Small Caps Strong Despite Trade Threats

Major Moves 

The futures market was signaling a very rough start to the week on Sunday night. At one point, the S&P 500 futures were down more than 2% before the open on Monday. Luckily, they have retraced many of those losses as investors bought small caps, health care and energy stocks off the lows.

The volatility resulted from a tweet President Trump sent to his followers threatening that tariffs paid by U.S. importers on $200 billion of Chinese goods would be raised from 10% to 25%. President Trump further added that other products currently not taxed would have tariffs applied if progress in current trade talks continued to progress too slowly. Bloomberg is reporting that Trump's Twitter outbursts were likely a response to attempts by Chinese trade negotiators to slow down or carve back some sought-after trade concessions from the US.

Although it was not as bad as the Sunday night futures indicated, the S&P 500 opened near 2,900. That's 1% off its Friday close. Most market indexes had recovered significantly by the close, but the effects of Trump's tweets weren't limited to stock prices alone.

Bond prices rallied on the news and were slower to give up their gains than stocks were to recover losses. Investors often buy bonds as a store-of-value when they are uncertain. As you can see in the following chart of the iShares 20+ Year Treasury Bond ETF (TLT), today's rally was a continuation of previous gains over the last few weeks. If bond buying continues, it could lead to a more significant decline in stocks in the short term.

S&P 500

The S&P 500 is bumping up against the resistance level of its prior long-term high, which helps explain the outsized reaction in the market to Trump's tweets. Investors tend to anchor to prior highs and lows that create levels of support or resistance.

The strength in bonds is a much bigger concern than a pause in the S&P 500. Consolidating at resistance is normal, and the subsequent rally this afternoon was a good sign that buyers are still in control. From a technical perspective, the S&P 500 was not able to break the bottom trendline of its recent rising wedge pattern that continues to act as support.

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Risk Indicators – Russell 2000 Looks Even Better

Although today's volatility is cause for concern, I also see evidence that bullish momentum is building in a critical investment category: small-cap stocks.

The Russell 2000 small-cap index had broken out of its long-term inverse head and shoulders pattern on Friday. At first, I was concerned that volatility would drop prices back below the neckline and we would see a longer consolidation. However, small-cap stocks have been the best performing category in the market today, which is usually seen as a positive signal for risk-taking. As you can see in the following chart, the Russell 2000 opened low with the rest of the market but closed above Friday's high.

If there are more disruptive tweets from the president, the market may still be prone to a reversal; however, small caps might outperform in the short term anyway. Large-cap stocks tend to have the most exposure to the drag created by government intervention and protectionist strategies like tariffs. Small caps are disproportionately focused on domestic business only and have less risk if U.S.-China trade talks continue to struggle.

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Bottom Line – Tariffs Could Still Spoil Rally

The flow of earnings reports continue this week but will soon begin to taper off. With more than 80% of the stocks within the S&P 500 reported already, it's unlikely that we will get any data that changes the average estimate for this round.

This is also going to be a relatively quiet week for scheduled economic reports. The Producer Price Index (PPI) and Consumer Price Index (CPI) for the U.S. will be reported on Thursday and Friday, respectively, and may change the outlook for interest rates slightly if they are surprisingly high. In the short term, the potential for unexpected trade news is the most significant X-factor that could spoil an otherwise positive market.

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