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Bank of America views small-cap stocks as a key indicator to watch in the broader stock market.
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High concentration in a handful of stocks and high valuations limit the stock market’s upside, BofA said.
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Small-cap stocks face challenges due to high interest rates, which affect companies without profits.
Bank of America said in a note Friday that one key area of the stock market will help determine whether the bullish rally will continue.
Michael Hartnett, an investment strategist at the bank, said that while the influence and policies of President-elect Donald Trump could provide a safety net for the stock market, the rally is limited by high concentration in a handful of stocks, high valuations and stretched positioning by investors.
Hartnett noted that the bank’s survey of fund managers in December showed investors are maintaining a record overweight position in U.S. stocks.
The key signal for a continued rally, according to Hartnett, is whether small-cap stocks can overcome a key resistance level set in 2021.
Small-cap stocks briefly broke above the resistance level following Donald Trump’s election victory in November, but have since given up most of those gains and are trading around the resistance level as investors fear that interest rates interest stay high for longer.
Higher interest rates are particularly painful for small-cap stocks because they are more sensitive to changes in borrowing costs. About 40% of small-cap Russell 2000 index companies don’t generate profits, meaning debt financing often plays an integral role in funding their operations.
If the cost of debt rises and remains higher when a company with little or no profits has to refinance its debt, it could ultimately lead to insolvency.
According to Hartnett, it’s all systems go if small-cap stocks can decisively break above their 2021 resistance level. However, if not, it could signal broader market weakness and he would expect asset allocators to reduce their overweight position in the stock market.
Hartnett recommends that investors buy bonds with Treasury yields that can peak near the 5% level and rate-sensitive stocks often found in the financial, utilities and home construction sectors.
Read the original article on Business Insider