3 Small Caps to Buy in the Fourth Quarter

The Russell 2000 small-cap index is set to end the third quarter with a small loss, after gaining just one point in the second quarter, held back by currency headwinds that favor multi-nationals over domestically oriented issues. Even the trade war has failed to put a bid under the group, due to expectations that crashing bond yields will signal an economic slowdown that affects small caps more aggressively than their big-cap cousins.

A handful of small caps look poised to head higher in the fourth quarter despite these barriers, rewarding patient buyers with opportune profits in a tough market environment. It's hard to pin down the strongest sectors on this winners' list because they're scattered among diverse groups that include software, retail, and business services. In addition, many of these rallies mark healthy turnarounds after multi-year declines, rather than upstarts exploding to new highs. 

Chart showing the share price performance of Enphase Energy, Inc. (ENPH)

California-based solar cell maker Enphase Energy, Inc. (ENPH) is set to benefit from a law that requires all new home construction in the Golden State to include solar power starting in 2020. The stock posted a new high at $17.40 in 2014 and entered a persistent downtrend, dropping to an all-time low at 65 cents in May 2017. It lifted to a three-year high in July and eased into a sideways pattern, breaking out in February 2019.

The rally reached the 2007 high in June and broke out, posting a string of all-time highs into the August peak at $35.42. It has been pulling back since that time, filling the Aug. 1 gap and testing an early September 50-day exponential moving average (EMA) breakdown. Given this price structure, the stock could now drop into the narrow alignment between the 200-day EMA and breakout level, offering a potential buying opportunity ahead of next year's mandate.

Chart showing the share price performance of Sonic Automotive, Inc. (SAH)

Shares of dealership chain Sonic Automotive, Inc. (SAH) topped out at $33.10 in 2007 after a multi-year uptrend and sank to 72 cents during the economic collapse. The subsequent bounce slowed down after reaching the mid-teens in the summer of 2009, yielding a shallow uptick that stalled in the mid-$20s in 2014. That level marked resistance into an August 2019 rally wave that has finally completed the round trip into the 12-year high.

The uptrend can set its sights on 2001's all-time high at $39.75 after a breakout, but that buying impulse may need to wait because the stock has gone straight up since May and is in need of a consolidation to shake out weak hands. That could be accomplished with a decline into the 50-day EMA, which has contained multiple pullbacks since April. The moving average is currently rising from $27.50, so a relatively shallow downdraft might do the trick.

Chart showing the share price performance of Hallmark Financial Services, Inc. (HALL)

Property-casualty insurer Hallmark Financial Services, Inc. (HALL) posted a 16-year high at $17.62 in 2007 and sold off into single digits during the 2008 economic collapse. A bounce into 2010 stalled at $11.98, marking resistance into two failed 2015 breakout attempts. The stock finally mounted that level in June 2019, generating steady accumulation that has posted gains in excess of 60% into late September.

The rally completed a round trip into the 2007 high in August and broke out, opening the door to additional upside that could reach 30-year highs in the $30s and $40s. Price action has been engaged in a narrow but persistent uptick since Aug. 19, with a pullback to the trendline at $18.75 offering a modest buying opportunity. However, continued downside into the 50-day EMA just above $17 could be more fruitful for risk-conscious dip buyers.

The Bottom Line

The Russell 2000 small-cap index lost money in the third quarter, but a handful of index components look set to book impressive fourth quarter returns.

Disclosure: The author held no positions in the aforementioned securities at the time of publication.

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