Small caps are latest threat to rally

Market watchers fear the stocks of smaller companies are getting overheated, which could poke a hole in the seemingly unstoppable market surge.

By MSN Money Partner Jul 25, 2013 3:01PM

CNBCArrow Down © Photodisc, SuperStockBy Jeff Cox


Smaller companies have helped light the way for the stock market rally -- and consequently could chart the way to the long-awaited correction.


Companies that make up the Russell 2000  ($TOMX) have pushed the index into stratospheric levels, crossing the 1,000 barrier and into a 23% gain for the year.


That's been a highly bullish sign for the market, as the domestically focused companies have benefited from a strong interest in U.S.-centric firms.


But those who watch the space fear that small caps are getting overheated and thus threatening to poke holes in the seemingly unstoppable broad market surge.


"Although the Russell 2000 has just made another new all-time high, we confess that we still can't quite get comfortable with the move we've seen," said Lori Calvasina, small cap strategist at Credit Suisse. "To get more bullish, we need to see more evidence that the economy and earnings are poised to re-accelerate in the back half of the year."


In fact, the index already has breached the 950 target that Credit Suisse had slapped on the group this year. Calvasina had conceded that the Russell 2000 could hit 1,025 at some point before pulling back, but even that lofty target has fallen.


Credit Suisse uses six barometers to test the space, and only two are positive -- investor sentiment and retail money flow.


Once the 1,025 mark hit, Calvasina said, "We had doubts such a move could be sustained through year end since we suspected that valuation pressures might return once that level was achieved. That valuation test we have been anticipating is also occurring now."


Valuation has passed 17 times earnings, and with profit outlook weak the ability of small-caps to gain at such high levels looks suspect.


A Credit Suisse investor survey for the first half showed just 18% found valuations to be compelling at these levels, despite a majority feeling bullish about the space over the long term.


"We think the lack of valuation appeal may have an impact on the appetite of long-only small cap investors, as those spending more time than usual looking for new ideas fell to 35% from 52%," Credit Suisse said in a narrative that accompanied the survey.


The firm advises investors to use caution.


Credit Suisse is overweight industrials and durable goods producers, and has raised tech to overweight after a cut in May.


It is market weight consumer discretionary, health care and utilities and underweight financials, staples and materials.


Even those bullish of small-caps are flashing warnings that some near-term resistance is probably in the works.


Todd Salamone, senior vice president of research at Schaeffer's Investment Research, said resistance levels for the Russell 2000 could be around the 1,060 range as the steam starts to run out of the rally.


That, in turn, could trigger a pause in the other major averages as they approach 20% gains for the calendar year.


"The good news for bulls is that the unwinding of negative sentiment that was evident in late June has not been fully unwound," Salamone said. "The various benchmarks are in uncharted waters and approaching short-term overbought levels, so we could see some sideways movement in the coming weeks, even though a continued unwind from the late-June fear could spur further momentum."


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