Inside Markets — Range Resistance

The RTY is extending gains beyond range resistance at ~2140 as today’s better-than-feared retail sales report keeps the soft-landing narrative intact. The RTY has rallied ~9% since last Thursday’s softer CPI report resulted in increased probability of a September rate cut. This compares to a ~3.6% gain for the equal weight S&P and ~0.30% gain for the SPX over the same period. As we’ve been noting, all equity rotations regardless of their duration or magnitude start as a short covering rally. That initial rally phase usually lasts about 3-5 trading days. Outsized gains in the RTY since Thursday are largely a function of extreme positioning dynamics but the initial short-covering phase should be nearly finished.

Monetary easing is a catalyst for small-cap outperformance because these companies tend to use more floating-rate debt than large cap companies. A lower cost of capital and relatively healthy operating environment (soft landing) should help the RTY close an historic performance gap (30 percentage points over last 2 years) with the SPX. However, ~42% of public small-cap companies are currently unprofitable vs. only ~10% of large-cap stocks. The complete RTY ‘catch up’ trade of 30+ percentage points requires more than one or two rate cuts. Note that recent Fed comments on the potential for rate cuts have emphasized weakening labor market conditions over slowing inflation. Labor market data operates with long lags, and the idea of reactive rate cuts increases the risk that the Fed ‘falls behind the curve’ and the economy slows more meaningfully. Evidence of a meaningful economic slowdown would generate a lower entry point for the RTY catch up trade.