What We're Talking About This Week!

• Weekly Market Reset

• Key Economic Reports This Week

• Dividend Landscape

• Market Outlook

Weekly Market Reset

Last week, I talked about how the small-cap rally could be finished. The justification was that volatility levels were still suppressed and there’s a tendency for the markets to “snap back” to previous leaders, such as mega-cap tech, in such a situation. That clearly didn’t happen. Small-caps are still firmly in control and tech remains one of the worst performing areas of the market. On top of that, defensive sectors have taken the lead within the S&P 500 as well as all of the strategies that are typically tied to them, including value, low volatility and dividends. This tech to small-cap rotation is something the markets haven’t seen in years and there’s still little sign that it’s slowing down.

The Treasury market, which would typically rally in a traditional risk-off reaction, hasn’t really moved at all. Yields are down very modestly over the past couple weeks, but nothing yet indicating that investors are rushing to the exits. If you’re an equity investor, this is a pretty argument for diversification and not being heavily overweight in just a handful of stocks. The S&P 493 (or you could use the Invesco S&P 500 Equal Weight ETF (RSP) as a proxy) is up several percent since this rotation began. The overall market has actually done fairly well in the past few weeks, it’s just been emphasized in the areas that have gone unloved and unnoticed for a while.

The small-cap rally has to take a breather eventually and it’s likely we’ll see some type of reversal soon because the group is short-term overbought if nothing else. If you pull back and look at the small-cap to large-cap ratio over the past decade, you’ll see that there’s still a very long way for small-caps to go to catch up to large-caps. Over the long-term, small-caps typically trade at a higher multiple than large-caps. Right now, the Russell 2000 trades at a 40% discount to the S&P 500. That’s a huge valuation gap that still needs to be normalized, even if it doesn’t come near getting closed completely. In the short-term, small-caps could keep outperforming if the value trade remains in favor. In the long-term, there’s a strong case to be made that small-caps are the much better value for multi-year holding periods.

Key Economic Reports This Week

There’s going to be A LOT of economic data for the markets to contend with this week. It’ll start over in Europe with Q2 GDP readings from every major economy on the continent and finish up with the all-important July non-farm payroll report on Friday. In between those dates, we’ll get interest rate decisions from the Bank of Japan, the Fed and the Bank of England. Also important will be Eurozone inflation, U.S. PMI data and the U.S. JOLTS job openings number.

Let’s try to tackle them one at a time:

Central Banks

The BoE is expected to begin cutting interest rates for the first time in this cycle. Inflation is back to 2% and GDP growth was up 0.7% in Q1, but it was stagnant for nearly two straight years prior to that. I’d expect this to be the first of several cuts as long as inflation is kept in check.

The Fed is expected to keep rates steady for the final time before a widely expected cut in September. The totality of the economic data suggests that there’s a slowdown in progress, which would support the idea of another cut before the end of the year, but a core inflation rate of 3.3% means the Fed shouldn’t be cutting too fast.

The BoJ is also expected to hold this time around, but rate hikes have to be at least under discussion here. I believe that the yen is priority #1 for the central bank. While it’s been making great progress relative to the dollar recently, it’s still quite weak on a longer-term view. For that progress to continue, rate hikes are the best way to do it.

Jobs

The JOLTS number in the U.S. has been trailing off in recent months, but they haven’t fallen off a cliff. Jobs added have remained surprisingly resilient, but the unemployment rate is now 0.7% above its low, a level that usually indicates trouble. The markets have been waiting to see cracks in the labor market. If they get such a number here, it could accelerate the current stock pullback.

Europe GDP

The Eurozone finally saw a meaningful increase in GDP growth in Q1 following several quarters of essentially zero growth. The markets will want to see a strong follow-up and expectations currently say they’re going to get it. If growth continues to accelerate and the ECB is able to keep slowly and gently lowering rates, this could be the market to watch over the next year.

Dividend Landscape

Dividend stocks are continuing to get some run here as defensive sectors and cyclicals take their turn in front. We’re still seeing high yield equities performing the best, which would be consistent with leadership from cyclicals, but the strong outperformance is pretty comprehensive. This is obviously one area of the market where tech doesn’t dominate, so I expect to see this group do well as long as the magnificent are kept at bay. Several of the companies within that group report earnings this coming week, so don’t be surprised to see a lot of volatility and performance that ends up going in either direction.

One dividend ETF worth pointing out is the WisdomTree U.S. Dividend Growth ETF (DGRW). In my recent updated rankings, I had DGRW at #2 based on performance and risk-adjusted returns. The reason those returns were so good was because it had a tech overweight that many dividend ETFs didn’t. That made it vulnerable to a tech pullback and that’s exactly what we’re seeing now. Since July 10th (when this rotation began), DGRW has lagged the WisdomTree U.S. Total Dividend ETF (DTD) by 3% and the Schwab U.S. Dividend Equity ETF (SCHD) by nearly 7%. This fund is tied to the tech sector in a way that most dividend ETFs aren’t and its future performance will be linked to where tech heads from here.

Market Outlook

This coming week looks like one primed for a lot of volatility. We’ve got all of the economic data I already ran down above, including jobs, GDP and central bank rates, as well as earnings from multiple mag 7 companies. This week’s returns are really going to be heavily dependent on which way that data goes. That makes the range of potential returns really wide.

Given that, I’m not sure I’d want to make any heavy bets in either direction. Higher volatility generally leads to lower stock prices, so there’s that to keep in mind. If the majority of the data/earnings disappoints, I’ll be interested in seeing if we start getting a stock-to-bond rotation instead of just a rotation within equities. If that happens, that would be the point where investors should get nervous.

Looking better for: Treasuries, value, junk bonds, Japan

Looking worse for: magnificent 7, dollar, energy