Valuentum Exclusive Analysis for the Discerning Investor

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By Brian Nelson, CFA

In short, nothing.

The U.S. stock market (SPY) was chugging along nicely until what was interpreted as a very favorable Consumer Price Index (CPI) print on July 11 that sent a rotation out of large cap growth and big cap tech into the beaten down areas of smaller cap stocks, prompting a broader market sell-off. The reasoning goes that, with inflation largely under control, smaller companies will benefit more from future rate cuts via reduced interest expense relative to larger companies.

Though this is true, to varying degrees, the magnitude of the rotation was somewhat surprising, as rate cuts should benefit large cap growth (SCHG) and big cap tech (XLK), too, but we’ve seen this rotation try to play out before. For the past several years, investors have been worried about the concentration of large cap growth and big cap tech in major indices, pointing to equal-weight indices (RSP) and the relative quantitative (statistical) discounted “valuations” of small cap value (IWN) versus large cap growth as alternative, less “frothy” plays. Time and time again, however, large cap growth and big cap tech have powered ahead to lead the market higher.

Will this time be different? It’s difficult to say, but fundamentally speaking, in my view, it’s hard to “own” most small cap stock indices (IWM) as a good percentage of the underlying holdings are unprofitable and the group has outsized exposure to two of our least favorite sectors, banks and energy. On a fundamental basis, large cap growth and big cap tech have pristine balance sheets, account for a significant amount of the earnings growth in the S&P 500, and are still throwing off strong free cash flow, despite an expected elevated capital spending cycle to invest in innovative artificial intelligence [AI].

Looking forward, we think Apple’s (AAPL) next-generation iPhone upgrade cycle will be absolutely huge as it incorporates nascent, yet innovative, AI technology. The iPhone maker also returned to growth in its fiscal third quarter (revenue up 5%, quarterly EPS up 11%), despite weakness in Greater China. Its Services business continues to chug along nicely. As it relates to Microsoft (MSFT), its cloud business is expected to accelerate in the second half of the year, and it continues to put up robust double-digit growth rates, as evidenced by expansion in its calendar second quarter (revenue up 15%, quarterly EPS up 11% in constant currency).

During its second quarter, Alphabet (GOOG) (GOOGL) put up revenue growth of 15% in constant currency while diluted earnings per share increased more than 31%. Meta Platforms’ second-quarter results were even more impressive, with revenue up 23% on a constant currency basis and diluted earnings per share up 73%, both year-over-year. Qualcomm’s (QCOM) fiscal third quarter results were solid, too, with revenue advancing 11% and diluted earnings per share up 25%. Amazon (AMZN) recorded 11% constant currency revenue growth in its second quarter, while earnings per diluted share nearly doubled. Out of bigger cap tech names, only Tesla’s (TSLA) second-quarter results weren’t great, with weak revenue growth and significantly lower earnings.

So, with the market pulling back in recent weeks after a strong year-to-date run, we’re viewing the recent market sell-off as largely profit taking and re-positioning. Revenue and earnings growth across large cap growth and big cap tech look great, inflation is now largely under control (the Fed’s preferred inflation gauge, the PCE price index increased 2.5% in June on a year-over-year basis), and the absolute level of U.S. unemployment of 4.3% is nothing to panic about, even though the trend has not been favorable of late. Though the Fed takes a lot of criticism, at the end of the day, the markets are but a few percentage points from all-time highs. After setting new high after new high during 2024, a correction in the market is probably long overdue.

Without a doubt, the sell-off the past few weeks hasn’t felt good, but we also understand stocks don’t always go straight up, as they have been doing through most of 2024. Economists will debate the probabilities of a hard landing given recent nonfarm payroll numbers, which came in a bit light relative to forecasts, but we think weakness in the U.S. stock market will be short-lived. Whether this correction in the Nasdaq-100 (QQQ) turns into a bear market, a decline of 20% or more, is anyone’s guess, but we’re sticking with the strongest, largest companies to ride out the storm. Not only are large cap growth and big cap tech safe havens in the event of a market meltdown given their pristine balance sheets, but fundamentally speaking, they remain among the most attractive growth areas.

We’re not panicking.