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Cool Inflation and Market Rotation

Inflation has continued to decline through this summer, as the Consumer Price Index (CPI) grew just 3% on a year-over-year basis through June, lower than the 3.3% increase in May.  The CPI was down 0.1% from May to June, meaning that prices moved lower for the first time since mid-2020.  The 3% rise in prices is a major decline from previous heights, as inflation peaked at 9.1% year-over-year growth in June 2022.

This recent CPI reading had a significant impact on the market, to the great benefit of diversified investors.  There was a sharp rotation out of the expensive mega-growth stocks and a surge of investor interest in cheaper parts of the market, such as small-cap and value-oriented investments.

The Russell 2000 Index of smaller companies shot up 11.5% over five days ending July 17 after the CPI report.  Small caps outperformed large caps by 10% over this period, the all-time largest return spread between small and large companies since the creation of the Russell 2000 index in 1979.  The broad indexes of large companies such as the S&P 500 Equal Weight ETF (RSP) also performed very well over this brief period; and bonds held their ground.

The timing of this type of explosive move cannot be predicted, and there is always a risk it could be shorter lived.  But we do believe that the last few weeks have demonstrated the value of a diversified portfolio.  The mega-cap growth stocks were all negative on the day of the CPI reading, dragging the S&P 500 lower by nearly one percent despite almost 80% of stocks in the Index having a positive return.  In our opinion, that type of performance dispersion highlights the risk of growing concentration at the top of the S&P 500, where just ten stocks make up 37% of the index (as of June 30).

As we wrote recently in your June market commentary:

“It is often said that rotation is the lifeblood of a bull market. This means that as a bull market continues, other investments often need to rotate in and take the lead.  There is no doubt that the other 493 stocks of the S&P 500 have struggled on a relative basis, and that story has been similar for several years.  But this lesser loved portion of the market, with the addition of international stocks, along with mid- and small-cap stocks, all are undervalued compared to their historical range, in some cases drastically so.  For example, valuations for U.S. small caps have only been as cheap as they are relative to large caps in two other periods: 1974 and 1999.  Each of those periods preceded the beginning of cycles where small companies provided excess investor returns.  It is quite possible that areas of the equity market that have lagged and have lower valuations could benefit from an ongoing expansion and a broadening out of the market rally.”

It is likely that the recent CPI reading supports coming interest rate cuts in 2024.  This should help the businesses of many companies and could lead to a broadening of market performance.  We may have witnessed the catalyst that leads to a longer-term market rotation.

It is premature to assume the broadening and market rotation that has occurred will last through the rest of the year and longer.  There is always the risk of market volatility, and with a coming election there are many political and economic unknowns (although on average election years tend to be good ones for the stock market).

As seen in the below chart, markets have tended to work in cycles, with leadership changes lasting not years but decades.  As Warren Buffet said, “Great companies make great investments at great prices.”  The starting prices for much of the market outside the mega-tech stocks remain attractive, and a stronger economic backdrop could help fuel ongoing rotation.

Source: Windgate Wealth Management; Ibbotson & Associates

Perritt Capital Management, Inc. is the registered investment advisor for Windgate Wealth Management accounts
All investments carry some level of risk, including the potential loss of principal invested.

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