Inside Markets — Dovish Implications

There were no major surprises in yesterday’s release of FOMC meeting minutes, although some note dovish implications from advanced discussions on slowing the pace of QT. It was also reassuring to read that the committee still considers rates having peaked, despite a sharp increase in January BLS wage growth.

The SPX is currently trading above the mid-month closing high of 5030.  From a technical perspective only, a sustained close above 5030 makes the swing objective near 5220 the new resistance level, while short-term support sits at the downside gap near 4905.  The rally since November is more persistent than expected, but narrow leadership also makes it more fragile.  We’re encouraged by today’s strength in the equal-weight S&P 500 (ETF symbol RSP now $161.46) with a new high above ~$165 putting leadership concerns on the back burner.  The small-cap Russell 2000 (RTY) is the missing piece with a sustained close above ~2070 potentially leading to a period of mean reversion in terms of relative performance.

Last year’s higher rate environment resulted in the widest underperformance spread in history for the RTY relative to the SPX.  Generally, the best time to own small cap stocks is just after a recession and prior to a cyclical recovery.  There have been six recessions since the RTY was created and the post-recession recovery resulted in 38 percentage points of outperformance vs. the SPX over the ensuing 12 months.  We haven’t had a recession, but a ‘no landing’ scenario could trigger a significant catchup trade in favor of small cap stocks.  The fundamental setup for small cap outperformance is nowhere to be found at the moment.  Real bond yields remain highly restrictive, which means the economy should be ‘late cycle’ at best.  We don’t expect the RTY will be able to sustain a break above ~2070, but know what to do if it happens.