U.S. small-cap stocks fell below an important support level, and large-cap stocks are in danger?

Source: Golden Ten Data

While the U.S. stock market rebounded slightly on Tuesday, the smallest publicly traded companies in the U.S. stock market, known as small-cap stocks, are sending a red flag that all investors need to watch carefully.

On Monday, the Russell 2000 index, which measures the performance of small-cap stocks, fell below 1,800, a level that could serve as a warning to the broader market. With the index down 4.2% to 1,762, traders are now watching to see if it can hold above its 2018 all-time high of 1,740, equity strategist Michael Casper wrote in a research note. Casper said:

“The Russell 2000 fell below its recent trading range, support between 1,900 and 1,850, and a breakdown in small caps could signal weakness across the stock market.”

Historically, large-cap stocks do not rally higher until small-cap stocks bottom. The early stages of major bull markets are often marked by strength in small-cap stocks, eventually giving way to the leadership of large-cap stocks.

Adam Sahan, CEO of investment advisory services firm 50 Park Investments, said:

“Bearish action on small caps is a dangerous omen for investors. It tells us that risk aversion is playing a broader role for the market.”

Now, the Russell 2000 is down 28% from its Nov. 8 peak. Losses in small-cap stocks, which are typically heavily indebted and tend to have less diversified business lines, accelerated on Monday as rising borrowing costs weighed on the stocks of smaller companies.

Last week, Fed officials said they planned to reduce the Fed’s roughly $8.9 trillion balance sheet starting June 1 at a faster pace than in the past 10 years. That will further tighten credit across the U.S. as the Federal Reserve raises interest rates to fight the worst inflation in 40 years.

Of course, there is also a silver lining for small-cap investors that the earnings outlook is expected to improve. Of the 363 companies in the S&P Small Cap 600 that have reported first-quarter results, earnings estimates are 8% higher than when the reporting season began, while sales forecasts are up 5%, according to Bank of America data.

Last month, Wells Fargo told clients that this year’s “excessive” decline in small-cap stocks could help spur a “relief rally.”

Strategists led by Wells Fargo senior equity analyst Harvey said they still see a bigger chance of a rebound in these small-cap stocks due to a possible upward revision in earnings forecasts.


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