Small cap stocks signaling market caution ahead of US election

Traders work on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters
Traders work on the floor of the New York Stock Exchange.

Small-cap and tech stock performance is sending a caution signal for a market counting down to the U.S. presidential election, several analysts say.

"What I think you're seeing is a bit of rotation out of small-cap stocks and into large-cap stocks," said Peter Coleman, head trader at Convergex. "One of the reasons we think that's happening is because of uncertainty in the market" ahead of the Nov. 8 election and a potential Federal Reserve rate hike in December.

The Russell 2000 is among the biggest laggards this month, down more than 5 percent for October in its worst month since January and more than 6 percent below its all-time high. The other major U.S. indexes are also tracking for their worst month since January, but are only about 3 percent below their intraday records.

"When combined with the technical picture for large-cap indexes, the small-cap breakdown is significant, in our view," analysts from Bespoke Investment Group said in a report. They also pointed out a break in a positive trend in the relative performance of the Russell 2000 and the S&P 500 that "signals underperformance for small cap stocks ahead."

Source: Bespoke Investment Group

Meanwhile, money has been going into tech stocks. The Nasdaq 100 touched an all-time high last week and tech is up more than 4 percent over the last three months as the best S&P 500 sector.

John Kosar, chief market strategist at Asbury Research, said the Russell 2000 and tech stocks have both gotten "a little overextended versus the benchmark."

"If we get a pullback in those two versus the S&P, the S&P could see a pullback after the election," he said.

With about a week to go before the U.S. presidential election, the major indexes have stuck to a trading range just below all-time highs. That churning action comes despite what looks like a recovery from the earnings recession, a reopening of the initial public offering market, and resurgence in corporate deal-making, all of which typically indicate a better environment for stocks.

Two-year performance: S&P 500 vs Russell 2000

Source: FactSet (S&P 500, blue, left)

Markets have been pricing in a Hillary Clinton win and a Republican-dominated Congress, which supports the perception of market-friendly gridlock in the federal government. However, a Donald Trump win is still possible, especially after the surprise U.K. vote to leave the European Union in June.

In an indication of just how uncertain investors are about the election outcome, markets sprang to life Friday following news the Federal Bureau of Investigation is probing a new set of Hillary Clinton emails. U.S. stocks erased gains and closed lower Friday, while the CBOE Volatility Index (.VIX), considered the best gauge of fear in the market, jumped above 17 to its highest since mid-October.

"This is a period where investors have a lot of cash on the sidelines and it's prudent to be cautious at this point," said Quincy Krosby, market strategist at Prudential Financial.

Cash levels have jumped to 5.8 percent, matching post-Brexit and post-9/11 levels, according to Bank of America Merrill Lynch's global fund manager survey released earlier in October. After cash, money managers are most long tech and banks, the survey showed.