It May Be Time For Small Caps To Shine

Stocks started off on the wrong foot yesterday when the Bureau of Labor Statistics announced that job openings in December rose to the highest level in three months. That may unnerve Fed officials, who want to see continued signs of softening in the labor market. Yet an open position is not inflationary unless it is driving the rate of wage growth higher, and that is not happening. Wage growth peaked in June 2022 and has been declining ever since. Furthermore, the number of workers who quit their jobs in search of a better one, otherwise known as the quit rate, fell to the lowest level in three years. That suggests workers are finding it harder to switch jobs for higher pay.

I expect to see a more meaningful deceleration in the rate of job creation during the first half of this year, with monthly numbers falling short of consensus estimates, but not to alarming levels. One factor should be a sharp deceleration in government hires. The government added an average of 56,000 jobs per month in 2023, which is more than double what it added in 2022. Most of these were at the state and local level, fueled by federal stimulus, which has now dried up. A decelerating rate of job growth should give the Fed all the ammunition it needs to begin normalizing rates in March. Regardless, Chairman Powell is likely to lean on this number to keep investors guessing about when it is appropriate to start reducing rates. That won’t do technology stocks any favors.

Based on nothing more than stellar year-to-date performance, as well as lofty valuations, I assumed we would see investors who had bought the rumor of good earnings reports from members of the Magnificent 7 decide to sell the news. That is what happened last night after the close when Microsoft and Alphabet posted their numbers. These mega-cap technology names trade at a 34% premium to the overall S&P 500 based on a forward price-to-earnings ratio. They may be magnificent, but investors must ask themselves up to what price.

Some are making comparisons between today’s dominance of the ten largest stocks, which include the magnificent ones, and the concentration we saw of the same number during the peak of the dot-com bubble in 2000. Back then their percentage rose to 33.2% of the MSCI USA Index, which accounts for 85% of total market capitalization. Today, the percentage has risen to more than 29%. Back then the hype was the internet, while today it is artificial intelligence. It sounds like the same story line with a different cast of characters, but I don’t see valuations as extreme today as they were back then, despite the premium. Still, everything must go right for these names, and I see a lot more value in small- and mid-cap companies.

I have been looking for a pullback in the major market averages since the beginning of the year to resolve the overbought technical condition of the market, but it has been elusive up to this point. The Magnificent 7 are to blame. Yet the average stock has seen a pullback, with the equal-weight S&P 500 sliding approximately 3.5% this year and the Russell 2000 small-cap index shedding more than 8%.

If the ten largest names correct 10%, that would shave 3% off the S&P 500, drawing the index closer to its 50-day moving average. I find it notable that while the Nasdaq 100 futures are lower by 1% this morning, the Russell 2000 is edging higher. That makes sense to me given the strength of the domestic economy. I think we will see a gradual rotation from expensive growth to inexpensive value as this year progresses, but it will take a rate-cut cycle combined with continued economic growth to see that happen.

Chairman Powell is likely to provide investors with reasons to be cautious between now and the next Fed meeting in March. That caution should be all it takes to fuel further consolidation in markets, but it will be one that sets the stage for the next leg up in the major market averages, as it was last March and October.