Bank of America is paying close attention to small-cap stocks, as they’re considered an essential gauge for the overall direction of the stock market. The bank noted that the market’s upside potential is somewhat limited due to the concentration of interest in just a few stocks and their soaring valuations.
Small-cap stocks, however, are grappling with significant hurdles, primarily due to rising interest rates, which impact companies that are not yet profitable. A report from Bank of America on Friday emphasized that these stocks could play a decisive role in determining if the current bull market will persist.
Investment strategist Michael Hartnett explained that while President-elect Donald Trump’s agenda might offer some support to the stock market, the limitations are clear. A handful of concentrated stocks and their high valuations, coupled with investors’ stretched positions, present notable challenges. According to the bank’s December fund manager survey, there’s a historically heavy tilt towards U.S. stocks among investors.
For Hartnett, the true test for sustaining the rally lies in whether small-cap stocks can climb above a key resistance level established in 2021. Post Trump’s election victory in November, small-cap stocks did breach this threshold momentarily, yet they retreated soon after, staying close to this resistance as fears over prolonged elevated interest rates loomed.
Small-cap stocks are particularly vulnerable to hikes in interest rates due to their higher sensitivity to borrowing cost fluctuations. Notably, around 40% of companies on the small-cap Russell 2000 index aren’t generating profits, meaning they rely on debt to finance their operations.
When interest rates rise, any firm with marginal or zero profits facing debt refinancing could be pushed towards insolvency. Hartnett suggests that if small-cap stocks convincingly break past their 2021 resistance, it’s a green light for continued market growth. Conversely, failing to do so might indicate a broader market downturn, prompting asset managers to reduce their stock market exposure.
Hartnett also advised investors to consider buying bonds, especially with Treasury yields potentially maxing out near 5%. He also pointed out that stocks sensitive to interest rate changes, such as those in the financial, utilities, and homebuilding sectors, are worth looking into.
You can view the full article on Business Insider.
