The small cap sector is the most impacted by rising rates. The spike in yield on the 10-year to 3.22% last week struck fear into the heart of every small cap investor. While a 3.2% rate today is not the end of the world for small cap companies it could be the first step in a long journey over 3%. Small caps are at risk because they borrow more money and have less capital available to make the higher payments. Fortune 500 companies have large cash balances and can borrow money from the public market using debt sales and secondary offerings. Small cap companies normally use bank lines of credit, which float with the interest based on the Fed funds rate, Libor or treasury rates. That means they can borrow at a 2% index rate, which means 5% in real interest to them and after a series of rate hikes they could be paying it back at a 9% rate. These numbers are just for example purposes.

The impact of higher rates on small cap stocks can easily be seen by comparing the different Russell indexes. The first chart is the Russell 2000 where the index is down -7% from the August highs and declined more than 3% last week alone.

The Russell 1000 index of the 1,000 largest U.S. stocks declined only slightly last week and remains well above the 200-day average. These big cap stocks are not materially impacted by interest rates at lease in the short term.

Similar to the Russell 2000 the S&P-600 also pulled back to critical support. The difference in the indexes is that the Russell 2000 is the smallest 2,000 stocks in the Russell 3000 universe. There is minimal exclusion and stocks are ranked simply by market cap. In the S&P-600, it is a curated list where specific stocks are selected to be in the index. Therefore, it should perform better than the Russell 2000.

The S&P-400 Midcap Index is also showning a similar pattern to the Russell 2000 only from a higher level. The R2K is at a 6-month low while the S&P-400 is only at a 2-month low. The S&P-400 has a heavy tech component and that is adding to the weakness.

While the small caps may be a weak sector the S&P A/D line is being dragged lower by the decline in the numerous large cap techs in the index. Big cap stocks may be somewhat immune to interest rates but those indexes are not immune to the serious decline in tech stocks. All 20 of the Nasdaq big cap tech stocks are in the S&P-500. The decline in the A/D only brought it back to the uptrend line from May.

The S&P chart is an accurate representation of the market. The 2.5% decline was right to support and the index rebounded slightly into Friday's close. There is no major threat of a breakdown with secondary support at 2,850. It would take a major bout of selling to reverse course on the S&P

Facebook is a major drag on the FANG stocks with a new 5-month low. Until these stocks begin to move together again the Nasdaq is going to remain weak.

The difference between the big caps and small caps is easily visible in the comparison chart of the Dow to the Russell 2000. The Russell is diving at a high rate of speed from the new highs on the Dow.

The chip sector crashed on Thursday after the news broke about the Super Micro cyber chip problem. This decline in the chip sector weighed heavily on the Nasdaq.

The AAII Sentiment Survey saw a dramatic surge in bullish sentiment. However, this survey ends on Wednesday and it was Thursday and Friday with the biggest declines. This is an example of sentiment fllowing the market rather than leading the market.

I believe this dip will be bought. It may not happen on Monday because the bond market is closed and there will be no rate information. This should produce a low volume day for equities. As long we rates do not shoot up again on Tuesday, we could see equities perk up.

Enter passively and exit aggressively!

Jim Brown

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