June 23, 2022

It continues to be a sloppy market but we’re working through it and there will be big opportunities in small-cap stocks on the other side of this.

It’s been encouraging to see that the 10-year yield has come down over the last week (now at 3.16%, versus 3.48% last Tuesday).

We’ve also seen crude oil come down from $119 a barrel last Tuesday to around $105. If it could hold around there and Biden pushes this gas tax holiday through we just might get a small boost in Q3 GDP if (might be a big if) consumers spend the savings in other areas. The holiday wouldn’t do anything for Q2 GDP, however, which is looking very iffy at the moment. More on that in a minute.

The modest drop in yields and crude has helped the major market indices come up a little from their lows of last week, though we’re a far cry from any semblance of an uptrend here.

As far as the S&P 600 Small Cap Index is concerned it slipped below the May low near 1,138 last Tuesday then broke through that level to close at 1,081 last Thursday. It looks slightly better now.

I still think it’s going to be hard for the market to make any real progress until we get through the major economic data and fiscal policy updates in July, which will include (among many other things) June CPI (released July 17), the July FOMC meeting (July 26-27) and the first read of Q2 GDP (July 28).

The market’s direction into August will be very influenced by these events.

Notably, the Atlanta Fed’s GDPNow estimate is now forecasting 0.0% growth in Q2. It had been closer to 2% in May then just under 1% in early June, so it’s come down quickly.

One thing about a recession right now: It’s worth mentioning that while negative growth is clearly not good, GDP grew by 5.7% in 2021. That was the fastest pace of growth in 37 years and well above the range of 1.7% to 2.9% GDP growth from 2010 – 2019.

Given that context (remember, a recession is two consecutive quarters of negative growth) it’s worth considering that negative growth may not be the end of the world, assuming it doesn’t last too long and we don’t go into crazy negative territory. It’s been such a screwy couple of years (GDP was -3.7% in 2020) and if we average out the two-year growth rate (2020 and 2021) we get 1.15%. That’s a pretty low bar to surpass in 2022.

This might be just an effort to put lipstick on a pig. But honestly I think it’s worth recognizing, especially given all the doom-and-gloom sentiment out there, that things really might not be all that bad.

Back to stocks, small caps still trade at a steep discount on a forward P/E basis (around 10.8) and are pricing in a recession. This chart is courtesy of yardeni.com and is current as of last Friday.

And turning to software this chart, courtesy of Morgan Stanley, shows that software stocks (which trade with a forward EV/Revenue multiple just above 6) are trading well below their trailing five-year average multiple and right about at their five-year average multiple from 2014 – 2018 (a very mediocre period for software stocks).

While there is always noise in data (especially forward-looking data) all this suggests an encouraging outlook for small caps in the coming years once we get on the other side of the current uncertainty.

That may be why rolling four-week average money flows from Bank of America showed capital moving into small-cap ETFs last week for the first time since March, which signaled “capitulation-like outflows” (biggest outflow in small-cap ETFs since 2017).

Bottom line: At both the index and individual stock level small caps don’t look too hot right now. But the data, and a lot of charts, are suggesting much brighter days ahead.

That will be a nice change!

Recent Changes
None

Updates
Avalara (AVLR) had slipped back to the early-May low (roughly 67) last week but held above my alert near 66 and has made a little progress to the upside this week. There’s no doubt the stock is reflecting a very weak economy. The trailing EV/Revenue multiple is near all-time lows (below 8) despite revenue growth expectations that should remain well above 20%. HOLD A QUARTER

CS DISCO (LAW) slipped below the May low of 20 last week, prompting me to cut the position in half. Absolutely nothing has changed over the last week as the stock price has just moved sideways. HOLD A HALF

DigitalOcean Holdings (DOCN) has been moving sideways since last week’s investor day, during which management reiterated its goal to get to $1 billion in revenue by fiscal 2024 (estimated 2022 revenue is $570 million). It will be interesting to see how the trends unfold here as DOCN is making moves to expand upmarket where it will more frequently encounter larger cloud infrastructure peers, such as Microsoft (MSFT). We started with a half position and I’m sticking with that, for now. BUY A HALF

Ingles Market (IMKTA) has been up and down in the 83 – 90 range this week and the stock is holding up relatively well. That’s not too surprising in the current environment given it’s a grocery store stock. That said, growth isn’t non-existent here. Ingles has been a relatively rapid grower in its industry (2021 revenue up 8%). Forward estimates are calling for -9% revenue growth this year but I think that’s bad data. Revenue for the first six months of the fiscal year has grown 16.6%. Also, EPS through the first half of the year is $7.10, up 35%, yet estimates call for 2022 EPS of just $5.10. Classic “nobody following this story” situation. BUY A HALF

Inspire Medical Systems (INSP) was moved to buy two weeks ago then got caught up in the broad market decline. But INSP has bounced back over the last three sessions, rising from a low of 158 to over 180. Notably, that low of 158 was well above the May low near 143. BUY

Procept BioRobotics (PRCT) has been a little up and down lately but overall is acting pretty well considering it’s a bear market. We took a 46% gain on the first half of our position and continue to hold the second half. HOLD A HALF

Rani Therapeutics (RANI) has roared back to life this week, rising from a low of 8 last Monday to trade well over 12 then close at 11.7 yesterday (a nearly 50% move). Some of that is likely attributed to increased attention after Wedbush initiated coverage (on June 13) with a buy rating and 28 price target. However, the broader biotech space has perked up recently as well. BUY A HALF

Revolve (RVLV) was sold last week as the odds of a recession have gone up (GDPNow estimates for Q2 GDP of 0.0%) and consumer stocks have simply fallen out of favor. I think the Revolve business will be fine and we’ll be back to the stock, but not a lot of incentive to stick with it right now. SOLD

Repligen (RGEN) revisited the May low near 137 last week and held there. It’s up 10 points since on no news. HOLD

Sprout Social (SPT) held above the May lows last week and is just a hair below its “recovering” high of 59.9 from early June. While clearly not in a major uptrend the stock is looking far better than many software names. HOLD A HALF

Xometry (XMTR) seems to have bottomed near 26.6 on May 12 and has worked its way back above 36 since. That’s above the 50-day line. Like SPT, it’s not a great looking chart but there’s enough here to work with. While multiples have cratered across the software space Xometry management raised the low end of its 2022 guidance on its last earnings call. HOLD

Please email me at tyler@cabotwealth.com with any questions or comments about any of our stocks, or anything else on your mind.