The large cap S&P 500 Index (SPX) has soared to new record highs in June, but small caps and transportation stocks are sinking to their lowest valuations relative to the S&P 500 since 2009, Bloomberg reports. Some analysts believe that their woes, along with declining bond yields, are clear signals of a deteriorating economic outlook that eventually will push the large caps lower as well.

“You normally think of small caps as that’s where the dynamic growth of the economy is coming from,” as Peter Jankovskis, co-chief investment officer (CIO) at Oakbrook Investments, told Bloomberg. “So to see the overall market doing well while they’re being left behind, it suggests that people are a little bit concerned about growth prospects,” he added. Meanwhile, shipping and transport stocks have been hurt by declining indicators of manufacturing output and consumer confidence, as well as the escalating U.S.-China trade war.

Significance for Investors

Among the bellwethers within the Dow Jones Transportation Average (DJTA) is FedEx Corp. (FDX). EPS for the fourth quarter of its fiscal year 2019, which ended on May 31, beat the consensus estimate by 4.2% but fell by 15.2% year-over-year (YOY), per Zacks Equity Research. The company's guidance anticipates continued weakness in global trade and industrial production during fiscal year 2020, sending earnings down by roughy 5%, the report adds. On June 27, FedEx closed 37.0% below its 52-week high and 18.1% below its recent high on April 18.

The small cap Russell 2000 Index (RUT) closed 11.2% below its own 52-week high. Its value relative to the S&P 500 is the lowest since 2016, and is approaching an even lower relative valuation set in 2009, Bloomberg notes. Weakness among the small caps historically has preceded broader stock market declines, the report adds. In 2018, the Russell 2000 peaked versus the S&P 500 in June, ahead of the sharp fourth quarter correction among the large caps.

Mike Wilson, the chief U.S. equity strategist and chief investment officer (CIO) at Morgan Stanley, has been persistently bearish for roughly a year or so. If economic data remains weak, he warns that the stage may be set for a 10% correction in the third quarter, per Bloomberg.

JPMorgan, meanwhile, has issued its own warning about the prospects for a big selloff in stocks. "If central banks fail to validate over the coming months market expectations of universal rate cuts, equities could be hit not only by a potential selloff in bonds that would mechanically make investors more overweight in equities, but also by a potential increase in cash allocations as investors cover their currently extreme cash underweight," they say in a recent to note to clients, as quoted by Business Insider.

In other words, JPMorgan's prediction rests on the premise that, should bond prices tumble if the Fed does not cut rates as anticipated, investors will try to maintain their target portfolio allocations by selling stocks and moving the proceeds into bonds and cash. Whether this premise is accurate remains to be seen.

Looking Ahead

“A combined slump in house prices and housing investment in the major economies could cut world growth to a 10-year low of 2.2% by 2020--and to below 2% if it also triggered a tightening in global credit conditions.” according to a report from Oxford Economics, as quoted by MarketWatch. Their proprietary index of the worldwide housing market shows declining home prices and investments in houses.