When the Market’s Biggest Rumor Becomes News

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The market’s biggest rumor becomes news this week… The small-cap rebellion heats up in response… But there’s no guarantee the Fed delivers… The Quantum Edge Hotlist reveals the new footmen to watch… Don’t ignore the most important seasonal trend in front of us… How to defend yourself from a choppy second half…

❖ Things have changed quickly in the second half of July…

Over the last two weeks, traders have been falling over themselves to buy the biggest rumor in the financial world.

And this week, we finally get the news…

Encouraging inflation and GDP data are making traders ever more confident that the Federal Reserve’s first rate cuts, which have been hotly anticipated, are now imminent.

More on all that in a moment. First, the trade.

All this rate-cut excitement has lit a fire under small-cap stocks. Looking at the S&P 600 index, which is made up of small caps with a track record of positive earnings, that benchmark is up nearly 10% from the start of the month. Over the same time, the large-cap S&P 500 is down 0.1%. (Prices as of Friday afternoon.)

High lending rates have weighed on smaller-cap companies for years.

• When rates are high, cash-strapped businesses struggle to borrow to finance growth.
• High rates also favor cash-rich mega caps, which can earn gobs more cash sitting in risk-free investments. Look no further than Berkshire Hathaway owning an estimated 3% of the Treasury bill market for the most dramatic example of this dynamic.

Now, though, the tide is turning. Small caps are heating up and large caps are cooling off. Going further, the chart of the S&P 600 looks constructive for another move higher after its recent breakout. Check out the comparison to the S&P 500 below.

Just as noteworthy is the fact that the iShares Russell 2000 ETF (IWM) is about to overtake the Nasdaq 100 ETF, Invesco QQQ Trust (QQQ), for the year. (The Russell 2000 is the more popular benchmark of small caps, though not limited to just the profitable companies among them, like the S&P 600 is.)

Clearly, the rotation is in full force.

❖ But we’re seeing it happen well before any announcement from the Fed…

Not to be a Debbie Downer, but from where we sit, it looks like traders might be getting ahead of themselves again.

Rate cuts are widely expected in September, but they’re in no way guaranteed. Some even think we’ll see something bigger than the 25 basis points most expect.

Check out the latest FedWatch reading, which shows a small but slowly growing probability (10.2%) of a 50-point cut at the September meeting.

That’s in reaction to last week’s core PCE numbers. Here’s Bloomberg with those:

The so-called core personal consumption expenditures price index, which strips out volatile food and energy items, increased 0.2% from May. From a year ago, it rose 2.6%, according to Bureau of Economic Analysis data out Friday.

Inflation-adjusted consumer spending rose 0.2%, while May’s increase was revised higher.

My gut tells me to temper expectations here, regardless of what traders expect.

We can’t forget that, at the start of the year, economists forecasted 150 basis points in cuts through 2024… double what the Fed itself forecast. And we’re still waiting for the first 50 in September.

Also, quite simply, we shouldn’t forget the Fed was late to react to strong inflation. Remember how “transitory” that was supposed to be? It just seems far more likely they’ll be late to cut rates as well, rather than learning from past errors.

But let’s just say the first cuts do come in September… Then what’s this week’s news?

It’s not about the cuts themselves, but the first tacit acknowledgement of the timing from the Federal Open Market Committee.

During the FOMC meeting on Tuesday and Wednesday, and in his press conference to follow, Fed Chair Jerome Powell may finally address the elephant in the room and give an idea of when traders should expect the first rate cut in over four years.

Really, that’s what’s driving this excitement for the long-hated small-cap sector. So we should keep in mind that, should the Fed not align with market expectations, this trade can turn down on a dime.

Also, don’t forget the “sell the news” impulse. As we’ll soon show, we’re entering an especially volatile time of year. Traders looking for a reason to take profits might just find one in the rate cut pre-announcement.

In the meantime, though…

❖ The Quantum Edge Hotlist confirms the Big Money loves small-caps…

This is one of my favorite sources for new stock ideas anywhere in TradeSmith.

Every Monday afternoon, Quantum Edge Pro editor Jason Bodner publishes his Quantum Edge Hotlist to his subscribers.

The top of the list holds the 10 highest-rated individual stocks, which tend to get there by experiencing buying volume so massive, it’s most likely to come from deep-pocketed Wall Street institutions.

That alone is a strong signal. But Jason makes sure to only surface the stock with strong underlying fundamentals and positive technical momentum. Then, on the flip side, Jason lets you know the Bottom 5 stocks that fall completely flat on both measures.

Jason’s shown time and again how this approach to stock-picking could’ve outperformed the market 7-to-1 over the last 25 years – a stunning feat.

And those numbers make this list a can’t-miss. Here’s last week’s (Jason’s subscribers will get the freshest version of this list later today.)

Dedicated readers will remember previous weeks when the top of the list was riddled with mega-cap tech and semiconductor companies. This week, though, all the semiconductor names are much, much smaller – like the $7 billion MACOM Technology (MTSI), $4.5 billion Camtek (CAMT), and $6.8 billion Cirrus Logic (CRUS).

The hotlist is also far more diversified. Ranking at the top is cruise company Royal Caribbean (RCL)… oil & gas services company Cactus (WHD) not far behind… and financial companies WisdomTree (WT) and Apollo Global Management (APO) rounding out the list.

Just as important are the stocks at the bottom of the above table – those are the ones with the most institutional sell signals and poor underlying traits. Wolfspeed (WOLF) and Beyond (BYON) are repeat offenders here, with Delek (DK), Sigma Lithium (SGML), and SolarEdge (SEDG) all being new additions this week. These are stocks to avoid like the plague.

I should also note that Jason’s subscribers have limitless access to his Quantum Edge system in the TradeSmith Finance dashboard. The same numbers that make up this hotlist are available for any stock on your watchlist… just punch them in and get an immediate result. For example, here’s the detailed breakdown of the latest score for RCL:

It’s a good tool to help put your portfolio through its paces… And uncover new potential winners.

And these resources are really just bonuses to the high-quality research and monthly recommendations Jason regularly sends his subscribers.

All this taken together, and you have a strong case for Quantum Edge Pro being the best stock-picking system available. For more info on a subscription, go here.

❖ Not to dampen this excitement, though…

But there’s a backdrop to all this that we can’t ignore.

The most important chart I’m watching right now is the seasonality chart of the CBOE Volatility Index (VIX) during election years.

The VIX is the market’s fear gauge. When it rises, it reflects higher premiums paid for S&P 500 options as traders expect higher volatility over the next 30 days. You can see that it’s shooting higher now, up near 18 from a low of 12. That’s the dark blue line below, which is diverging sharply from the historical average (light blue line below). Take a look…

From now through the end of August in election years, the VIX has fallen an average of 7%, with declines 62.5% of the time. That means August could prove to be a great month for the stock market, and especially large caps.

But look out to the range from September (when the Fed is expected to cut rates) to the start of November (when election mania reaches its merciful peak), which I’ve included above. We can see that the VIX has risen more than 60%, on average… and it’s done that for each of the past eight election years.

As Trade Cycles editor William McCanless has pointed out many times this year, the start of Fed cutting cycles tends to correlate with higher volatility (including the VIX) and lower stock prices – not the mind-melting rally that most traders seem to be hoping for. Here’s William on this topic in his Monthly Game Plan video for Trade Cycles members in June:

“Cutting rates does not mean stocks go up. I don’t know why everyone thinks that. They keep saying the market’s rallying in anticipation of rate cuts. The market doesn’t rally on rate cuts. It drops almost every time.”

And here’s the data William used to illustrate his point:

As William concludes, “Basically the market crashes when the Fed pivots, when the Fed cuts rates. It rallies into the expectation of rate cuts. There might be an initial rally when the Fed does cut rates. But historically, cyclicality shows that it almost always drops.”

Bear in mind, we don’t believe this will be a bull-market killer. But as we showed in TradeSmith Daily last week, seasonality shows stock prices are already well ahead of themselves for the type of year we’re in. It wouldn’t surprise us to see a prolonged pullback like we saw around the same time last year.

Once the election is decided, though, you want to get extremely bullish. We coined “always remember to buy in November” for a reason – the November-December period is one of the best periods to own stocks.

So, what can you do to prepare for the volatile stretch that’s a few weeks away?

❖ Three things to consider…

One tried-and-true way to shelter from market volatility is to simply hold cash. Months ago, we recommended the iShares 0-3 Month Treasury Bond ETF (SGOV) as a great place to store your non-working capital. The latest 30-day SEC yield was 5.24%, with payouts every single month.

So if you took profits recently at our recommendation, and you’re averse to more risk, that’s a good spot to put them.

Another option is to buy gold and silver. In times of volatility, gold has historically acted as a shelter. Everyone should hold a small allocation to precious metals in their portfolio, and even more so during times of expected volatility.

But for those seeking a more active way to beat volatility, TradeSmith has no shortage of tools that can help.

One of the best is our Options360 tool, which helps you find options trades with the absolute highest Probability of Profit (POP). Structurally, a great way to do that is to actually sell (short) options, rather than buying them and hoping their price will go up. That’s because, as an options seller, we earn our profits upfront – then if the option contract stays “out of the money” through expiration, we pocket that options income and simply move on to the next trade.

Constant Cash Flow subscribers get a new opportunity to trade like this – by selling put options – every single day of the year. And not just any put options, either. The Options360 tool finds puts to sell where your Probability of Profit is about 80% or more.

To your health and wealth,

Michael Salvatore
Editor, TradeSmith