Monitoring Earnings, The Rotation Trade, and The Pullback

Welcome to RBC’s Markets in Motion podcast, recorded July 29^th, 2024. 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: First, earnings season has been fine so far, and what we’ve read has kept us in the “tired goldilocks” camp. Second, we run through the latest updates for the indicators we’re monitoring in the rotation trade. We are mindful of headfakes, but think the trade may still have some room to run in the short term. We also still think whether a durable multi-year leadership transition is underway remains to be seen. Third, individual investor sentiment took a big hit last week per the AAII survey, while US equity flows have remained strong, keeping us on guard for an end to the current pullback.

If you’d like to hear more, here’s another 6 minutes.

Takeaway #1: Earnings Season Has Been Fine So Far on the Stats, Our Reading Has Kept Us in the Tired Goldilocks Camp

On the stat, the good news is that 79% of companies in the S&P 500 are beating consensus on EPS. The bad news is that only 58% are beating on sales. This has been a trend of late, but the gap has widened. It’s also worth noting bottom-up consensus EPS forecasts are holding steady for the S&P 500 ($244 for 2024, $278.50 for 2025). We simply haven’t seen much change to these since the start of reporting season.

The key themes in 2Q24 earnings call transcripts are still emerging but overall what we’re reading is keeping us in the “tired goldilocks” camp. Companies we’ve been reading have been highlighting a strong and stable backdrop and resilient consumers despite pressures from higher rates and inflation. Labor and cost pressures remain in focus. Commentary on international markets has been mixed. The Fed has been in focus, particularly the pressures emanating from higher interest rates. Uncertainty associated with the US election has been a bigger discussion point than the past.

Moving on to Takeaway #2: The Rotation Trade Still Has Some Room, Though We’re Mindful of Headfakes as some of our indicators are back to levels where the trade stalled out at last time. Whether This Is a Durable Leadership Transition Also Remains to Be Seen.

Here’s a rundown on what we’re watching:

First, we’ve been watching earnings sentiment (upward revisions trends) for a shift that would support further rotation in market leadership in the short term, but haven’t seen it yet. Despite the challenging news flow from the first few mega cap growth names that reported, the rate of upward EPS estimate revisions for the top 10 names in the S&P 500 remains much higher than the rest of the index.

The Russell 2000 remains at parity with the S&P 500 on this stat, an improvement from 2023 when this stat favored the S&P 500. But we’ve still not seen a clear shift in favor of Small Cap yet.

Second, consensus expectations. Different segments of the equity market are at very different places in their earnings cycles. Mag 7 names saw net income growth contract in 2022, and surge into recovery in 2023, with decelerating growth rates embedded for 2024-2025. Meanwhile, Russell 2000 net income growth contracted last year, and is expected to move into recovery in 2024 with a major ramp in 2025. The S&P 500 ex Mag 7’s cycle is more similar to Small Cap, with a milder recovery. Consensus forecasts are looking for the strongest net income growth in the next year and half from Small Caps. For the moment, Mag 7 net income growth is still expected to exceed the S&P 500 ex Mag 7 slightly. On both of the earnings stats we’re monitoring, the case for a leadership shift from Large to Small seems stronger than the case for rotation within Large Cap to us.

Third, positioning. It’s started to move but has more room to go for Mega Cap Growth and Small Cap. CFTC positioning data for Nasdaq 100 futures has started to slip from levels in line with February’s peak, but the decline has been modest so far. 

We’ve seen more of a shift in R2000 futures positioning, it’s getting close but isn’t quite back to early 2024’s peak. 

Fourth, valuation. Not too much change here recently. The top 10 S&P 500 names are still trading at a median forward P/E of 30x (a ceiling they’ve had trouble breaking through), while the rest of the S&P 500 remains at a median P/E of 17x (a little above average but well below prior peaks).

Meanwhile, the Russell 2000 weighted median forward P/E continues to sit at historical averages, a level that served as a ceiling after the big move in November and December of last year. Overall, we believe valuations remain a reason for the rotation trade within Large Cap to keep going. On the Small Cap side, valuations are neither a headwind nor tailwind.

Fifth, flows. In recent weeks, equity funds flows data has been highlighting a shift away from Growth and Tech, alongside a shift into Value, Small Cap, Industrials, Materials/Commodities and Financials. 

There were some hints of stabilization in Growth and Tech flows in last week’s update…

…and a little slippage in Value, Financials and Materials that we’ll be keeping an eye on. Bottom line – flows have been a tailwind for rotation but we are monitoring them for signs of a stall.

All of this speaks to shorter-term tactical issues. Whether or not we’re at the start of a durable multi-year shift in leadership is a separate question that we are still debating. We’ve highlighted in recent weeks that a sluggish below-average economic backdrop is more supportive of Growth and Large Cap leadership than Value and Small Cap leadership. In last week’s meetings, another concern came onto our radar. Our Rates team expects a short and shallow Fed cutting cycle, similar to 1995, due to the resilience of the US economy. The problem here for Small Caps is that Fed cuts usually only tend to serve as longer-term springboards for a new Small Cap leadership cycle when they occurred alongside recessions. 1995, when no recession occurred, was a rate cutting cycle that only benefited Small Caps for a short time.

Wrapping up with Takeaway #3: Individual Investor Sentiment Takes a Hit, While US Equity Flows Remain Strong, Keeping Us on Guard For an End to the Pullback

The current pullback in the S&P 500 has been -4.7% from recent highs at the closing low, not quite as bad as the April pullback but getting close.

We’ve gotten some relief on our sentiment work. AAII net bullishness fell to 11.5% as of 7/25/24, taking its 4-week average to 21.0%. This stat is no longer more than one standard deviation above the long-term average on the 4-week average, as was the case in last week’s update. This is good news for US equities, as stocks often stumble after hitting that one standard deviation mark on the 4-week average. We’ll be keeping a close eye on this data in coming weeks to see if optimism gets extended again or remains subdued.

Politics remain a challenge. The S&P 500 has generally continued to track expectations that Trump will win the White House in betting markets. Trump showed some signs of stabilization in certain betting markets/averages toward the very end of last week. But zooming out, Trump’s lead in betting markets has been narrowing. Interestingly, polling on the generic congressional ballot also tightened up over the weekend. We see the election as a source of uncertainty for the US equity market in coming months that could deepen the pullback, but note that pullbacks in presidential election years are normal.

That’s all for now. Thanks for listening. And be sure to reach out to your RBC representative with any questions.