Why investors should be wary of New Year’s ‘head fakes’ for this hot asset class

This week will bring the minutes of the Federal Reserve’s last meeting and important December jobs data.

“Data that comes in too hot will kill the idea of rate cuts starting as soon as March, and data that comes in too cold will kill the idea of a soft landing. It means Goldilocks must return from her Christmas trip to Aruba and appear this week,” says Michael Kramer, founder of Mott Capital Management.

Read: A stock investor’s guide to the first trading days of 2024

On to our call of the day from MacroTourist blogger Kevin Muir, who sees a rally in small-cap stocks as one big theme for the coming year, though investors should beware of getting in too soon.

In a post, Muir draws on a 2021 observation from Raoul Pal, co-founder and CEO of the Real Vision financial-media platform, who posted on Twitter (now X) about the perils of piling into “head fakes,” or new ideas, in January.

Pal noted how hedge funds and asset managers start the new year with a clean investment slate, but two weeks later often start moving into so-called consensus Wall Street year-ahead trades. And once the rest of the investment world gets in, the trend reverses or corrects, and those managers get back to flat or have to start over.

Muir says that given the Fed’s pivot away from monetary tightening at the end of 2023, small-caps will end up as stock leaders this year. A bull on that asset class, he flagged his readers to buy in early November and December.

After a tough year, the Russell 2000
RUT
rallied late in 2023 as it became clearer that Federal Reserve interest-rate increases, which were particularly hard on smaller companies, were coming to a close.

As per this Russell 2000 chart, Muir says he did get the timing right on that bullish call:

However, Muir says he’s concerned that the rally was mainly from “hedge fund covering” and not a solid signal that the bear market for those stocks has ended.

One reason, he notes, was that the stocks blasting higher at the end of 2023 were the most heavily shorted. He offers Goldman Sachs’s most-short index chart here:

The chart is evidence of how hedge funds got caught out when the Fed surprisingly guided toward interest-rate cuts at its December meeting. Within a few hours of the Fed announcement, the most-short index had rallied 15%. But along with that, the ARK Innovation ETF
ARKK
also shot higher, a red flag for Muir.

That short index is tightly correlated to ARKK and the Russell 2000 small-cap index, he said.

So says it’s possible the small-cap push was “just a hedge-fund short-covering rally that will sag back down now that the buying has flamed out,” he said. And based on Raoul Pal’s theory, it makes sense that hedge funds and other investors may be piling into the asset class.

Muir says he stands by his view that small-caps are cheap and deserving of gains. “However, if this small-cap rally is for real, then it can’t be led by crap. We can’t have the [Goldman Sachs] rolling most-short leading the charge. We need quality small-cap stocks to rally,” he says.

So the correlation between broader small-cap indexes and the most-short index (also tightly correlated with ARKK) will have to break down.

“As a proxy for this index, and a hedge against my small-cap long position, I am shorting ARKK. So far, the short covering drove all these smaller capitalized stocks higher, but my bet is that an actual small-cap bull market will see much better differentiation, and that new small-cap leadership will emerge (and it won’t be ARKK),” he says.

The markets

The Nasdaq
COMP
is leading the way lower for U.S. stocks
SPX

DJIA
as trading kicks off, with Treasury yields
BX:TMUBMUSD10Y

BX:TMUBMUSD02Y
climbing. Gold
GC00,
-0.92%
is also higher, though oil
CL.1,
+0.88%
has pared gains, sparked by worries after Iran sent warships to the Red Sea. The Hang Seng
HK:HSI
fell 1.5% after weak China factory activity.

The buzz

U.S. nonfarm-payroll data for December is due Friday, with the Institute for Supply Management’s manufacturing report and minutes of the Dec. 12-13 Fed meeting both due on Wednesday. Construction spending is due at 10 a.m. Eastern time on Tuesday.

Read: Health of U.S. labor market looms large on markets’ radar this coming week

Apple’s stock
AAPL,
-3.58%
is down 2% after Barclays analysts cut the iPhone maker to underweight from equal weight on signs of weak iPhone 15 and other hardware sales.

Voyager Therapeutics’ stock
VYGR,
+6.64%
is up 32% after the biotech announced a licensing deal with Novartis unit Novartis Pharma
NOVN,
+3.68%.

Joyy
YY,
-14.66%
is off 11% after Baidu
BIDU,
-3.15%
cancelled a $3.6 billion offer for the Singapore-based live-streaming platform.

Bitcoin
BTCUSD,
-5.26%
is at $45,447, a high not seen since April 2022, on ETF approval hopes.

Tesla
TSLA,
-0.02%
said it delivered 484,507 EVs in the fourth quarter, producing 494,989. Deliveries grew 83% to 1.81 million for 2023 as a whole. Tesla shares are slipping. Meanwhile, China’s BYD
002594,
+0.30%
sold 3.02 million electric vehicles in 2023, eclipsing Tesla for a second straight year.

Japan’s western coast was hit by several heavy earthquakes on New Year’s Day, leaving at least 30 people dead. Additional quakes could occur. A collision between a Japan coast guard plane and a Japan Airlines flight that caught fire on the runway on Tuesday resulted in the deaths of five people.

Best of the web

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The chart

More on small-cap caution from Chris Kimble at See It Market. He points out that investors may be getting greedy as some big resistance levels approach for the Russell 2000:

Top tickers

These were the top-searched tickers on MarketWatch as of 6 a.m.:

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