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Bank of America sees small cap stocks as a key indicator to watch for the broader stock market.
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High concentration in a handful of stocks and high valuations are constraining the stock market in tandem, BofA said.
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Small cap stocks face challenges from high interest rates, which affect unprofitable companies.
Bank of America He said in a note on Friday that one key area of the stock market will help determine whether the bull rally continues.
Michael Hartnett, an investment strategist at the bank, said that while the influence and policies of President-elect Donald Trump could provide a safety net for the stock market, the downside is limited by high concentration in a handful of stocks, high valuations, and extended placement by investors.
Hartnett pointed out that the bank's fund manager survey in December showed investors holding an all-time overweight position in US stocks.
The key signal for a sustained 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 resistance following Donald Trump's election victory in November, but have since given up most of those gains and are trading around resistance as investors worry about it. interest rates remain higher for a longer period.
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 Russell 2000 index are small cap non-profit, which means that debt financing often plays an integral role in financing their operations.
If the cost of debt moves higher and remains higher when a company with little to no profit becomes due to be refinanced, it could eventually lead to insolvency.
According to Hartnett, it's all systems go if small-cap stocks can break decisively above the 2021 resistance level. However, if not, it could be a sign of broader market weakness and he would expect asset allocators to trim their positions overweight in the stock market.
Hartnett recommends that investors buy bonds with Treasury yields possibly 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