Welcome to RBC’s Markets in Motion podcast, recorded June 13th, 2023. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.
Three big things you need to know today. First, we continue to see expectations for a 2024 economic recovery embedded in GDP forecasts, and a healing process in earnings expectations is also underway – something we’ve been writing about a lot recently. Second, sentiment is embarking on its own recovery, with net bullishness returning to the AAII investor survey. Third, Small Caps appear to be getting their own recovery started, with a gain of more than 6.6% so far in June through Friday’s close, well in excess of the S&P 500’s 2.8% gain. Passive inflows have helped fuel the rebound, but we think the move is justified and remain overweight Small Caps relative to Large Caps.
If you’d like to hear more, here’s another five minutes. While you’re waiting a quick reminder that if you’ve found our work helpful, we’d appreciate your vote in this year’s Institutional Investor All America Research Survey in the Portfolio Strategy category. Voting is open now and expected to close June 23rd.
Now, the details.
Takeaway #1: Expectations For A 2024 Economic Recovery Persist, and Earnings Expectations Continue To Heal
We’ve been talking and writing a lot recently about the concept of recovery and its contribution to the strong move in the S&P 500 recently. One of the things we think the bears on US equities have forgotten is that the stock market is inherently a discounting mechanism. Big things usually gets priced in ahead of time. 2022 performance priced in challenges to the economy and earnings backdrop that are unfolding now, and our read on 2023 pricing is that it’s at least partly being driven by unfolding expectations for 2024.
On the economy, consensus GDP forecasts are expecting QoQ growth to return in early 2024 despite recent downward revisions to 2024’s full year forecast.
On earnings, bottom-up 2023 EPS forecasts among the stock picking sell-side have stabilized, as is normally the case around mid year in downgrade cycles.
The rate of upward EPS estimate revisions has also improved to 57% in early June.
And most sectors in the S&P 500 are experiencing positive revisions to both EPS and revenue forecasts.
Moving on to Takeaway #2: A Recovery Also Now Appears To Be Underway In Investor Sentiment
Like earnings revisions trends, investor sentiment is also mid way through a healing process. Last week, bulls surged and outnumbered the bears for the first time since February 2023 in the weekly AAII survey of individual investors. The shift in the data was striking and moved up to more than 20%, but was still shy of the 30% level that, on a four-week average, often signals trouble lies ahead for the stock market.
On the four-week average, it’s worth noting that this indicator is still tracking at -4.15%.
The improvement we’ve started to see in AAII is similar to the pick-up in positioning among asset managers that we’ve been seeing in the weekly CFTC data for S&P 500 e minis, which appears to be middle innings.
Interestingly, Nasdaq minis positioning among asset managers has broken through the high end of the range it’s been stuck in over the past few years.
Wrapping up with Takeaway #3: Small Caps Appear To Be Getting Their Own Recovery Started, With An Assist From Passive Flows
Small Caps are also trying to participate in the recovery theme, with a gain of more than 6.6% in June through Friday’s close. That’s been well in excess of the S&P 500’s 2.8% gain and Nasdaq’s 2.5% move over the same time frame. The outperformance of Small Caps has been striking, and started after the relative ratio between the Russell 2000 and the S&P 500 came close to its March 2020 low.
As we combed through higher frequency data last week, the thing that jumped out to us the most on Small Caps was the improvement in flows to Small Cap funds that has occurred in June.
Digging down deeper, the improvement has been driven by blend funds….
As well as passively managed funds, a data point that will likely fuel skepticism of the move.
Even though passive inflows have helped fuel the rebound, we think the move that the Russell 2000 has experienced is justified and remain overweight Small Caps relative to Large Caps. Last week we highlighted how earnings revisions trends have also started to turn positive for the Russell 2000 again, a development that has been driven by multiple sectors.
Valuations have also been compelling for the Russell 2000 versus its own history…
…as well as on a relative basis vs. the S&P 500…
and on the latter this has also been driven by most sectors.
Beyond Small Caps’ improvement in the earnings backdrop and compelling valuation profile, we’ve also been highlighting how periods of economic stress are normally good entry points for Small Caps.
Small Caps tend to start outperforming midway through recessions around when the u-rate begins to rise and around when tightness in C&I lending standards peaks. Small Caps also tend to outperform during easing cycles. Our Rates Strategy team has been highlighting how markets have mostly priced out 2023 cuts, but are still baking them in for 2024. Given how forward-looking Small Caps have been over the last few years, it’s rational to assume Small Caps are focusing more on the possibility of 2024 cuts than the potential for one more hike in 2023.
That’s all for now. Thanks for listening. And be sure to reach out to your RBC representative with any questions.