The Bull Takes a Breather

The bull was due for a rest. After six straight weeks of gains, U.S. stocks last Friday closed out the week in the red.

Volatility has remained remarkably low. Since September, the market has only experienced two down weeks. The last time stocks suffered a 5% pullback was about four months ago.

Defensive sectors, e.g. utilities, real estate, and consumer staples, are outperforming cyclical sectors this year. Risk assets continue to perform strongly as well, but the increasing popularity of safe havens reflects investor nervousness about the trade war and recessionary signals such as the manufacturing slowdown.

This caution is a good sign, because it shows that investors aren’t growing too complacent, which in turn mitigates the possibility of a correction in the final quarter of 2019.

In another good sign, market breadth has been improving. The number of stocks participating in the rally has expanded. As of this writing, about 75% of S&P 500 companies’ stock prices are above their 200-day moving averages, up from 50% in May. Around this time in 2018, on the cusp of the correction in December, this measure was about 40%.

I’m also encouraged that small-cap stocks in recent weeks have been outperforming large-caps, which suggests optimism about the economy is returning to Wall Street.

So while last week closed on a down note, stocks have nonetheless racked up a solid year so far (see table).

In pre-market trading this morning, the three main U.S. stock indices were poised to all open in the green, as investors held out hope for a Santa Rally this quarter. But risks remain, including the unpredictable trade war, political dysfunction in Washington, and negative earnings growth combined with high valuations.

Retail sector earnings have been a mixed bag, reflecting a bifurcated industry. Adaptable “big box” retailers such as Target (NYSE: TGT) and Walmart (NYSE: WMT) exceeded Q3 expectations, proving that e-commerce giant Amazon (NSDQ: AMZN) isn’t necessarily a death sentence for legacy store chains.

However, stodgier department stores such as Macy’s (NYSE: M) and Kohl’s (NYSE: KSS) both missed Q3 earnings expectations and cut profit projections.

Target and Walmart have enjoyed success in driving earnings and revenue, by redesigning their stores and enhancing customer service. They’ve also devoted considerable resources to improving their online presences.

America’s love affair with shopping just might sustain this aging bull market a bit longer. Many analysts have decided that the U.S. is headed for a recession, but no one told consumers.

In the waning weeks of 2019, all eyes turn to holiday retail sales. Three-fourths of the U.S. economy is made up of consumer spending, and in turn, three-fourths of consumer spending occurs during the holiday season. For retailers and the overall economy, it’s crunch time.

Research firm eMarketer forecasts that total U.S. holiday retail sales will increase 3.8% on a year-over-year basis to $1.008 trillion this year, the first-ever trillion-dollar holiday season. The annual frenzy kicks off with “Black Friday” on November 29.

Rise of the small fry…

In the context I’ve just described, small cap stocks are appealing. The definition of small cap varies, but it’s generally a company with a market capitalization of between $300 million and $2 billion.

Large-cap stocks are getting whipsawed by trade war headlines. One way to protect your portfolio is to buy high quality small-cap stocks, especially in sectors that benefit during the late stage of economic recovery.

America’s small companies are positioned to outperform their larger brethren and provide much-needed adrenaline to an economy that’s probably on course for a downturn.

Small businesses represent more than 99.7% of all U.S. employers, employ half of all private sector workers, and account for 60% to 80% of the new jobs created annually in the country.

Small caps disproportionately gain from economic growth, which has wavered but remains on track. As opposed to the souring mood of large-cap CEOs, small-business confidence has stayed persistently high, due to the Trump administration’s deregulation and tax cuts.

It begs the question: what about penny stocks? I’m generally leery of penny stocks, but if you conduct careful due diligence, you can find a few hidden gems amid the dross, especially in hot sectors that face multi-year momentum.

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What qualifies as a worthy penny stock? The company must have strong fundamentals and quality management. Look for a solid balance sheet, growing earnings and revenue, and a competitive edge against industry rivals. A common red flag is excessive debt, without sufficient revenue to cover liabilities.

Insider ownership is always a plus; it shows that management has “skin in the game,” which lessens the chance of financial gimmickry. The company’s niche should be rapidly expanding and its products and/or services distinctive.

Small caps are insulated from concerns about global growth, because they tend to get most of their revenue domestically. Trade conflict and increasing instability in emerging markets have driven investors to smaller stocks, which have less exposure to these overseas risks.

Small-cap stocks outperform all other market capitalizations over the long term. Indeed, over the past 10 years, nearly all of the highest gaining stocks were small caps.

Enjoy the long-running bull market, but gravitate toward defensive sectors. Now’s a good time to pocket at least partial gains from your biggest winners; overvalued large-cap tech stocks are good candidates.

Elevate the cash level in your portfolio to at least 15%. And increase your exposure to small caps, which are poised for big gains. With a trillion-dollar holiday spending season ahead of us, many small companies aren’t ready to rest.

Questions or comments? Drop me a line:

John Persinos is the managing editor of Investing Daily.