Actionable Stock Ideas -AlphaRank Top Stocks for July

July 27, 2024 — In last month’s edition of Top Stocks, we discussed the issue of narrow market leadership and the implications of the lack of stock market breadth. In the memo, we stated:

“The lack of market breadth, explained by the significant multiple expansion of a small handful of the largest stocks, has created a vulnerability in the broad market index. Should sentiment for AI-adjacent securities turn or should one or more of the Magnificent 7 hit an air pocket, the effect on the broad market index could be considerable. Whether the seemingly unstoppable momentum of large-cap growth stocks continues indefinitely is anyone’s guess, however, investors should consider the scenario in which it slows or even reverses.”

Since then, much has changed. In a jaw-dropping reversal this month, large cap growth stocks seemingly went out of fashion, albeit briefly, while small cap equities staged a stunning comeback.

Starting July 10th, small cap stocks, by way of the Russell 2000, went on an unprecedented run compared to their large-cap brethren. Over five trading days, the Russell 2000 surged more than 11%, outperforming the S&P 500 by the widest margin on record going back to 1986. In contrast, the basket of market darlings, colloquially known as the Magnificent 7, were shunned by investors as they suffered market declines.

As expected, flows followed this performance. By the end of this small cap surge, the Russell 2000 ETF had inflows of nearly $6 billion, representing its fourth largest monthly inflow in 20 years.

While there was no definitive catalyst for the unparalleled market action between small and large cap securities, there are a few theses to explain why the divergence in equities occurred, including:

• A rise in the market’s forecast regarding the probability of near-term rate cuts from the Fed. Typically, small cap stocks are more interest rate sensitive than larger companies.
• An increase in the odds of Donald Trump winning the U.S. presidential election. Economists believe that the Trump administration would be beneficial to the U.S. economy, by creating attractive conditions for smaller companies.
• A short squeeze caused by hedged investors, who were long what was “working” and short what was not, reducing their market exposure by selling their large cap longs and covering their small cap shorts

In any event, the market move was likely a blend of the above factors. The rally in small cap stocks, along with the corresponding decline in large cap growth names, has bolstered diversified portfolios and reduced the concerns of market prognosticators regarding the risk of lack of market breadth.

Now, the main question on investors’ minds is: Was that the first inning of a mean reversion trade, in which the laggards lead, and the market darlings fall out of favour? Or was it just a technical short-squeeze driven blip, with the market leadership from the Magnificent 7 expected to continue?

Our belief is that the former is more likely than the latter, and the mean reversion trade is still in its early stages.

Nonetheless, investors can isolate themselves from this conundrum by hedging their bets and including short positions to offset the market risk of their longs. Therefore, we highlight one top-decile stock expected to outperform and one bottom-decile stock expected to underperform in this month’s AlphaRank Top Stocks.

OUTPERFORM: Progressive Corp (NYSE: PGR) is a prominent American insurance company that primarily offers auto insurance but also provides other types of insurance such as home, commercial, and personal lines insurance. Founded in 1937, Progressive has become one of the largest insurers in the United States, known for its innovation and customer-centric approach. Progressive has shown consistent revenue growth over the years, driven by an expanding customer base and diversified product offerings while maintaining solid profitability metrics. The company has a robust balance sheet with strong capital adequacy ratios, ensuring financial stability and the ability to weather economic downturns. Progressive continues to gain market share in both personal and commercial insurance lines. PGR has been a stock market winner, showcasing top decile price and fundamental momentum, which we expect to continue. Disclosure: Long PGR in the Accelerate Absolute Return Fund (TSX: HDGE, HDGE.U).

UNDERPERFORM: Wolfspeed Inc (NYSE: WOLF) is a manufacturer of silicon carbide (SiC) and gallium nitride (GaN) semiconductor materials and devices. These materials are critical for power electronics and radio-frequency applications, particularly in industries such as electric vehicles, renewable energy, telecommunications, and industrial applications. The semiconductor industry is becoming increasingly competitive. Larger players like Infineon, ON Semiconductor, and STMicroelectronics are investing heavily in SiC and GaN technologies, squeezing Wolfspeed’s market share and margins. Wolfspeed’s growth is closely tied to electric vehicle adoption, which has recently lost significant momentum. WOLF’s low quality financial performance, including negative operating income, along with its deeply negative free cash flow, may cause liquidity issues if it is unable to develop consistent profitability. In addition, a recent miss of quarterly earnings expectations has hurt market confidence, compounding its negative momentum and adding to the case to short the stock. Disclosure: Short WOLF in the Accelerate Absolute Return Fund (TSX: HDGE, HDGE.U).

The AlphaRank Top and Bottom stock portfolios exhibited mixed performance last month:

• In Canada, the top-ranked AlphaRank portfolio of stocks gained 1.6%, outperforming the benchmark’s -1.8% monthly loss by 340bps. Meanwhile, the bottom-ranked portfolio of Canadian stocks dropped by -5.5%, underperforming the TSX 60 by 3.7%. The long-short portfolio (top — bottom ranked stocks) generated a return of 7.1% for the month and approximately 140% over the past five years.
• In the U.S., the top-decile ranked equities fell -2.3%, underperforming the S&P 500 by 5.9% while the bottom-ranked sunk by -4.4%, underperforming the benchmark by 8.0%. Over the past five years, the top-ranked U.S. equities have gained more than 100% while the bottom-ranked portfolio has dropped by more than one-third.

AlphaRank Top Stocks represents Accelerate’s predictive equity ranking powered by proven drivers of return. Stocks with the highest AlphaRank are expected to outperform, while stocks with the lowest AlphaRank are anticipated to underperform. AlphaRank assigns a numeric value to each security from zero (bottom-ranked) to 100 (top-ranked) based on selected predictive factors. All Canadian and U.S. stocks priced above $1.50 per share and $100 million in market capitalization are evaluated. In both the Accelerate Absolute Return Fund (TSX: HDGE) and the Accelerate Canadian Long Short Equity Fund (TSX: ATSX), Accelerate funds may be long many top-ranked stocks and short many bottom-ranked stocks. See AccelerateShares.com for more information.