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Bank of America sees small-cap stocks as key indicator to watch for the broader stock market.
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High concentration in a handful of stocks and elevated valuations limit stock market upside, BofA said.
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Small-cap stocks face challenges from high interest rates, affecting profitless companies.
Bank of America said in a Friday note that one key area of the stock market will help determine whether the bull rally will continue.
Michael Hartnett, an investment strategist at the bank, said that while President-elect Donald Trump’s influence and policies could provide a safety net for the stock market, upside is constrained by high concentration in a handful of stocks, elevated valuations, and stretched positioning by investors.
Hartnett highlighted that the bank’s December fund manager survey showed investors are holding a record overweight position in US stocks.
The key signal for a continued rally, according to Hartnett, is whether small-cap stocks can rally above a key resistance level set in 2021.
Small-cap stocks briefly broke above the resistance level following Donald Trump’s election win in November, but they have since given up the bulk of those gains and are trading right around the resistance level as investors worry about interest rates staying higher for longer.
Higher interest rates are particularly painful for small-cap stocks because they are more sensitive to changes in borrowing costs. About 40% of companies in the small-cap Russell 2000 index are profitless, meaning debt financing often plays an integral role in funding their operations.
If the cost of debt moves higher and remains higher when a company with little to no profit has debt come due for refinancing, it could ultimately lead to insolvency.
According to Hartnett, all systems go if small-cap stocks can decisively break above their 2021 resistance level. However, if not, it could signal broader market weakness and he would expect asset allocators to trim their overweight positioning in the stock market.
Hartnett recommends investors buy bonds with Treasury yields potentially peaking near the 5% level and rate-sensitive stocks often found in the financial, utilities, and homebuilding sectors.
Read the original article on Business Insider
