GO
Loading...

Small caps pose the latest threat to market rally

Thursday, 25 Jul 2013 | 6:01 AM ET
Getty Images

Smaller companies have helped light the way for the stock market rally—and consequently could chart the way to the long-awaited correction.

Companies that make up the Russell 2000 have pushed the index into stratospheric levels, crossing the 1,000 barrier and into a 23 percent gain for the year.

That's been a highly bullish sign for the market, as the domestically-focused companies have benefited from a strong interest in U.S.-centric firms.

But those who watch the space fear that small caps are getting overheated and thus threatening to poke holes in the seemingly unstoppable broad market surge.

(Read more: Yoshikami: Is this the death of diversification?)

Stocks beat bonds in next 1-2 years: Kantor
Larry Kantor, Barclays head of research, shares his market forecast. "As the economy gets stronger, bond yields will creep up," he says.

"Although the Russell 2000 has just made another new all-time high, we confess that we still can't quite get comfortable with the move we've seen," said Lori Calvasina, small cap strategist at Credit Suisse. "To get more bullish, we need to see more evidence that the economy and earnings are poised to re-accelerate in the back half of the year."

In fact, the index already has breached the 950 target that Credit Suisse had slapped on the group this year. Calvasina had conceded that the Russell 2000 could hit 1,025 at some point before pulling back, but even that lofty target has fallen.

Credit Suisse uses six barometers to test the space, and only two are positive—investor sentiment and retail money flow.

Once the 1,025 mark hit, Calvasina said, "We had doubts such a move could be sustained through year end since we suspected that valuation pressures might return once that level was achieved. That valuation test we have been anticipating is also occurring now."

(Read more: Yet another market bear throws in the growl)

Valuation has passed 17 times earnings, and with profit outlook weak the ability of small-caps to gain at such high levels looks suspect.

A Credit Suisse investor survey for the first half showed just 18 percent found valuations to be compelling at these levels, despite a majority feeling bullish about the space over the long term.

"We think the lack of valuation appeal may have an impact on the appetite of long-only small cap investors, as those spending more time than usual looking for new ideas fell to 35 percent from 52 percent," Credit Suisse said in a narrative that accompanied the survey.

The firm advises investors to use caution.

(Read more: What you need to know about earnings (so far))

Credit Suisse is overweight industrials and durable goods producers, and has raised tech to overweight after a cut in May.

Small caps overheated?
Stocks have erased earlier losses, and the small caps are helping to drive the market higher. Jeff Cox and Bob Pisani of CNBC; and Kenny Polcari, O'Neil Securities, dig into the Russell 2000.

It is market weight consumer discretionary, health care and utilities and underweight financials, staples and materials.

Even those bullish of small-caps are flashing warnings that some near-term resistance is probably in the works.

Todd Salamone, senior vice president of research at Schaeffer's Investment Research, said resistance levels for the Russell 2000 could be around the 1,060 range as the steam starts to run out of the rally.

(Read more: While the traders are away, the bulls will play)

That, in turn, could trigger a pause in the other major averages as they approach 20 percent gains for the calendar year.

"The good news for bulls is that the unwinding of negative sentiment that was evident in late June has not been fully unwound," Salamone said. "The various benchmarks are in uncharted waters and approaching short-term overbought levels, so we could see some sideways movement in the coming weeks, even though a continued unwind from the late-June fear could spur further momentum."

By CNBC's Jeff Cox. Follow him @JeffCoxCNBCcom on Twitter.

  Price   Change %Change
RUSS 2K
---

Featured

NetNet TV

Wall Street