Small caps sink to three-year lows; collapse 12% for week

Kevin Pendley | Oct 03, 2008 4:26pm EDT | Comment

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Small-cap stocks pushed lower Friday, as optimism over government approval for a massive bailout of financial bad debt gave way to somber economic data on the employment picture. It was a strange session from a market movement standpoint, but in the end the Russell 2000 (NYSE:IWM) stumbled 18.27, or 2.87%, to 619.40, the lowest weekly close since May 2005. Even more startling is that the Russell 2000 collapsed 12.1% this week, clearly one of the largest one-week debacles in history. For the year, the Russell is down 19.2%, while the Dow is off 22.1% and the S&P 500 is down 25.1%.

In some ways, it was an unusual session as the market initially shrugged off the negative employment report, instead rejoicing about a large banking merger deal between Wells Fargo (NYSE:WFC) and Wachovia (NYSE:WB). In addition, stock traders appeared to be basking in the glow that the House would certainly OK the rescue plan this time around. Earlier this week, House Republicans shocked the market by narrowly rejecting the $700 billion “Paulson Plan” but with the economy careening toward recession and a couple of tax break sweeteners added to the deal, there was little choice in an election year from lawmakers but to embrace (perhaps with gritted teeth) the rescue plan.

In typical “buy-the-rumor, sell-the-fact” market action, equities rallied into the House vote, then promptly reversed course and sold off in the afternoon. There was some sense that if the market weren’t so oversold and if talk wasn’t circulating that a potential emergency rate cut by the Federal Reserve might be in the works that the slide would have been even greater.

As for the employment report, 159,000 non-farm jobs were shed in September, the largest one-month decline in some five years, while the unemployment rate held steady at 6.1%. The market was looking for a loss of 100,000 jobs, so the number was worse than feared, but there were “whisper” numbers ahead of the release that were even worse. The bad news is that most economists are predicting the next two months will be even more painful as the economy deals with the credit crisis and the recent loss of huge financial firms. So, from a price standpoint today, the market:

• Rallied after a bearish employment report
• Sold off after good news on the House vote for the rescue plan

“I think the House passage was generally expected and the jobs report was bearish, but not a great surprise and at least the unemployment rate didn’t tick higher. After all, the ISM and claims numbers earlier this week had already pointed to poor economic conditions,” Nick Kalivas, vice president of financial research with MF Global, said in an email interview with SmallCapInvestor.com.

After being the best place to park money all year, small caps started to under perform relative to their large-cap brethren this week, a trend that was noticeable on both up and down days.

“I think small caps are being hurt by adverse credit conditions and liquidation. Market chatter has highlighted that the hedge fund and leveraged community has been under stress,” Kalivas said. “Some have assets frozen at a recently bankrupted prime broker and others are being hit with redemptions. From a business standpoint, the cost of credit has risen sharply and that is bad for small businesses which have less flexibility in their balance sheets,” he said.

Kalivas also noted that commodity and transport stocks were hammered this week, and small-cap indices have shown a close correlation recently to weakness in commodity markets and any slow growth worries. In the S&P 600, aluminum, railroad, chemical companies were the worst performers this week, while agriculture products and oil and gas exploration shares were also sold off aggressively.

From an overall market standpoint, Kalivas said that General Electric’s (NYSE:GE) stock issuance and a decision by Ford Motor Co. (NYSE:F) to sell equity to pay down debt are adding weight to the market from a supply standpoint. “GE’s issuance was large and is sucking up the risk capital that is willing to go work” right now in a difficult and tight environment, Kalivas said. He also noted that there was a surge in the money supply over the last week, which indicates a high degree of panic. “M2 was up about $165 billion. Historically, this type of fear has been consistent with a market bottom. However, this current crisis has a different feel than 1998 or 1987,” he said.

Looking ahead to next week’s action, the market won’t see very many big economic indicators and the biggest event on the calendar will likely be a Tuesday speech by Federal Reserve Chairman Ben Bernanke in which he is expected to address the economic outlook. Also, the FOMC minutes will be released Tuesday afternoon, which could stir things up a tad. Kalivas said the market will be watching to see if credit shows signs of loosening up, money market rates easing, and the potential for some kind of Fed surprise rate cut (perhaps coordinated with the Bank of England’s meeting Thursday?). In addition, he said that earnings from Costco (Nasdaq:COST), Infosys (Nasdaq:INFY), Monsanto (NYSE:MON) and Alcoa (NYSE:AA) could get broad market attention.

From a charting standpoint, the Russell looks awful. We are now back in official bear market territory (and then some). There was a violent rejection of the bullish reversal from two weeks ago, and the market closed at three-year lows in the bottom portion of the range. Today’s high matched up almost perfectly with resistance projected in the 650-660 range (which was a previous support zone). Persistent action below 660 in the next couple of weeks will suggest that a new lower range is in play, and will open up new downside targets. Key support next week is at 614, which marked the lows from October 2005. Even though the market is oversold on most momentum readings, there is still room to press lower and when a market hits an extreme the move will often cruise right through typical corrective valuations. Spreads against the Dow and S&P 500 tightened dramatically this week, which is consistent with bearish behavior. If trends from the past six years mean anything this time around, then the market is in a healthier position when small caps outperform large caps.