MW The market rally is broadening, so here's one way to play the small-caps trade

By Jamie Chisholm

There are technical and seasonal reasons why it may be a good time to buy smaller-cap stocks, strategist says

Wall Street will start the new week at a fresh peak. The S&P 500 SPX on Friday registered its 45th record close of 2024.

Importantly, the rally has been more inclusive of late. Banks, for example, have been having a good run, with the third-quarter earnings season getting off to a good start and helping the Financial Select Sector SPDR ETF XLF hit a new high.

Such a broadening out of the current two year-old bull market is welcome news to 22V Research's Jeff Jacobson, who believes it bodes well in particular for small caps, which he feels can not only break out but also outperform.

One reason the market has been able to broaden says Jacobson is because there is now less intense focus on the Magnificent 7 mega cap stocks, which as a block have been underperforming since July.

"In fact, of the 7 stocks in the Mag 7, only [Meta Platforms] has been able to eclipse the July highs (and that is with the S&P 500 making new highs). This rotation away from the mega cap names as the overall market stays bid supports other areas of the market and should help the small caps," Jacobson says.

Another factor that may help small caps - as measured by the iShares Russell 2000 ETF IWM - in coming weeks, is that it was during earnings season in July that the market last saw a bounce for the sector.

"Between July 10th and July 30th we saw IWM rally 9.44% AND tech (QQQ QQQ) decline by over 9%. Earnings season for the mega cap tech names starts in the next few weeks and should we see a similar-type of rotation away from the tech names that is likely to boost IWM once again," he says.

And referring back to the banks, it should be recognized that along with other financials they represent nearly 20% of the Russell 2000. So, if the smaller banks/financials can deliver well-received earnings in coming weeks, like their bigger cousins, then it will help the IWM a lot, as was the case in the summer.

Another factor that should help the small caps is the Treasury market. Jacobson notes that the recent lurch higher in 10-year yields BX:TMUBMUSD10Y from around 3.6% to just over 4% has mainly occurred because the market has reduced the chances of an economic contraction.

"Rising yields because of strong data/economy is supportive to owning/buying the cyclical small caps, yet the markets knee-jerk initial reaction is usually to sell the group on fears that higher yields are a headwind for the group," says Jacobson.

Besides, he adds, the Treasury market is now oversold and any pullback in yields without accompanying worse economic data will benefit small caps.

There are also some technical and seasonal factors that should support the small caps as well. The sector has managed to stay above its 200-day moving average since last December, even managing to not drop below during the early August sell-off.

"IWM is now only 2% below the well-defined resistance level of 225 (the July and September highs) and given the markets broadening out and continued bid, a breakout above that resistance level seems much more likely now (especially with November and December being the two best months for IWM over the past five years)," says Jacobson.

Given the current set-up, Jacobson prefers to use options as a trade, selling the IWM December puts at a 205 strike price to buy IWM December calls at a 230 strike.

"On the sharp rally in July (breakout above the March/May highs) we saw upside call volatility explode higher into the move - [which is] why I want to own calls outright and not an upside call spread," Jacobson explains.

Markets

U.S. stock-index futures (ES00) (YM00) (NQ00) are higher and the dollar index DXY is a touch stronger. Oil prices (CL.1) are slipping, and gold (GC00) is trading around $2,659 an ounce. The bond market is closed in observance of Columbus Day.

   Key asset performance                                                Last       5d      1m     YTD     1y 
   S&P 500                                                              5815.03    1.11%   3.36%  21.91%  34.37% 
   Nasdaq Composite                                                     18,342.94  1.13%   3.73%  22.19%  36.81% 
   10-year Treasury                                                     4.105      7.20    48.20  22.41   -60.72 
   Gold                                                                 2676       0.53%   2.53%  29.16%  38.44% 
   Oil                                                                  73.8       -4.52%  4.68%  3.46%   -15.21% 
   Data: MarketWatch. Treasury yields change expressed in basis points 

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The buzz

Federal Reserve Governor Christopher Waller speaks on the economic outlook at 3 p.m. Eastern.

Boeing shares $(BA)$ are down 1% in premarket trade after the plane maker said late Friday that it plans to cut about 10% of its workforce, and warned it sees a bigger third-quarter loss than Wall Street expected.

Caterpillar shares $(CAT)$ are down more than 2% after Morgan Stanley downgraded the stock to underweight and reduced their price target to $332.

Mainland China stocks XX:000300 resumed their rally despite many commentators expressing disappointment at a lack of specifics on proposed stimulus from a Ministry of Finance briefing on Saturday.

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The chart

The S&P 500 continues to form a rising wedge pattern, notes Michael Kramer, founder of Mott Capital Management. Such shapes often end with a sharp break out in either direction, and indeed Kramer observes that "volume levels in the S&P 500 futures are declining, a classic signal of a rising wedge pattern nearing its final stages."

"Moreover, a secondary bump-and-run pattern emerged, further indicating that the recent rally in the S&P 500 may be approaching its end," he adds.

Top tickers

Here were the most active stock-market tickers on MarketWatch as of 6 a.m. Eastern.

   Ticker  Security name 
   TSLA    Tesla 
   NVDA    Nvidia 
   GME     GameStop 
   NIO     NIO 
   MSTR    MicroStrategy 
   TSM     Taiwan Semiconductor Manufacturing 
   PLTR    Palantir Technologies 
   DJT     Trump Media & Technology 
   AAPL    Apple 
   AMZN    Amazon.com 

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-Jamie Chisholm

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October 14, 2024 06:35 ET (10:35 GMT)

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