6-13-23: Small Caps and Energy Stocks Still Look Good

by Louis Navellier

June 13, 2023

Our friends at Bespoke Investment Group issued a report that showed the Russell 2000 has beaten the S&P 500 by 5% over a five-day period only seven times in history, and the eighth time happened last week. They looked at the gains of the two indexes over various time periods the previous seven times:

After the Russell 2000 Beat the S&P 500 by 5% in a 5-day period: What Happened Next?

The good news is that both indexes tend to rise very well and consistently, with the S&P 500 rising the most at first, but both indexes rose over 20% on average in the year after the last seven occurrences.

As usual, we try to do even better by finding the crème de la creme in each market. The small-cap stocks we own are currently trading at only 4.7 times forecasted 2023 earnings, so I do not expect their price-to-earnings (P/E) ratios to be compressed much further, if at all. Furthermore, our small cap stocks boast 22% average forecasted sales growth and 82% forecasted earnings growth, at last count. And now, I expect to see more buying power, as much of the cash on the sidelines could pour into the stock market if investor confidence improves, boosted by the annual Russell Reconstitution that is triggering institutional buying pressure, aided by mounting evidence that a recession is less likely to occur this quarter or next.

The annual Russell Reconstitution has already caused many of our small cap stocks to surge, and institutional buying pressure is anticipated to filter down from the eight largest NASDAQ companies that have been hogging most of the money, as leaders of the AI craze. Outside of those eight tech stocks, there are many other great stocks, like Rambus, which recently surged over 30%, and Super Micro Computer that surged over 110% in just the past month during the AI feeding frenzy!  As a result, I am expecting more institutional money to drive small cap stocks significantly higher in the upcoming weeks.

I am also getting a lot of questions about my big energy bet, so I want to tell you what is unfolding as summer officially begins next week. First, Russia did not follow through with its big 500,000 barrel daily cut in crude oil production that it pledged back in March, so excess Russian crude oil and refined products are being bought by China, India, Saudi Arabia, UAE, and several countries in Latin America.

Second, the annual wildfires in Alberta started early from lightning and are not expected to be put out until October, when the first snows fall, since the peat in the soil makes any fire hard to put out. This limits Canada’s crude oil output. Before Memorial Day weekend, inventories of crude oil and gasoline were depleted to five-year lows, so crude oil prices are poised to rise as seasonal demand rises during the summer months. Finally, Saudi Arabia announced an additional 1 million barrel per day production cut, effective in July, in addition to the 1.6 million OPEC+ production cut that was announced in early April.

The OPEC+ meeting in Vienna on June 4^th did not go well after Saudi Arabia pushed other OPEC nations to curtail their crude oil output. As a result, Saudi Arabia is accounting for 2 million of the 2.6 million in crude oil production cuts that OPEC+ has announced. It is widely perceived that Saudi Arabia needs $80 per barrel crude oil to balance its budget, so it is obvious that it is now desperate to curtail production.

I should add that there are an estimated 413 wildfires in Canada that have burned 82 million acres, which is 13 times worse than the average for this time of year vs. the past decade. Seizing a political opportunity, Prime Minister Justin Trudeau said, “Year after year, with climate change, we’re seeing more and more intense wildfires in places where they don’t normally happen.”  Trudeau has deployed Canada’s Armed Forces, but the truth of the matter is that lightning strikes caused the vast majority of these fires, so there is little that Trudeau can do to stop lightning. He is using climate change as a scapegoat to grab even more power.

Despite these horrific wildfires that have curtailed Canadian crude oil production, North America and South America are producing more crude oil, which is one reason why The Wall Street Journal noted that the five largest U.S. energy companies are characterized by record cash flow, vigorous stock buy-backs, and an eagerness to make more acquisitions. Guyana is the most exciting crude oil production area, since its output of 400,000 barrels per day is expected to triple to 1.2 million barrels per day by 2027.

This rising crude oil output in the Americas, plus Russia effectively circumventing sanctions by selling 80% of its heavy sour crude oil to China and India to be refined and resold as petroleum products, is one reason why oil speculators have temporarily succeeded in suppressing crude oil prices. However, supply and demand cannot be circumvented forever by tricks and political games, so I am still optimistic that crude oil prices will meander higher in the summer months when there is seasonally peak demand.

In the meantime, the hideous smoke from Canadian wildfires over the Northeast has interrupted air traffic and is reducing energy demand, which should allow refineries to replace depleted inventories. In addition, China’s April trade data was horrible, with exports and imports both declining, so their second-quarter GDP growth is highly questionable, and the eurozone is officially in a recession due to an economic contraction in Germany and Ireland. This trend toward slower global growth keeps energy demand down.

Another interesting anomaly that should impact crude oil prices long-term is that in recent months, after China and Germany dropped their electric vehicle (EV) incentives, EV sales moderated, so a lot of the excess EV inventory has been dumped in the U.S., which is why Audi and Mercedes are offering special leases and other incentives to move unsold EVs. In California, with high state gasoline taxes, EVs make sense, since EV owners can drive in the HOV lanes and there are plenty of charging stations. However, outside of California and other deep-blue states, EVs are not selling well, and customers are defiantly sticking with internal combustion engines. In fact, Ford is ready to convert back to internal combustion engines if customers demand them, despite the F-150 Lightening and other innovative EVs, like Mach-e.

I should add that the primary reason that EVs are popular in China is that the vehicles are cheaper and utilize predominantly iron-phosphate (LFP) batteries. CATL in China dominates LFP batteries and has 39% of the world’s battery market share, followed by LG Energy with a 15% market share.

A new battery technology is poised to capture more market share, which is a lithium iron manganese phosphate (LMFP) battery by Gotion High-Tech, which is a Chinese company that has VW Group as its largest shareholder. These LMFP batteries have approximately 26% higher energy density than LFP batteries and cost about 5% less than an LFP battery to manufacture, so a new generation of cheaper batteries is expected to lower EV costs slightly in the upcoming years, especially VW Group’s EVs.

Recent Economic Indicators Point to a More Restrained U.S. Consumer

Complicating vehicle sales are high interest rates and a consumer that is reluctant to buy high-priced durable goods. For example, the Conference Board announced that its consumer confidence index slipped to 102.3 in May, down from a revised 103.7 in April. The expectations and present situation components both declined in May and contributed to declining consumer confidence. Interestingly, the employment component also declined, which means that consumers are less confident about finding a job. Overall, consumer confidence is now at a six-month low and indicative that most consumers remain cautious.

Another reason why the auto industry is struggling is that the manufacturing sector is already in recession (while the larger service sector is not). The Institute of Supply Management (ISM) announced that its manufacturing index declined to 46.9 in May from 47.1 in April, the seventh straight month that the ISM manufacturing index has been below 50, the mark which indicates a contraction. The new orders index plunged to 42.6 in May, down from 45.7 in April. Even worse, the backlog component collapsed to 37.5 in May, down from 43.1 in April. The prices component plunged to 44.2 in May, down from 53.2 in April, which indicates that wholesale prices continue to decline – a “silver lining” of sharply-declining inflation.

If the Fed is looking for an excuse to delay interest rate hikes this week, the ISM manufacturing report should be a good reason, since only four of the 18 industries ISM surveyed reported any expansion.

ISM also announced that its non-manufacturing (service) index declined to 50.3 in May, down from 51.9 in April. This was well below the economists’ consensus expectation of 51.8, so the ISM miss was a big disappointment. The big drop was partially attributable to the huge (9-point) “backlog of orders” drop to 40.9, from 49.7 in April. The price component declined to 56.2 in May, down from 59.6 in April, which is a good sign – that service inflation is cooling off. The other silver lining is that the new order component was 52.9 in May, down from 56.1 in April, but still above 50, indicative of expansion. Overall, 11 of the 18 service industries that ISM surveyed reported expansion in May, so the service sector is still growing.

The Commerce Department announced on Wednesday that the trade deficit rose 23.1% to $74.6 billion in April as exports declined 3.6% to $249 billion and imports rose 1.5% to $323.6 billion. This widening trade deficit is now at the highest in six months and may cause economists to lower their second-quarter GDP forecast. However, the Atlanta Fed on Wednesday raised its second-quarter GDP estimate to +2.2%.

The Labor Department announced on Thursday that weekly jobless claims rose to 261,000 in the latest week, up from a revised 233,000 in the previous week. Continuing claims reached 1.757 million in the latest week, vs. a revised 1.72 million in the previous week. Weekly jobless claims were significantly higher than the economists’ consensus expectation of 235,000, causing concern among some economists.

The FOMC Meets This Week and Will Likely “Pause” on Rate Increases – Finally!

I am on record that the Federal Open Market Committee (FOMC) meeting this week will be the first time the Fed has not raised key interest rates after 10 straight key interest rate hikes. The Fed rate remains above market rates based on Treasury yields and there are a lot of outspoken doves on the Fed – from Chicago, Minneapolis, San Francisco, and other influential Fed districts. Although Fed Chairman Jerome Powell likes the FOMC to agree, recent FOMC minutes revealed disagreement within the FOMC.

One of the factors that might alarm the FOMC is that the unemployment rate rose to 3.7% in May, up from 3.4% in April, as 440,000 new workers entered the job market. Another factor is that inflation is expected to decelerate rapidly in the next couple of months, since the big CPI increases from May and June 2022 will be “cut off” from the trailing 12-month data, so the annual pace of the CPI may be under 3% by mid-July. As a result of inflation cooling, the Fed can afford to pause on any further rate hikes.

The Treasury Department is refinancing about $1.1 trillion in securities. Most of the sales will be on the short end of the yield curve, where yields are higher. This “sweet spot” between the 3-month and 6-month Treasury yield curve should account for the majority of refinancing. Naturally, I will carefully watch the “bid to cover ratio” on these Treasury auctions. Typically, a 2.6 bid to coverage ratio is a healthy auction, while a 2.2 ratio could be problematic, causing yields to rise. Since this refinancing is so massive, it will be closely scrutinized. I am expecting a successful series of auctions due to all the cash on the sidelines.

Before wrapping up, I should mention that the fighting between Russia and Ukraine may have to wait for another day – or month – due to the big Kakhovka dam break in Ukraine that is flooding so much land that it will effectively postpose a Ukrainian counteroffensive to oust Russian troops. Ukraine is blaming Russia for the blast at a hydroelectric dam that is now threatening the largest nuclear plant in Europe.

Another blast on an ammonia pipeline is sending fertilizer and wheat prices higher. Russian forces were shelling flooded residents in the city of Kherson as they were being evacuated. Ironically, the flooding on the Dnipro River is also causing both Ukrainian and Russian troops to retreat. Hundreds of thousands of people are at risk, so a cease fire may ensue, as rescue efforts take priority and Russian troops pull back.

Kherson had been occupied by Russian forces for eight months. Ukrainian forces were on the West side of the Dnipro, while Russian forces were on the East side. Since the Dnipro is impassable, fighting has stopped. The Kakhovka reservoir provides drinking water to the Russian-occupied Crimean Peninsula.

On his new Twitter program, Tucker Carlson accused Ukraine of causing the Kakhovka dam break. Whether or not this is true (we still don’t know the source of the explosion of the Nord Stream 2 pipeline, even though the investigation has been closed), if Ukraine did cause the Kakhovka dam break, it may cause NATO support to erode, since a massive human tragedy has unfolded in Southern Ukraine.

In conclusion, whatever investors were worried about, there is suddenly less to worry about, now that (1) the debt ceiling has been lifted, (2) inflation is cooling, (3) the Fed may pause at its June FOMC meeting, (4) the U.S. economy is growing, although slowly, (5) fighting may decrease in Ukraine for much of the summer, due to the recent dam break, and (6) corporate earnings are finally on the road to recovery.

The truth of the matter is that many stock investors are convinced by the press and the bears to be scared of their own shadow and reluctant to invest, but most of the old excuses not to invest have disappeared.

Navellier & Associates owns Volkswagen Ag. (VWAGY), Rambus Inc. (RMBS), and Super Micro Computer, Inc. (SMCI), in managed accounts. We do not own Ford Motor Co (F), in managed accounts. Louis Navellier and his family personally own Volkswagen Ag. (VWAGY), Rambus Inc. (RMBS), and Super Micro Computer, Inc. (SMCI), via a Navellier managed account.