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Are Small Caps making a splash?

One man’s trash is another man’s treasure. The concept of something having contradictory qualities to different people best describes the small and large cap debate. It suggests that investors have different values, preferences, and risk tolerance levels. What one investor overlooks or disregards could be desirable or valuable to another investor.


The recent surge in small-cap stocks and heavily-shorted and unprofitable technology companies have the press and media arguing that this is the start of another shift from quality to riskier and speculative investments.


The recent sharp rise in speculative names may be the hope that the central bank will begin cutting interest rates next year. Previous rate cuts by the Fed have benefited speculative investments. It forces investors to chase returns in riskier assets to catch up to a rising market.


Some are suggesting the chasing of small-cap and speculative names or a dash for trash investments are repeating, evidenced by the 2020-2021 meme-stock trading frenzy that witnessed unprofitable and heavily-shorted names such as GME, AMC, BB, BBBY, etc. explode to the upside.


Since 10/31/23, investors have rushed in to bid up small-cap stocks, driving a stunning turnaround in the SML small-cap index. SPX jumped 8.97%, NDX gained 9.92%, and SML exploded by 12.56% over the same period.

 

The Fed rate-cut hopes may be forcing short-covering in heavily shorted small-caps and speculative names. And yes, the small-cap sharp rise has been explosive over the last few weeks, as small-cap stocks have dramatically underperformed their large-cap counterparts this year.


So, is the recent rotation into small-cap stocks sustainable? And should investors be chasing the small-cap and speculative names?


A quick review of the S&P 600 Small Cap Index (SML – 1,220.24) suggests technical improvements. The ability of SML to rebound at 1,065.49 (10/27/23) signals a successful test of pivotal support at 1,027-1,058 (50% retracement from Mar 2020 to Nov 2021 rally, the Nov 2020 breakout, and the Sept/Oct 2022 lows). The recent surge above the 50-day ma (1,134.21) and the 200-day  ma (1,177.98) are also constructive.


However, SML retains its Nov 2021 and Mar 2023 primary downtrends at 1,244 and 1,282, respectively. The lower-highs pattern, coinciding with 2/3/23 highs (1,320.95) and 7/31/23 highs (1,282.58), must be negated to confirm the Sept 2022/Oct 2023 lows (1,058-1,065.5). Also, the 50-61.8% retracements from Nov 2021-Sept 2022 decline resides at 1,267 and 1,317, offering formidable intermediate-term resistances. A convincing move above 1,317-1,321 confirms an intermediate-term breakout and signals a retest of the 2021 all-time highs (1,477.45). On the downside, the 200-day ma (1,178) and the 50-day ma (1,134) offer key support.


Cathie Wood’s Ark Innovation ETF (ARKK), a proxy for unprofitable disruptive technology companies, may be bottoming via a head and shoulders or triangle pattern. A breakout above 50-51/53.42 suggests +24.23 points or ARKK rally toward 62.5 (Feb 2021 downtrend) and above 75-78 (38.2% retracement from Feb 2021-Dec 2022 decline and h/s bottom/triangle breakout projection). Key support rises to 45.08-45.30 and below, 40-41 (50-day and 200-day ma), and 34-35 (left and right shoulders).


Can the rotation into small-cap and speculative names continue?


Will the rotation away from this year’s market leaders (i.e., Magnificent Seven and mega-cap technology names) and toward more speculative securities and assets fizzle if the market’s rate-cut hopes fade by the end of the year?


Will the rotation into small caps and speculative investments signal the end of the Oct 2023 euphoria-driven rally?


If so, does this warn of another late-cycle stock market rally?


Traders will be monitoring the monthly labor market reports later this week. Next week, the Fed convenes for its December FOMC meeting. The two events will give investors further insights into the Fed’s rate cuts and will influence stocks, including small and large-cap names.


Source: Chart courtesy of StockCharts.com

Source: Chart courtesy of StockCharts.com

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