Opinion: Small-cap stocks get tripped up, suggesting the broader stock market rally is in danger
Published: Nov. 9, 2017 at 9:02 a.m. ET
Thomas H. Kee Jr.
Investors, fearing more risk, are favoring large-cap stocks for now
The beginning of the end of central bank stimulus is hobbling demand for some stocks.
The tax debate in Washington is heating up, so expect anxiousness among investors.
But don't take your eye off the ball. Liquidity is free-flowing from central bank stimulus, and that's good for people who expect the stock market rally to continue. Still, there's been a very important shift: the willingness of investors to assume added degrees of risk has diminished.
Reasonably, with the S&P 500 Index SPX, +0.08%, Dow Jones Industrial Average DJIA, -0.56% and the Nasdaq 100 Index NDX, +0.75% hitting all-time highs, it's hard for some people to see the shift. If you invest in small-cap stocks, you see it very clearly. The Russell 2000 Index RUT, +0.14% has been extremely weak lately, and there's a reason for that.
"The divergence between the Russell 2000 and the Dow is evidence that risk perceptions are changing."
Small-cap breakdown
While other markets are pressing higher, the Russell 2000 is breaking down, and that's because small-cap stocks carry a higher degree of risk. When the Russell 2000 is weak versus the Dow, it's often an indicator that investors are favoring larger and more reliable companies, and that is usually a sign that risk perceptions have increased.
This could come as a surprise to investors who focus on companies like Apple AAPL, +0.51% and Amazon AMZN, +0.57%.
Central bank stimulus vs tax cuts
Risk perceptions are changing because central bank stimulus is set to dwindle to levels not seen since late 2014, and the smart money — professional investors — knows it. I have produced a special report that looks ahead to 2018 given these changes, but it is important to point out that the changes to the tax code are not the same as central bank asset purchase programs. Changes to the tax code can be a good way to improve underlying economic conditions, but the constant asset purchases of central banks matters more to securities prices because it is direct buying.
Risk perceptions are changing, and that's because the liquidity picture is going to change, and eventually it will matter to the select group of large-cap stocks that have been driving this rally too, but not immediately.
When risk perceptions change, it usually hits smaller stocks first, and then trickles its way to larger companies. The same is true in real estate, by the way. The worst properties get hit first and the best last, so this progression is not isolated to equities.
Demand is weakening
The divergence in the Russell 2000 is evidence that risk perceptions are changing, and it is not in line with the tax benefits either. Arguably, the changes to the tax code would benefit smaller companies over their mega-cap rivals, but the Russell 2000 is still weak. It's because of demand, not tax benefits.
The market for all assets is driven by supply and demand, and demand levels are going to fall materially. When they do, risks will become more apparent, but that's months away.
Demand is not changing today, but it will soon, and we have quantifiable models now that we did not have a month ago. Institutional investors recognize this, and their interest in equities is therefore even more isolated than it has been. All year there has been a focused rally in larger companies, but since the liquidity changes have become more identifiable, that has been even more pronounced.
The risk adjustments have begun.
Consider this a warning and be prepared. I offered a suggestion for this environment in a MarketWatch article in which I wrote about our CORE Portfolio Strategy. It is a good place to look.
Thomas H. Kee Jr. is a former Morgan Stanley broker and founder of Stock Traders Daily. Kee managed the fourth-best-performing strategy in the world in 2016, according to HedgeCo.
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