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Bank of America considers small-cap stocks a key indicator of the broader stock market.
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High concentration in a handful of stocks and high valuations limit the stock market’s upside potential, BofA said.
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Small-cap stocks are facing challenges due to high interest rates, hitting profitable companies.
Bank of America said in a note Friday that a key component of the stock market will help determine whether the bull rally will continue.
Michael Hartnett, 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, the upward trend is limited by high concentration in a handful of stocks, high valuations and an extended positioning by investors.
Hartnett highlighted that the bank’s fund manager survey in December showed investors have a record overweight in US equities.
The key signal for a sustained rally, according to Hartnett, is whether small-cap stocks can rise above a key resistance level set in 2021.
Small-cap stocks briefly broke above the resistance level after Donald Trump’s election victory in November, but have since given up most of those gains and are trading around the resistance level as investors worry about interest rates stay higher for longer.
Higher interest rates are especially painful for small-cap stocks because they are more sensitive to changes in borrowing costs. About 40% of the companies in the small-cap Russell 2000 index are profitable, This means that debt financing often plays an integral role in financing their operations.
If the cost of debt increases and remains higher when a company with little to no profit needs to refinance debt, it could ultimately lead to insolvency.
According to Hartnett, all systems work if small-cap stocks can decisively break above their 2021 resistance level. However, if this is not the case, it could indicate broader market weakness and he would expect asset allocators to reduce their overweight positions in the stock market.
Hartnett recommends investors buy bonds where Treasury yields may peak near the 5% level, and interest-rate-sensitive stocks common in the financial, utility and homebuilding sectors.
Read the original article Business insider