The recent out-performance of US small-caps is facing technical resistance and lacks fundamental drivers to carry on for a longer period of time, according to Morgan Stanley’s chief US equity strategist Mike Wilson.
Driven by softer inflation and rising chances for another Donald Trump presidency, the Russell 2000 index, is up 6.7% in July versus a modest 0.8% for the S&P 500 as a lower-than-expected CPI reading propped up expectations of the US Federal Reserve lowering borrowing costs, which typically boosts smaller companies.
“While we’re respectful of still light sentiment/positioning in small caps, we see limited fundamental and macro justification for small cap outperformance continuing in a durable manner,” Wilson and his team said in a note to clients.
For Morgan Stanley strategists, the surge in small caps, fueled partially by dealer demand and short covering, lacks justifications in terms of profits when one compares the situation to past rallies.
“For those looking to the 2016 playbook, we would point out that relative earnings revisions for small cap cyclicals are much weaker today than they were during that period,” Wilson’s team wrote in a note.
US small-cap funds recorded $9.9 billion of weekly inflows, the second largest ever, Bank of America strategists said last week, citing EPFR Global data. During that week, the Russell 2000 hit its higher level in more than two years. Within the small cap universe, the strategists believe stocks which are growth-oriented offer the best prospects.
“Their valuation should benefit as the Fed cuts, yet at the same time, their revenue streams are less adversely exposed to the reason why the Fed is able to cut — falling pricing power,” they concluded.
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