one month of good CPI and PPI data hardly constitutes such a trend in the Fed’s eyes, investors are not going to wait for confirmation and so the market has rallied.
Small cap stocks have led the way during the upswing. Small caps may be viewed as having more leverage to U.S. economic growth versus large cap stocks, which are typically more global in nature and have more diversified business lines. The increased likelihood of a soft landing for the U.S. economy has provided a tailwind for small cap names.
Source: The Daily Shot, August 11, 2022
Another factor favoring small caps versus large company stocks is their relative valuation. The last time small caps were as cheap on a relative price-to-earnings basis was in the early 2000’s. Small caps, less exposed to the tech bubble during those years, subsequently had a long stretch of outperformance. Valuation measures such as the P/E ratio are poor short-term market timing tools, but they are helpful for building out medium- and long-term return expectations.
Source: Bank of America Global Research, August 2022
These valuation factors and exposure to economic growth support a measured allocation to small caps in a diversified equity portfolio.
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