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Are the Large Capitalized Issues Finally Rolling Over Like Their Small Cap Brethren?

Are the large capitalized issues finally rolling over like their small cap brethren?  Yesterday was an ugly day as all indices came under considerable selling pressure. The catalysts for the selloff include a slowdown in Europe perhaps the result of the Russian Ukrainian invasion, potential greater sanctions against Russia because of this invasion, civil unrest in Hong Kong, and fears the US central bank may rise interest rates sooner than expected.

Some have questioned whether Ebola was a cause for yesterday’s selloff?   Perhaps for the airlines that were hit hard, but generally speaking no for a myriad of reasons.  Perhaps most specifically at this juncture the diagnosis is a very isolated event.

I would instead argue the selloff was also predicated by the violation of several moving average lines, a violation that triggered more selling in this much automated market where traders have been replaced by computers and an anathema of risk taking fearing regulatory backlash.

For many of the smaller capitalized entities, it is getting really nasty as over 54% of the NASDAQ companies are down over 25% since March according to Bloomberg.  It is generally accepted higher interest rates will have a greater impact upon the smaller companies than the larger entities, thus the selloff.

But is not the 10-year Treasury trading at a 2.39% yield just one basis point away from its lowest yield for the year?  Some are utilizing the potential change in the overnight rate as the interest rate benchmark to explain why small caps have been crushed.  All must remember the largest component of most valuation models is current and expected corporate cashflow discounted by some interest rate.

I have opined several times about large pools of monies gravitating from sector to another, driving that sector up in price and then abandoning it causing shares to fall and then proceeding to yet another.

This massive sector rotation is keeping the indices positive for the year but is causing great damage beneath the surface.

Tomorrow the all-inclusive BLS employment report is released.  Will the jobs data be weaker than expected for the second consecutive month thus elevating economic concerns in the US?  If this is indeed the case, will the markets sell off as bad might be regarded as bad given the dearth of monetary options remaining?

Or conversely, what happens if the data demonstrates unexpected strength, thus further challenging the interest rate time table, where good is regarded as bad?

Because of the recent volatility, I can argue barring a major surprise in either direction, prices are already discounted.

Third quarter earnings season commences next week.  There is little narrative about upcoming reports but I expect this to change in the immediate future.

I think the odds are greater than 60% the indices, more specifically the smaller capitalized issues will rally given attractive valuations, a relatively benign interest rate environment, potentially strong corporate cashflows, markets that in many aspects are oversold, low confidence and entering into a period of seasonal strength.

How accurate will I be in this outlook?

Last night the foreign markets were down.  London was down 0.19%, Paris down 0.30% and Frankfurt down 0.08%.  Japan was down 2.61% and Hang Seng down 1.28%.

The Dow should open little changed.   The 10-year is off 5/32 to yield 2.40%.


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Ken Engelke

Chief Economic Strategist Managing Director

The views expressed herein are those of Kent Engelke and do not necessarily reflect those of Capitol Securities Management. Any opinions expressed are statements of judgment on this date and are subject to certain risks and uncertainties which could cause actual results to differ materially from those currently anticipated or projected. Any future dividends, interest, yields and event dates listed may be subject to change. An investor cannot invest in an index, and its returns are not indicative of the performance of any specific investment. Past performance is not indicative of future results. This material is being provided for informational purposes only. Any information should not be deemed a recommendation to buy, hold or sell any security. Certain information has been obtained from third-party sources we consider reliable, but we do not guarantee that such information is accurate or complete. This report is not a complete description of the securities, markets, or developments referred to in this material and does not include all available data necessary for making an investment decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. If you would like to unsubscribe from this e-mail distribution, please reply to this e-mail and indicate that you wish to unsubscribe in your response.