A Breadth of Fresh Air
Market Insights
Brian Weisenberger, CFA, Senior Market Strategist
Market Insights is a piece in which Kensington’s Portfolio Management team will share interesting and thought-provoking charts that we believe provide insight into markets and the current investment landscape.
Improving Breadth as Q2 Earnings Approach
The first half of 2024 for U.S. equity markets, particularly large caps, has been defined by advancing indices with very limited breadth. Of the 11 sectors that make up the S&P 500, only two have outperformed the index over the past year (chart below): Technology and Communication Services (which is technology-heavy). While markets have benefitted from these sectors’ strong performance, it has also created significant concentration, leaving markets vulnerable should tech underperform.
Small Caps on the Rise
However, with last week’s better-than-expected CPI inflation report, a potential shift has taken place as the more interest rate-sensitive small-cap sector has started to take off. Last week, the small-cap index, the Russell 2000, advanced by 6%, outperforming the S&P 500 for the week by the largest such margin since April 2020. Encouragingly, the trend has continued into this week, with the index rising an astounding 10.3% in five trading days (through July 15th), compared to just 1.08% for the S&P 500 over the same period (chart below).
A Breadth of Fresh Air
The shift is not just confined to small caps. In the first half of 2024, the S&P 500 had been buoyed by the performance of a small number of stocks. In fact, the top 10 biggest stocks in the S&P 500 contributed to 77% of the index’s total return through June. However, the recent surge in small caps has also coincided with a rotation within the S&P 500. For only the 26th time since 1936, advancing issues on the NYSE outpaced declining issues by a ratio of 3 to 1 over successive trading sessions last week (chart below), expanding breadth within the S&P 500 to its strongest reading since April.
Q2 Earnings on Deck
While all of this is potentially a positive indicator for market strength going forward, this recent push has been predicated on optimism for Fed rate cuts in September (a long way away) and will likely need to be supported by improved Q2 earnings if it is to continue. Outside of the Magnificent 7, S&P 500 earnings have been flat to down for the past five quarters, justifying their underperformance over the past two years. Q2 is expected to mark the first growth quarter for the “Other 493” since Q4 2022 (chart below).
This improvement would come at a good time as earnings expectations for AI stocks, which have carried the market for a year and a half, are expected to decline going forward (chart below). A rise in earnings for non-AI-related companies is a best-case scenario for the bull market to continue.
Even with a significant rise in earnings for the “Other 493,” the bar is set fairly high for this earnings season. The S&P 500 is currently projected to show 8.8% year-over-year growth in EPS for Q2 (chart below), a meaningful rise from previous quarters, and even if accurate, it may not be enough to support further growth.
According to DataTrek Research, “The magic number for Q2 earnings season is a 6.6% earnings beat versus expectations. Given that U.S. large caps are near record highs, this is the bare minimum necessary to keep equity valuations at current levels.” While this number is certainly achievable (the average earnings surprise beat since 2019 is 8.6%) (chart below), given the higher earnings expectations this quarter, it is certainly not a given.
Conclusion
As we look ahead, it’s clear that while the recent market performance is encouraging, the upcoming Q2 earnings will be a critical determinant of how the second half of 2024 unfolds for U.S. equities. The improving (but still limited) breadth of market participation, driven by a few key sectors, underscores the necessity of robust earnings across a wider array of companies to sustain momentum. Given the current landscape of higher valuations, it is essential for investors to remain nimble and vigilant in order to capitalize on opportunities while managing risks effectively.
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