Small Caps Sinking Below Support Level Is Warning for All Stocks

(Bloomberg) — Even with equity futures gaining Tuesday morning, the smallest companies in the stock market are sending a danger signal that all investors will want to watch carefully.

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The small-cap Russell 2000 Index broke below 1,800 on Monday, a level that could serve as a warning for the broader stock market. With the index falling 4.2% to 1,762, traders are now watching to see if it can hold above 1,740, a prior all-time high hit in 2018, Michael Casper, an equity strategist at Bloomberg Intelligence, wrote in a research note.

“The Russell 2000 broke below its recent trading range,” Casper wrote, referring to the index falling below support between the mid-1,900s and 1,850 in recent trading sessions. “The breakdown in small-cap stocks could foretell weakness for equities at large.”

Historically, broader markets don’t bounce higher until small-cap stocks bottom. Early phases of major bull runs are often marked by small-cap strength, which eventually gives way to leadership by larger companies.

“Bearish action in small caps is a ‘canary-in-a-coal-mine’ for investors,” said Adam Sarhan, chief executive of investment advisory service 50 Park Investments. “It’s telling us risk-off is in play for broader markets.”

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The Russell 2000 Index is now down 28% from its Nov. 8 peak. Monday’s losses accelerated as rising borrowing costs have pressured shares of small companies, which are typically heavily indebted and tend to have less-diversified business lines.

Last week, Fed officials signaled they plan to reduce the central bank’s massive $8.9 trillion bond holdings more rapidly than they did last decade starting June 1. That will further tighten credit across the economy as the Fed lifts interest rates to fight the hottest inflation in four decades.

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Of course, there is a silver lining for small-cap investors: improving earnings outlooks. Of the 363 companies in the S&P Small Cap 600 Index that have reported first-quarter results, profit forecasts are 8% higher compared with the start of reporting season, while sales forecasts have increased by 5%, according to Bank of America Corp.

Last month, Wells Fargo told clients that the scale of this year’s drop in small caps was “overdone” and could help spur a “relief rally.”

On Thursday, Wells Fargo said it still sees an opportunity for a “much larger” bounce back in those shares, citing potential upward revisions to earnings estimates, according to Wells Fargo strategists led by senior equity analyst Christopher Harvey.