What Are Small Caps Telling Us About Risk?

By: Chris Ciovacco | Wed, Aug 29, 2012
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Small cap stocks appear to be confirming the bullish signals recently given by oil and precious metals. All three markets point to a central bank induced reflation theme driving asset prices higher. From a fundamental perspective, strength in small caps shows investors are willing to buy stocks of smaller, more volatile, and less established companies.

According to MarketWatch, the Fed may assist in pushing small caps higher:

Supporting momentum from small-cap stocks may come in the form of bank lending incentives from the Fed, according to Michael Jones, chief investment officer of RiverFront Investment Group. Such measures could be announced at the Federal Reserve's retreat in Jackson Hole, Wyo., later this week or at the September Federal Open Market Committee meeting.

The small cap ETF, IWM, has a potentially bullish chart pattern known as an "inverted head-and-shoulders". Stocks, commodities, silver, and gold would all like to see IWM close above 81.53, 81.71 and 81.97. Those levels represent possible resistance based on the pattern shown below.

IWM

Since the S&P 500 faces strong resistance between 1,403 and 1,415, we have to remain open to false breakouts. Therefore, even if the bullish set-ups outlined in the video below are followed by weakness in small caps, we will still gather useful information about the health of the current rally in stocks, commodities, and precious metals. Key bull/bear levels for the small cap ETF (IWM) are shown at the 00:16 mark of the video. We will monitor these levels in the days ahead to gain a better understanding of the current rally's sustainability.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

Eric Marshall, portfolio manager of the Hodges Small Cap Fund, told MarketWatch why he believes small caps offer more attractive valuations than their large-cap brethren:

"Stocks were mispriced because people were focused on Greek and Spanish bond yields and less focused on company fundamentals," Marshall said. "Those kinds of market inefficiencies get exaggerated in the small-cap space."

Another widely utilized pattern by traders is the "cup-with-handle" formation. The handle represents the last wave of selling (or doubt) before a market can move higher. It is possible to see two cup-and-handle formations on the chart of IWM below.

IWM

Our respect for the significant overhead resistance facing stocks was a driving force to book profits in the oil services ETF (OIH), a position we established back in late June. If small caps, precious metals, and foreign stocks can hold their breakouts, we will turn to our short list of buy candidates, which includes regional banks (KBE), small caps (IWM), and agricultural commodities (DBA).

To feel better about the bullish case, we would like to see the S&P 500 close above 1,415 on a weekly basis. Should conditions deteriorate further, we are happy to raise additional cash. With the Fed and ECB just around the corner, flexibility is more important than ever.

 


 

Chris Ciovacco

Author: Chris Ciovacco

Chris Ciovacco
Ciovacco Capital Management

Chris Ciovacco

Chris Ciovacco is the Chief Investment Officer for Ciovacco Capital Management, LLC. More on the web at www.ciovaccocapital.com.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors and tax advisors before making any investment decisions. Opinions expressed in these reports may change without prior notice. This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. The investments discussed or recommended in this report may be unsuitable for investors depending on their specific investment objectives and financial position. Past performance is not necessarily a guide to future performance. The price or value of the investments to which this report relates, either directly or indirectly, may fall or rise against the interest of investors. All prices and yields contained in this report are subject to change without notice. This information is based on hypothetical assumptions and is intended for illustrative purposes only. THERE ARE NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO ACCURACY, COMPLETENESS, OR RESULTS OBTAINED FROM ANY INFORMATION CONTAINED IN THIS ARTICLE.

Ciovacco Capital Management, LLC is an independent money management firm based in Atlanta, Georgia. CCM helps individual investors and businesses, large & small; achieve improved investment results via research and globally diversified investment portfolios. Since we are a fee-based firm, our only objective is to help you protect and grow your assets. Our long-term, theme-oriented, buy-and-hold approach allows for portfolio rebalancing from time to time to adjust to new opportunities or changing market conditions.

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