Don’t Jump Into Small-Cap Stocks For The Wrong Reasons

*Analyzing the markets with Richie Naso, a Wall Street veteran of over 40 years and former member of the NYSE.

DJIA 52-wk: +23.91% YTD: +19.16% Wky: +1.39%

S&P 500 52-wk: +31.29% YTD +26.47% Wky: +1.06%

NASDAQ 52-wk: +34.35% YTD: +28.02% Wky: +1.03%

Roundhill Mag 7 ETF: 52-wk: +60.76% YTD: +54.71% Wky: +1.39%

During the week of November 25–29, 2024, U.S. stock markets exhibited mixed performances, with various factors influencing sector and index trends.

1) Major Index Performance:

• The S&P 500 experienced moderate losses as technology stocks retreated following a strong earlier rally. Broader market leadership is now shifting beyond mega-cap tech stocks, benefiting sectors such as financials, industrials, and utilities. ​Investopedia Edward Jones.
• The Dow Jones Industrial Average was relatively stable, buoyed by gains in more traditional sectors like energy and financials. ​Investopedia.
• The Nasdaq Composite, heavily weighted in tech, saw a sharper pullback as investor enthusiasm for AI and high-growth names cooled slightly ​Investopedia Edward Jones.
  

2) Sector Highlights:

• Tech Sector: Companies such as Dell Technologies faced declines, attributed to mixed earnings and concerns over AI hardware adoption ​Investopedia.
• Energy: Firms like Texas Pacific Land Corp. performed strongly, supported by diversification into energy-related services like carbon sequestration and renewable energy ​Investopedia.
• Consumer Goods: HP and Autodesk saw sharp drops due to weak earnings forecasts and leadership transitions​ Investopedia.

3) Economic Context:

• Continued focus on interest rate policies and inflation kept markets cautious. Analysts suggested that the market is entering a phase of broader participation across sectors, marking a healthier shift in the ongoing bull market ​Edward Jones.
• For the week, investors were reminded of the importance of diversification as the leadership in market performance transitions from tech to other sectors like financials and industrials​ JPMorgan.

Expect a Pullback

Sometimes the market does not need a catalyst to sell off. At some point, investors just start to sell as the market runs out of steam.

It is always prudent to take some profits, and now may be a great time to do so. The historical rally suggests that a pullback could be in the cards early next year, and investors should prepare for that.

One option is to hedge, whether through options, futures or inverse ETFs. Alternatively, a simpler approach is to sell some stocks and raise cash, giving you the flexibility to buy on the next dip.

My end-of-year S&P targets have already been met, but we could see a slight extension to 6150 before an aggressive pullback—around 2-3% above current levels.

With many short-term treasury bills offering a risk-free return of over 4%, it may make sense to park cash in these instruments while waiting for a sell-off.

I anticipate a pullback, but strong support will be found at key technical levels. Many investors who missed the rally are waiting for an entry point, so it is important to monitor these levels in the S&P:

50-day Moving Average: Currently 5820 SPX

200-Day Moving Average: Currently 5440

50% Fibonacci Retracement: 5040 SPX

61.8% Fibonacci Retracement: 4800 SPX

Investors should consider nibbling at these levels during any sell-off. If support is confirmed, they can fully allocate cash into equities. A pullback to the 200-day moving average would represent a 12% drawdown, which is common in volatile markets.

Post-election “animal spirits” continue, with risk assets persisting in rally mode. As I wrote in a recent column, one area of heightened interest for investors has been small-cap stocks. The Russell 2000 Index posted its best single-day gain in almost two years following the election, as investors positioned for accelerating growth (via tax cuts and deregulation) combined with potential policies (tariffs) that favor companies with high relative levels of domestic production and revenue, i.e., small caps.

Small-cap value has been the biggest beneficiary of these ‘themes’ in the weeks since the election, outperforming mid-cap and large-cap stocks across the value and growth spectrum. The trade is logical on its face—small-cap value stocks derive about 80% of their revenues domestically.

The tax cut, deregulation, and tariff themes may play out just as investors are anticipating they will. But the decision to crowd into the small-cap trade—or significantly increase your allocation to small-caps now—would mean making assumptions about what future policy will look like, and how those policies will impact the economy. In other words, the allocation decision would be driven by changes to sentiment, not changes to economic fundamentals. That’s why I caution jumping into small-cap value stocks for the wrong reasons.

Donald Trump’s nomination of Robert F. Kennedy Jr. and other healthcare skeptics has caused investors to flee the sector—which means it’s time to pay close attention to the stocks.

The reaction to Trump’s election has been generally celebratory, with the S&P 500 up nearly 5% in November alone. Not healthcare stocks—the Health Care Select Sector SPDR exchange-traded fund (ticker: XLV) has fallen about 2% this month.

Those moves accurately affect where investors have been putting their money. According to BofA Securities’ latest fund flow data report released on Tuesday, its clients were net buyers of equities the previous week for the third week in a row, with inflows accelerating to their highest level since September. However, healthcare ETFs were the only sector ETFs that BofA’s clients were avoiding. Among individual companies, healthcare stocks saw their first outflows in five weeks, one of only two sectors, along with real estate, to experience net selling.

It’s easy to understand why investors are so jittery: The incoming Trump administration could make plenty of waves with changes in policy and various potential appointees, including Dave Weldon to lead the Centers for Disease Control and Prevention and the aforementioned RFK Jr. as secretary of Health and Human Services, could be wild cards given their rejection of some scientifically accepted facts. Their previously disclosed stances have investors worried about the near-term future of everything from vaccines to formerly highflying weight-loss drugs. And given Wall Street’s aversion to uncertainty, they may remain out of favor in the near term until there’s more clarity.

But sometimes the reward more than makes up for the risks, and healthcare stocks are trading cheaply enough to start looking interesting. The Health Care ETF trades at 17.8 times earnings, down from 19.9 times at the end of August and near its cheapest level of the year.

That valuation would be particularly appealing if regulatory actions proved less onerous than the recent concerns. Guggenheim analyst Debjit Chattopadhyay notes that his industry contacts have expressed some skepticism “on the scope of both broader agency and potential drug development changes given the relatively limited time frame ahead of midterm elections in 2026, the broader goals of the Trump agenda, and the uncertainty that remains around Trump and congressional support and mind share for sweeping changes.”

He also notes that changes around vaccines specifically could be an “uphill battle,” with the Health and Human Services chief still having to work within existing infrastructure “and state authority as guardrails against his actions.”

Nor is there anything wrong with the sector’s fundamentals. Revenue for healthcare stocks is expected to climb by 11% in the year ahead, according to Trivariate Research founder Adam Parker, the best performance of any sector save technology, while gross margins of 54% are in the historical 93rd percentile. That seems like a disconnect despite the ongoing uncertainty, especially as most other sectors are more expensive based on their historical averages.

Moreover, many investors are betting that merger and acquisition activity will pick up under the new administration. That’s caused shares of potential takeover candidates to rise, Parker explains, adding that about 5.5% of the 1,000 largest healthcare stocks by market cap typically receive a tender offer every year. “It is incongruous to bid up stocks levered to increased M&A as we have seen since the Red Sweep—and not conclude that the valuations of select healthcare stocks will also begin to expand,” he writes.

Ultimately, much of what healthcare policy will look like in 2025 and beyond is still debatable, but a growing sector that is trading cheaply shouldn’t be treated as DOA.

It looks to me like a year end Santa rally has started.

Factors this week I'm focusing on this week:

1) PMI on Monday

2) Jobs report on Friday

DATA: Barron’s print edition page 21 12/2/24 Market Week Teresa Rivas

Paragraph: one Market Recap online 11/25/- 11/28 ChatGPT

Paragraph: two Weekend Wisdom online 11/30/24 An Investor Game Plan Jeremy Mullin

Paragraph: three Mitch on the Market online 11/30/24 Small Caps Mitch Zacks

Paragraph: four Closing remarks Richie Naso.

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