A little humility goes a long way

Wow! That didn't take long! Two weeks ago, in what we posited could be one of those, Humility at the Highs moments, Federated Hermes' macroeconomic team cut our equity exposure in our PRISM^© balanced portfolios, selling large-cap growth and EAFE while retaining overweights in small-cap, value and emerging-markets stocks. One of our arguments was that despite how well large-cap growth stocks had worked since our adds there in 2023, and despite how strong the longer-term AI story is, the Magnificent Seven had become too much of a momentum trade that required the fuel of accelerating AI capex growth to stay afloat. At the same time, we thought better relative earnings growth in the neglected and undervalued areas of the market, along with the advent of a Federal Reserve rate-cutting cycle, could fuel a rotation into these names. It turns out, our contrarian idea wasn't so contrarian, after all. Within days, "The Great Rotation" had started. From July 10-26-a mere two weeks-the Russell 2000 Index outperformed the Russell 1000 Growth Index by 17.9%, and the Russell 1000 Value Index outperformed the same growth index by 11.4%. EM has yet to work, but even so, has at least done as well as the broader S&P 500. So what now?

We think it's a time to stay humble, on almost all fronts, and are sticking with this rotation trade for now. Let's walk through some specifics:

1. Earnings updates so far have reinforced our call. Earnings season is going well so far, validating our expectation that guidance for the back half of this year and for 2025 will drive stock prices. Overall, reported earnings are running 5% above consensus forecasts; importantly, analysts have been raising full-year numbers ever closer to our $250 forecast for full-year 2024. Guidance has been the key. Among regional banks, for instance, concerns about credit risks relative to already established reserves are ebbing, helping those stocks. At the same time, in Mag 7 land, Alphabet's revenue growth of 15% and earnings-per-share growth of 31% were not great enough. And importantly, as we'd feared, Alphabet did not signal another acceleration in its AI investments. That was enough to spark another sell-off in the Nasdaq. More of the same will likely be coming from the other Mag 7 reporting this week.
2. Inflation numbers came in light, as the Fed began increasingly guiding the markets toward a September beginning of the rate-cut cycle. The headline Consumer Price Index (CPI) dropped on a month-over-month basis, falling 0.1% compared to estimates of a growth of 0.1%, while core CPI grew at just 0.1% compared to estimates of 0.2%. This resulted in year-over-year growth rates of just 3.0% and 3.3%, respectively. Again, we'll probably get a reinforcement of this idea at this week's Fed meeting, especially now that the presidential race has no present incumbents, thereby putting a September ease even more in play.
3. The political cycle turned in favor of the 'Trump trade,' at least initially. As we've stated previously (see From here on, the election will matter), the Trump trade is, on balance, better for value stocks and small caps. Since we called this rotation two weeks ago, Trump got a pretty good bounce in the polls. However, the emergence of Kamala Harris as the likely Democratic nominee substantially altered the dynamics of the race, and polls suggest the outcome is trending toward a toss-up. Our advice to both sides on this: "humility" works at a lot of levels, including politics. Whoever demonstrates more of it in the coming weeks probably has the best shot of pulling in the undecided votes.

Given how far, fast, and violent the great rotation has evolved, our guess now is that some back-and-forth action is likely forthcoming, and a counter-trend bounce is possible at any time. This said, given investors massive mis-positioning going into this, and the likely news flow on earnings and rates continuing to support value and small-cap stocks, a continuation of the last two weeks is on order through year-end. So, we are sticking with the portfolio adjustments we made two weeks ago. Good time to stay humble.