After a week that saw a bearish shift in sentiment among many market strategists and pundits, U.S. equities rebounded sharply yesterday, as the Standard & Poor’s 500 Index gained nearly 1.8 percent. While language in the notes from the Federal Open Market Committee’s September meeting released yesterday suggest that the Federal Reserve won’t be raising interest rates anytime soon, a positive for stock investors, the market’s sudden, large upward move appeared outsized to many observers. For now, it seems that U.S. investors have yet to make up their minds about the balance between good news domestically and grim news abroad. Corporate earnings appear likely to be a deciding factor for investors as many large-cap companies announce third quarter results in the coming weeks.
Bank of England stays the course. As most market watchers had expected, Britain’s central bank voted today to keep its benchmark interest rate at 0.5 percent. At the same time, the Bank of England announced that it is leaving its asset-buying program at £375 billion ($607 billion). Bank of England governor Mark Carney has recently expressed concern over the economic impact of the steep rise in U.K. housing prices and household debt over the past year.
More bad news for Europe. German trade data for August released today by the Federal Statistics Office added to the gloom hanging over the European Union’s largest economy, with exports registering a 5.8 percent contraction. This constitutes the largest single month drop in exports since 2009 and was well below consensus forecasts. In the wake of yesterday’s announcement that the International Monetary Fund (IMF) had reduced GDP projections for Germany in 2014 and 2015, political debate over economic policy in Berlin is beginning to pick up steam.
Machinery orders in Japan show improvement. After a string of disappointing data releases for Japan in recent weeks, a positive development arrived this morning. August machinery orders registered a 4.7 percent month-over-month expansion and a year-over-year contraction that was shallower than forecast. Machinery orders are considered a significant indicator for the overall production levels, suggesting that factory activity may have found a bottom in September. The encouraging industrial numbers, however, are unlikely to dispel larger concerns regarding the health of recovery, as extraordinary easing measures by the Bank of Japan have failed to offset the impact of increased consumption taxes on overall economic activity.
Today’s U.S. data unlikely to move markets. In the U.S. initial jobless claims and August wholesale inventories will be released today with no expectations of a significant market impact from either number. Consensus forecasts are for a marginal uptick in the ranks of newly jobless after last week’s surprising drop of 8,000. Last week’s continuing claims figures reached a recovery low of 2.398 million. Meanwhile, wholesale inventories have risen modestly in August after a surprise reduction in July largely driven by a decrease in farm and computer equipment.
Earnings season takes center stage in the U.S. After aluminum maker Alcoa’s profits beat forecasts yesterday, earnings season is now in full swing. Companies reporting today include retailers Gap and Sears Holdings Corp. Shares of Sears tumbled yesterday on reports that a significant vendor had ceased to ship to the beleaguered department store chain and discount retailer on concerns over credit worthiness. Gap shares were down 10 percent in premarket trading after the San Francisco–based retailer announced that CEO Glenn Murphy would be stepping down in February and be replaced by Art Peck, president of its growth, innovation and digital division.
Portfolio Perspective: Small- and Mid-Cap Stocks Are Due for a Fall — Nicholas Ragone, Villicus Capital Group
The most important technical indicators are screaming that small- and mid-cap stocks are bound for bigger losses. The small-cap iShares Russell 2000 Index ETF (IWM) and SPDR S&P MidCap 400 ETF (MDY) have both broken below their key 50-, 150- and 200-day moving averages, as well as below a trend line going back to 2012. The small-cap index has formed a bearish head-and-shoulders chart pattern, indicative of market tops, while the mid-cap benchmark has formed an equally bearish double-top pattern. If the two indexes fail to find support at current levels, the next level of chart support is at the 2013 September low — about 10 percent below current levels.
The combination of weakness in small- and mid-cap stocks and strength in large-cap stocks means that institutional investors and hedge funds — the bull market’s primary drivers since 2009 — are lowering their exposure to the more speculative areas of the stock market and gravitating to less volatile, more liquid stocks.
The first phase of the Federal Reserve’s plan to scale back quantitative easing is nearly done. With QE being eliminated, hedge funds and institutional investors will have less access to cheap money and therefore less firepower to push stocks higher.
The iShares Russell 2000 Index ETF has returned an average of 7.8 percent annually the past ten years, according to Morningstar. But over the past three years, it has gained a whopping 19.3 percent a year. This outsized divergence from the historical average is unsustainable, suggesting that the small-cap index has to underperform for the next few years to revert to the mean. The same holds true for the SPDR S&P MidCap 400. Its three-year average return is about double the ten-year average.
Nicholas Ragone is founder and portfolio manager of Villicus Capital Group, a Melville, New York–based alternative investment management firm catering to institutional and high-net-worth clients.
