Finding Value in Mid and Small-Cap Stocks
Federal Reserve Chairman Jerome Powell acknowledged during his recent congressional testimony what many Americans have been feeling. The economy, while stable, is showing signs of fatigue. Job opportunities are slightly scarcer, and inflation remains a persistent concern for both consumers and policymakers.
Simultaneously, the stock market has experienced a meteoric rise since October, leaving investors and analysts alike questioning its sustainability. The rapid ascent has led to speculation that the market may need a breather, or as Street Pro columnist Doug Kass suggested, we might be entering a phase where individual stock performance diverges from the broader market trends.
Market Anticipations for the Upcoming Week
The coming week holds significant potential for market shifts as earnings season ramps up and a series of economic reports are set to be released. This period could provide the necessary conditions for a market slowdown, allowing investors to reassess their positions.
The Implications of Thursday’s Decline
Following record-setting highs for the S&P, Nasdaq, and Nasdaq-100 indexes, a notable stumble occurred on Thursday, primarily triggered by an 8.4% drop in Tesla (TSLA). This decline, the largest one-day fall for Tesla since January, was attributed to reports suggesting a potential delay in the company’s planned August 8 robotaxi unveiling.
This sudden drop halted the impressive rallies these indexes had experienced, having risen in 10 out of the previous 11 days. On Friday, the Dow Jones Industrial Average closed at 40,000.90, marking its second-ever close above the 40,000 threshold. However, earlier in the day, the Dow reached an intraday record high of 40,257.24 before a wave of selling ensued, pushing the index down by 257 points.
Evaluating Market Volatility
The volatility observed on Thursday and Friday raises critical questions about the market’s future trajectory. Specifically, investors are contemplating whether a significant market correction is imminent and if the dominance of Big Tech stocks is about to wane.
Understanding Market Corrections
A market correction is typically defined as a decline of 10% or more from recent highs. The last significant correction occurred between November 2021 and October 2022, when the S&P 500 fell by 24%, entering bear market territory. This downturn was driven by rampant speculation in meme stocks and cryptocurrencies, coupled with the Federal Reserve’s aggressive stance on inflation, resulting in 11 rate hikes from early 2022 to July 2023.
The current market scenario bears some resemblance to the 2021-2022 period. Overbuying, especially among large-cap stocks, has been a notable trend this spring. Data from Yardeni Research highlights the disparity in forward price-to-earnings (P/E) ratios between the largest and smaller stocks. As of Friday, the P/E ratio for the largest stocks, including the “Magnificent 7” and Netflix (NFLX), stood at 31.5, compared to 21.4 for the S&P 500 overall, 15.5 for the S&P Midcap 400, and 14.6 for the S&P Smallcap 600.
Key Takeaways
Economic Fatigue: The U.S. economy shows signs of slowing, with job growth decelerating and inflation remaining a persistent issue.
Market Rally: The stock market’s rapid rise since October has led to concerns about overvaluation and the potential need for a correction.
Tesla’s Impact: Tesla’s significant decline triggered a broader tech stock stumble, highlighting the volatility within the sector.
Correction Concerns: Investors are wary of a potential market correction, defined by a 10% or more decline from recent highs.
Valuation Disparities: Large-cap stocks exhibit higher P/E ratios compared to mid-cap and small-cap stocks, suggesting overbuying in the biggest companies.
Conclusion
The stock market’s recent performance has sparked discussions about the sustainability of its gains and the potential for a correction. As the earnings season progresses and new economic data emerges, investors will need to navigate a landscape marked by economic fatigue, inflation concerns, and sector-specific volatility. Diversifying beyond high-flying tech stocks and seeking value in mid-cap and small-cap stocks may provide a prudent strategy in the current environment.
