Why tech and small cap stocks are on fire while the Dow is all wet: trader

Peter Kenny
Peter Kenny

By Peter Kenny, founder of Strategic Board Solutions and owner of KennysCommentary.com

This week’s economic calendar focuses on housing. On Monday, the Housing Market Index reading for June came in at 68, a bit weaker than Wall Street expectations for 78. On Tuesday, Housing Starts totals for May will be released. Econoday consensus is calling for Starts – Level – SAAR of 1.320M, up from April’s 1,278 M. On Wednesday, MBA Mortgage Applications and Existing Home Sales are set for release. In the case of the latter, Econoday consensus is calling for a modest reset in May to 5.520M from April’s robust reading of 5.460M. On Thursday the FHFA house price data is released. Though this reading draws from a very broad database, it does reflect what we all know. Housing prices are on a tear. Econoday consensus is calling for April’s reading to be 0.4% versus the prior month’s relatively tame 0.1%. April’s year-over-year reading was a solid 6.7%. Otherwise, the calendar is light. Investors will focus on Weekly Jobless Claims, Leading Indicators, the EIA Petroleum Status Report, and on Friday, the PMI Composite Flash reading. In the case of the PMI Flash, even if the reading is hotter than consensus, I doubt it will have a meaningful impact on interest rates given Chairman Jerome Powell’s speech last week, one in which he made it clear that rates were likely to move higher in lock-step with quarterly FOMC meetings— at least for the next 12 months.

The solid economic data and strong corporate results that investors have been treated to thus far in 2018 have been most clearly reflected in both the Nasdaq Composite (^IXIC) and the Russell 2000 (^RUT) YTD performances. Both indices are trading either at or fractionally off their record high closes. That “risk-on” appetite reflected in the charts below speaks to investor confidence.

Source: Yahoo Finance

On the other hand, less growth-centric equity indices have languished in comparison. The Dow Industrials (^DJI) chart clearly reflects underperformance relative to both the Nasdaq Composite and Russell 2000. The Dow put in its historic top of 26,616 on January 26 in a post-Trump Tax cut trade. The S&P 500 did the same — recording a record high close of 2872 on January 26. Since those record high index closes, composite companies on both indices have largely beat expectations by a rate of roughly 70% while providing constructive forward-looking guidance. It begs the question: Why?

Source: Yahoo Finance

Friday’s trade was in some respects emblematic of what has hampered both the S&P 500 and Dow Industrials. Both indices have suffered under the weight of trade fears. Both indices have significant exposure to international trade, particularly in the technology, manufacturing, and financial services verticals of the economy. Additionally, with clear signs of trade friction between the world’s two largest economies and evidence of fraying intra-national political tensions in Europe, investor caution has gradually emerged over the past several months — effectively acting as a wet blanket for the Dow and S&P. With Q1 earnings season on the wane, equity markets are susceptible, particularly those indices that have exposure to a heightened degree of perceived risk as a result of trade friction and geopolitical uncertainty.

An additional headwind for large-cap equities comes in the form of higher borrowing costs. As has been covered exhaustively, the FOMC raised rates by 25 bps last week as expected. However, it was the clarity with which the Fed projected additional tightening that triggered a degree of investor pause. That said, the widely watched 10-year (^TNX) yield closed out last week sub -3%, at 2.92%. In mid-May, I projected a floor of 3% for the 10-year. Clearly, I was off base. Between the headwinds outlined above and the ensuing caution that has enveloped investor perception in recent weeks, risk aversion and yield compression has been the real story, even in the face of Fed policy that projects as many as four moves over the next 12 months.

In a noteworthy shift in trend since May, 21, crude oil prices have reversed lower on sharply elevated volume. The widely held suspicion is that this week’s OPEC meeting will usher in a modest loosening of production limits. If that in fact does materialize, any follow through lower in prices this week, from Friday’s close, will have to do with the specifics of the announcement.