Is Wall Street preparing for a big rally?

Emerging strength in small-cap and cyclical stocks point to continued gains.

By Anthony Mirhaydari Feb 16, 2010 1:04PM

MirhaydariSince stocks hit bottom on February 5, there has been a noticeable performance differential between the small caps in the Russell 2000 and the mega caps in the Dow. Over the last seven trading days, the Russell 2000 (RUT) has gained 6% while the Dow Jones Industrial Average (INDU) has gained just 3.7%. This is what leadership looks like.

 

Such behavior reflects a rise in investors risk appetites and suggests a strong rebound rally is just getting started.  Similar periods of relative small cap strength, following periods of small cap underperformance, has marked important turning points since the March 2009 low. It happened back in December. It happened in September. It happened in July. It happened in May. And it's happening now.

 

We're seeing similar leadership from technology stocks; specifically, by semiconductor stocks like Entegris (ENTG) and SMART Modular Technologies (SMOD) which gained 14% and 15% last week respectively and are up 6.8% and 5.5% during Monday trading. Looking back, relative outperformance by semiconductors against the S&P 500 has marked the most important market moves over the last 18 months. By most important, I mean moves to new highs.

 

All of this suggests that savvy Wall Street insiders are preparing for a move higher by positioning themselves in the stocks and sectors with the most leverage.

 

Another way to view this is to look at the Morgan Stanley Cyclical Index (CYC) compared to the S&P 500. The CYC is designed to measure the performance of economic sensitive industries in the U.S., including autos, metals, machinery, chemicals, and transportation.

 

Cyclicals

 

As you can see in the chart above, the ratio of the CYC to the S&P 500 does a nice job of removing the day-to-day volatility of stocks -- leaving behind a representation of the major trends that move the market. You can see how the March to May, July to August, and December to January moves in cyclical stocks have been responsible for the vast majority of the stock market's overall gains over the past year.

 

And right now, the CYC is recovering from the most oversold condition seen since the March low. This suggests that at the very least, cyclical stocks should enjoy a short period of outperformance. And this means that stocks in general should find the support needed to push higher.

 

There are more reasons to be constructive on cyclical stocks. Strategist Jonathan Golub at UBS reminded clients in research note this week that while investors have been preoccupied with events in Europe and China, corporate America is reporting some outstanding results for Q4. Finally, companies are starting to see some top-line revenue growth to complement the earnings growth seen over the past few quarters due to deep cost-cutting initiatives.

 

The real story is that we are seeing a bifurcation of performance between cyclical and non-cyclical corporations -- which is exactly what we would expect coming out of a recession. Removing the financials (they are in unique circumstances at the moment), cyclical stocks have reported 25% year-over-year earnings growth according to Golub. Compare this to the relatively flat earnings growth by more defensive names.

 

Technology and semiconductor stocks have been doing particularly well. In Golub's words, tech stocks have been "knocking the cover off the ball, posting top-line and bottom-line growth of 11% and 62%."

 

My positions

 

My portfolio at Wall Street Survivor has a heavy allocation to cyclical sectors and small cap stocks. Holdings include Century Aluminum (CENX), ProShares Ultra Semiconductor (USD), and the Direxion Small Cap Daily Bull 3x ETF (TNA). For the week, my portfolio is up 9.5%. Since it was initiated in September, it's up 56.6%.

 

Disclosure: The author does not own or control a position in any of the funds or companies mentioned.

 

Anthony Mirhaydari is a researcher for the Strategic Advantage investment newsletter. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.

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