Could Earnings Stop the Small-Cap Stocks Rotation in Its Tracks?

The Magnificent Seven soared on Monday ahead of a slew of earnings reports that could shake up the small-cap rotation that hammered the market’s leading stocks last week.

Shares of Nvidia (NVDA) and Tesla (TSLA) each gained around 5%, while Meta (META) and Alphabet (GOOGL) both advanced more than 2%.

The Small-Cap Rotation

Equity markets have been turned on their head in recent weeks amid a shift in expectations for U.S. monetary policy. In the week ending July 17, the small-cap Russell 2000 outperformed the tech-heavy Nasdaq 100 by more than 13.4 percentage points, the Russell’s biggest seven-day stretch of outperformance since 2001 and the third-largest on record.

Optimism that the Federal Reserve will cut interest rates soon got a boost earlier this month when data showed inflation fell more than expected to 3% in June. Market participants see a greater than 90% chance the Fed will lower its benchmark federal funds rate by 25 basis points in September, according to trading data.

Lower interest rates are expected to benefit smaller companies, which are far more reliant on floating-rate debt than their mega-cap peers. 

The reversal was a painful one for a market that has become increasingly concentrated over the last year and a half. For the first time since April 2000, the S&P 500 on Thursday fell more than 1% even though more than half of the index gained.

Mixed Earnings Expectations

The mega-cap to small-cap rotation could be tested by earnings reports in the next two weeks. Mag Seven members Alphabet and Tesla will report quarterly results on Tuesday afternoon. Microsoft (MSFT), Meta, Apple (AAPL), and Amazon (AMZN) are slated to report next week. 

Bank of America Securities analysts expect the tech giants to report their second consecutive quarter of slowing earnings growth. Profit is forecast to have risen 30% from the year-ago quarter, compared with 53% last quarter and 63% in the quarter before that.

Meanwhile, the rest of the S&P 500—or the “Other 493”—is forecast to report earnings grew for the first time since 2022. Profit growth has been stagnant for much of corporate America for the past year and a half as companies have grappled with a slowing economy and higher interest rates. 

The outlook for small caps is muddy. BofA started the year forecasting the Russell 2000 would grow earnings by 16% in the most recent quarter. Those same analysts now anticipate profit will decline by 3%. Among the companies that have already reported, small caps have missed earnings and sales estimates at higher rates than large caps.

“Lack of improvement could suggest a pause in outperformance, but if we see better guidance/revisions, the rally likely continues,” analysts wrote.