Roger Montgomery | Montgomery Investment Management
Patience is a virtue in the investment world. It can take two to three years, or even longer, for sentiment to shift the full 180 degrees from bearish to unbridled optimism. This is because scepticism, an uneven distribution of information, and inertia ensure the path to enthusiasm is not instant but takes time. This slow shift is a normal part of the investment and market narrative, and understanding this can bring a sense of reassurance and calm to investors.
The full implications of important information are never immediately absorbed by everyone in the market simultaneously. That means that even good news takes time to be considered, assessed and adopted through prices, ensuring trends occur.
Additionally, really big-picture developments such as those that can’t be summarised in a single statistic and those attributed to themes – think AI or decarbonization – are usually underestimated by investors and, therefore, provide the platform for those same investors to react at their own pace, ensuring the dispersion of the ‘new’ news takes time.
Finally, humans are prone to holding on to old views, even despite compelling contrary evidence. They don’t like to admit being wrong, and so it takes time for investors to be convinced. A rising price is a simple example of how investors can be convinced. Some investors won’t buy until they see prices rising. That of course requires time. Later buyers will only follow when prices have already risen, again helping to form trends.
So, why the lesson on market sentiment and investor behavior? It's because we are currently in the midst of a significant market shift. We're experiencing a rotation from the bearish sentiment about rising interest rates, the possibility of recession, and fears of declining corporate earnings that pervaded the equity market in 2022.
Now, twenty months on from the lows of October 2022, the S&P500 is up 55 per cent, the Nasdaq is up 74 per cent and our own S&P/ASX 200 Index is 20 per cent higher. But it seems not everyone is convinced which suggests there is more to run.
As I have repeated here since 2022, the absence of a recession (I never thought it was likely) combined with the presence of disinflation, would set the stage for good times in equity markets, especially for innovative growth company shares – especially those with pricing power (have a look at Spotify’s share price – a company attracting new subscribers and growing market share even as it raises prices and ‘premiumizes’ its offering).
I expected good times for equity investors in 2023, 2024 and 2025. Sure, there will be bumps along the way, and on some days, the falls in market prices will be so large they will inspire fear and doubt. My framework, however, is that the switch to a bullish posture has only just begun to convince investors they should participate. Up until now the rally in the major indices has been very narrow. By way of example, small-cap companies haven’t really participated in the rally at all. Since October 2022, the Small Ordinaries Index is up 14 per cent – materially lagging its big cap peers here and overseas. And in the U.S., the small cap Russell 2000 Index is up just one per cent this calendar year compared to the S&P500’s 17 per cent return.
If my thesis about the slow dissemination of information and adoption of big-picture changes in the narrative is right, we will start to see a rotation in stock leadership. Small-cap company shares will begin to ‘catch up’ and even surpass big-cap returns as investors look to buy stocks that haven’t risen as much as those they have already missed out on because they were paralysed by inertia and disbelief.
That process already seems to be underway.
Recently, stocks that were lagging have surged, while the previously unstoppable "Magnificent Seven" tech giants have faltered, at least relatively.
The Russell 2000 Index, for example, outperformed the S&P 500 over the last five trading days – perhaps a sign of things to come. And the S&P500 is up just two per cent in the last month while the Russell 2000 Index is up 10.46 per cent.
As my theory about the gradual dissemination of good news and shifts in big-picture narratives typifies, many investors are reportedly now ‘trying to discern whether this shift in market leadership is a temporary blip or the start of a longer-term trend’. According to the Wall Street Journal, for example, Raheel Siddiqui, senior investment strategist at Neuberger Berman, was quoted saying, “that’s what everybody is trying to answer.”
A surprisingly low inflation report on July 11 also helped reinforce more optimistic investor sentiment. As the disinflation picture we have written about here since 2022 becomes more widely accepted, investors will bet on imminent rate cuts, and reallocate funds from high-performing tech stocks to other sectors that will benefit from lower borrowing costs and a stimulated economy.
We all know that companies with earnings further out on the horizon benefit most from a valuation shift when rates fall. Moreover, about 30 per cent of the debt of Russell 2000 companies is floating-rate, compared to just six per cent for S&P 500 companies, according to Goldman Sachs. This, too, will fuel a rush into smaller companies and even more speculative issues.
For the rotation in market leadership to be sustained however, earnings reports and forecasts will need to support the idea that smaller and more cyclical businesses can thrive. Being selective and discerning will, as always, be essential.
For what it’s worth, the companies that constitute the US Russell 2000 Index are projected to report an 18 per cent rise in second-quarter profits, ending a five-quarter streak of year-over-year declines, according to The Institutional Brokers' Estimate System (I/B/E/S) data.
I believe many investors remain wary of the present run-up in stocks. Those investors will take time to be convinced but as the market climbs a wall of worry, more of them will be. And as recent price action suggests the shift may already be underway.
Are you investing in small cap stocks yet?
All prices and analysis at 26 July 2024. This document was originally published in Livewire Markets on 26 July 2024. This information has been prepared by Montgomery Investment Management Pty Limited (ABN 73 139 161 701)(AFSL No. 354564).The content is distributed by WealthHub Securities Limited (WSL) (ABN 83 089 718 249)(AFSL No. 230704). WSL is a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited (ABN 12 004 044 937)(AFSL No. 230686) (NAB). NAB doesn’t guarantee its subsidiaries’ obligations or performance, or the products or services its subsidiaries offer. This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. Past performance is not a reliable indicator of future performance. Any comments, suggestions or views presented do not reflect the views of WSL and/or NAB. Subject to any terms implied by law and which cannot be excluded, neither WSL nor NAB shall be liable for any errors, omissions, defects or misrepresentations in the information or general advice including any third party sourced data (including by reasons of negligence, negligent misstatement or otherwise) or for any loss or damage (whether direct or indirect) suffered by persons who use or rely on the general advice or information. If any law prohibits the exclusion of such liability, WSL and NAB limit its liability to the re-supply of the information, provided that such limitation is permitted by law and is fair and reasonable. For more information, please click here.