When size matters: an equity rotation or market breather?

Much has been made of the so-called rotation in equity markets towards small cap stocks. But what does the data say? This week’s edition of Simply put investigates the trends by sector and geography as well as market cap size to investigate what’s behind the latest bearish turn.   

 

Need to know: The recent decline in equities has led market observers to surmise a rotation is underway from large cap names Our analysis finds little trace of this rotation globally in terms of region, sector or market size If indeed the market is undergoing a bearish period rather than a rotation, it has implications for active portfolio management. We are ready to adjust our multi-asset strategies

 

Rotation or profit-taking?

A great deal of discussion currently surrounds the shifts in the stock market, particularly those regarding a rotation that is perceived to show investors moving out of predominantly tech-centric and US-based sectors and towards a broader array of equities, especially those names that had previously lagged within major indices. 

While this narrative may make sense intuitively, it also prompts a degree of scepticism on our part. One could interpret recent price action in the equity market as indicative of a rotation. However, moves could equally suggest a period of profit-taking following an exceptional half-year. To ascertain the true nature of these market dynamics, it is crucial to delve into the numbers and decipher whether the recent trend represents a genuine bearish rotation or merely a transient bearish phase, akin to those witnessed in recent years. 

This week’s Simply put investigates the data to analyse what’s really driving equity markets.
 

How broad is the equity selloff?

Our analysis of recent market moves is rooted in the comprehensive data provided by the Bloomberg world equity index, which encompasses 2,528 different traded stocks, predominantly large and medium caps. This coverage across various countries, sectors and sizes makes it an invaluable resource for analysing the quality of the recent directional shifts in the equity market. 

Notably, since mid-week last week, both equity and credit markets have taken a sharp downturn, without duration paying off significantly. This trend shift coincided with the Russell 2000 index gaining about 10%, sparking talk of a potential rotation within the equity market.

One straightforward method to verify a change in regime is to calculate the percentage of stocks that are rising, commonly referred to as the participation rate – this measures the breadth of the selloff. Various methods can compute this rate, and figure 1 illustrates the rate’s recent evolution since January 2021, calculated over 20, 60, and 120 working days (equivalent to 1 month, 3 months and 6 months, respectively). The lower the frequency of the calculation, the less volatile the signal, but this comes at the expense of potentially overlooking the sub-cycles that animate markets and are precisely what we are exploring.

The insights from figure 1 are threefold: 

1. The bullish trends of 2021 and 2023 are reflected in the red line, with the bullishness notably stronger in the latter part of 2023 and the beginning of 2021 
2. Since the start of 2024, the participation rate has been declining, as indicated by both the black and red lines, suggesting a dynamic similar to that of 2021– starting positively but potentially ending on a challenging note 
3. We have observed three phases of rises so far this year, concluding mid-March, mid-May and mid-July. These pauses have, so far, not led to declines larger than 5% post-March

These observations suggest that current market trends are lighter, and the potential for continued market declines exists as investors take profits on the (still elevated) 10%+ performance in the year-to-date. 

Nonetheless, the critical question remains: is the market decline merely a profit-taking phase, or does it signify a deeper rotation, with investors disproportionately selling US large-cap tech stocks?

FIG 1. Percentage of rising stocks (World equities, Bloomberg WORLD index)

Source: Bloomberg, LOIM. As of 25 July 2024. For illustrative purposes only. Past performance is not an indicator of future returns.

 

Considering sectors and geographies

Before delving into market cap size, it is imperative to examine two other crucial characteristics: the sectors and geographies of stocks. While there is speculation about an imminent small-cap rally, it is essential to recognise that investors have been significantly engaged with characteristics other than market cap size. Most notably, US tech stocks have experienced considerable growth over the past five years. Figure 2 uses the same data sample previously mentioned to illustrate the year-by-year participation rates by sector and geography.

Four key points stand out:

1. At the country level, the participation rate shows limited differences. Since the beginning of the year, most regions have displayed comparable upside participation, with Asia slightly lagging behind North America
2. Only Latin America, represented here by Brazil and Mexico due to the similarity of their markets, has significantly lagged this year after leading in terms of participation last year
3. By sector, the picture is even more homogeneous, with participation rates ranging from 53% in consumer discretionary to 58% in financials
4. This contrasts sharply with the barbelled situation of last year, when most sectors exhibited limited participation rates, where the Information Technology sector showed 56% of stocks on the rise

From this perspective, the notion of a market rotation receives scant support. If anything, the data reveals a greater homogeneity in the percentage of rising stocks per characteristic than before. This makes it difficult to label the move as a rotation and it is more aptly described as a normalisation. 

Now, what does this suggest about market cap size?

FIG 2. Percentage of rising stocks year by year and year-to-date in 2024 per country zone (top) and per sector (right)

 

Source: Bloomberg, LOIM. As of 25 July 2024. For illustrative purposes only.

 

Is size everything?

One argument supporting the notion of a rotation in the stock market emphasises the robust performance of US smaller caps, as exemplified by the Russell 2000's impressive recent progression. To further investigate this, we sorted our investment universe by size and compared the participation rates over a one-month period for each of three groups: the smallest and largest quartiles versus the sum of the two middle quartiles (figure 3).

The significance of figure 3 lies in its ability to dissect market dynamics in terms of market cap size. While the Russell index predominantly includes smaller stocks, if a genuine rotation is occurring – especially given the recent concentration in performance – such a trend should manifest distinctly when contrasting the small and mid-caps against large caps. Moreover, this trend must be consistent across various countries to validate the rotation hypothesis. Interestingly, the initial two upward phases of 2024 were remarkably uniform across different company sizes, suggesting an absence of rotation. Contrary to expectations, the most recent data from the lowest quartile in terms of size shows a 45% participation rate over 20 days. This rate indicates that smaller stocks are not garnering as much attention as their larger counterparts on a global scale. Far from indicating a rotation, the data suggests the opposite.

What seems to be occurring in the market is a need for a breather, or a pause that might actually reveal uniformity in the downturn. The narrative surrounding the Russell index should be viewed in its proper context: as a phenomenon specific to the US and influenced by Federal Reserve policies, rather than as evidence of a broader, global market rotation.

FIG 3. Year-to-date evolution of the percentage of rising stocks by size

Source: Bloomberg, LOIM. As of 25 July 2024. For illustrative purposes only. 
 

What this means for All Roads

In the context of the All Roads strategy, the apparent rotation – or lack thereof – has minimal implications for equity allocation. Given that the much-discussed market rotation has made little impact on participation rates across regions and sectors, it becomes clear that the current market breather should be addressed more as a matter concerning drawdown management rather than a prompt to reallocate resources.

Currently, All Roads maintains a 150% market exposure in our balanced profile¹. Given the lack of substantial rotation and the homogeneity in market participation rates, our primary concern shifts to managing potential drawdowns effectively, especially if the downturn persists.
 

Simply put, the so-called rotation looks a lot like a market breather, requiring adjustments to global market exposure rather than re-allocations within equities.

[1] Holdings and allocations are subject to change.

 

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Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises is designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

• Growth signals point to a subdued environment, although a majority of indicators are still progressing at the moment
• The recovery in the inflation indicator is stalling, with currently less than 50% of the inflation data collected showing progress
• The monetary policy signal remains in the lower part of its neutral zone, which remains consistent with rate cuts for normalisation reasons rather than for declining growth reasons

  

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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