Keep An Eye On Small Caps

Market Outlook

Even if next week’s economic data signal a mediocre rebound in U.S. economic growth, that might be enough to keep the stock market churning toward record highs and the Federal Reserve on target in its winding down of stimulus through bond purchases. Relatively weak data on housing and capital spending, plus a mixed bag of second-quarter earnings, have raised the concern that even a moderate GDP bounce may fall short of expectations. While recent anxiety over conflict in Ukraine and Middle East has somewhat contained stock prices, it has not scared investors enough to prompt them to dump equities for other investment assets. "The market has been resilient to these setbacks. They have taken bad news in stride," said Steve Weiting, global chief investment strategist with Citi Private Bank in New York.

On Wednesday, the Federal Open Market Committee (FMOC), the Fed's policy-setting group, is scheduled to announce whether it will further pare its bond purchases, currently at $35 billion a month. While more Americans have returned to work, Federal Reserve Chairwoman Janet Yellen told two Congressional panels earlier this month she remained worried about tepid wage growth and a low inflation rate that is below the Fed's 2 percent target. Those concerns have contributed to a perception that the Fed is in no hurry to move away from its near-zero interest rate policy. Market watchers are expecting no new information from the Fed meeting. However if the Fed does make an unexpected pronouncement, expect a volatile reaction from the market. The ultimate question is what will move the market when the Fed completely winds down quantitative easing?

As evidenced in the updated graph below, the Russell 2000 index approached its all-time high in early July challenging the previous high made in early March. But the price support abruptly fell apart and dragged the index into negative territory for the year on what seems to be technical trading, supported by a desire for less risk and increased liquidity offered by larger capitalization stocks. Whether you want to call the technical chart pattern a ‘double top’ or a ‘head & shoulders’ top, the interpretation is the same, small caps are due for a lot more pain if the overall market does turn down. Many market analysts are concerned about the divergence between large capitalization stocks and the smaller caps. Specifically, the Russell 2000 and the S&P 500 index as the former currently sports an approx. one percent year-to-date loss while the latter continues to make new highs and challenges anyone to dare call it a market top. Since peaking out just below its all-time high at the beginning of July, the Russell 2000 index quickly sank almost 5%, basically in a straight line. And because small cap stocks have generally topped out before the overall market during the majority of previous cycles, the current divergence is making many investors nervous.

Investor Analysis

NASDAQ is stuck in the same holding pattern as the Dow Jones Industrial Average and S&P 500 while the Russell 2000 has plunged since early July. The outcome will most likely be the same as earlier in the year; large-caps (tech included this time) will likely meander in a sideways pattern until the Russell 2000 can find a firm footing. Last time, it took nearly three months for that to happen. A similar time frame would have small caps declining and large caps bobbing along until late September.

Our analysis from last week is still valid "Looking at the performance graph covering the past three months you can see which sectors are hot, and who is not. As earnings season picks up steam, the best bets are stocks you like in the best performing sectors. Technology, Energy and Healthcare are the hottest sectors right now; buying shares of the best performing companies in these industries should be profitable… With stock market index indicators in a bullish to neutral position, options traders should return to a neutral weighting between bullish and bearish positions. Bullish in the event that the indexes regain their upward momentum, and bearish in the event that bonds and commodities prove to be correct and economic uncertainty translates into equity weakness…”

The updated graph below confirms that technology and biotechnology stocks are lifting the market higher, especially as these shares surge upward during second-quarter earnings season. According to the Stock Trader’s Almanac, biotechnology shares have enjoyed average gains of 29.1%, 16.4% and 28.0% over the last 5, 10 and 15-year periods respectively from the beginning of August through the beginning of March.

  

By Gregory Clay

Investment Strategist

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