Uncategorized, Weekly Update

Small-Cap Stocks Continue to Struggle, Thanks to the Banks

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Published October 4, 2019


The stock market has begun the month of October with small-cap stocks trading back down to the bottom of their months-long trading range (green box below). The inability of small-cap stocks to find strength continues to hold back a stock market longing for a spark to drive a new uptrend.

Small-cap stocks continue to struggle

A closer look below at the trading range shows small-cap stocks having made zero progress over the past two years of trading. This performance seems at odds with the market’s narrative of strong domestic growth but weak or uncertain international growth. Small-cap stocks are generally viewed as being driven by domestic economics. If the domestic economy is growing well, why are small-cap stocks struggling?

small-cap stocks having made zero progress over the past two years of trading

A good chunk of that small-cap underperformance can be explained by the flat results from the regional banking sector (shown below). Financials account for almost 20% of the small-cap index.

The presumed strength in the domestic economy has not translated into gains for the banks. Banks benefit from a steep yield curve where cheap short-term money can be lent out at higher longer-term rates. With substantial economic uncertainty pushing the yield curve to flatten out, bank profit margins have been constrained. Bank stocks have suffered, trading flat for three years now.

Bank stocks have suffered, trading flat for three years now

Even the largest blue-chip bank, JP Morgan, has recently seen a breakout attempt fail (circle below).

JP Morgan, has recently seen a breakout attempt fail

A healthy stock market needs banks to participate in the uptrend. Banks need optimism about future economic growth to assert a steep yield curve and generate increasing profit margins. We can see below that regional banks have gone through other periods of stagnant returns only to burst higher. The start of a move higher occurred last year (boxed area below) only to be thwarted by the trade uncertainty. Another burst higher would kickstart a move, finally, in small-cap stocks, giving the market some new rally fuel.

Regional banks saw the start of a move higher occurred last year

Market Update

Stock investors continued wrestling with a boatload of uncertainty this week. Monday kicked the week off with a bit of a relief rally to close the month of September modestly positive. The relief came when the prior Friday’s reports that the Trump Administration might delist some Chinese companies were refuted by the Treasury Department. Monday’s +0.5% gain left the S&P 500 higher by almost +2% for the month and +1% for the volatile July-August-September quarter. But stocks stumbled -1.2% Tuesday to begin the month of October and 4th quarter. The ISM Manufacturing Index posted a second consecutive month of contraction with its lowest reading in a decade. The report was fodder for the bears as it fueled concerns of a recession forming in the U.S. Stocks followed up on Wednesday with an even steeper loss, an almost -2% plunge as employment data suggested tepid hiring activity. The two-day swoon was halted Thursday as investors shifted to viewing bad news as increasing the likelihood of another interest rate cut by the Fed. Stocks bounced off the key 200-day moving average, regaining about half of the prior day’s losses. Stocks added another +1.4% in Friday’s trade when the monthly employment report further solidified the view of a slowing economy, thus confirming expectations for lower interest rates to come. Adding to the positive tone was a rumor that Apple (AAPL) had asked its suppliers to increase production, boosting expectations for strong sales of their new iPhone. Apple closed the week at a new all-time high.

The S&P 500 (SPY) recovered almost all of a -3% slide early in the week to close with only a -0.36% dip. The Nasdaq 100 (QQQ) used the strength in Apple’s stocks to actually recoup all of the early-week slip to post a +0.95% gain. Small-cap stocks (IWM), however, continued to show relatively weaker, losing -1.34% for the week.

Warm wishes and until next week.