Small Caps Start to Flex Even as Credit-Market Worries Appear
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Our Views
- The S&P 500 is up +1.70% so far this week and down -0.4% for the month – not bad. But the level of “apprehension” for equities has risen as the VIX climbed as high as 28 on Friday, the highest levels since the tariff days of April to May 2025. So markets are worried.
- The driver for this concern appears to be “cracks” in U.S. credit quality emerging in the past week, including the collapses of Tricolor and First Brands, as well as large losses in distressed commercial mortgages reported by Zions and Western Alliance. Equity markets appear to be taking JPMorgan CEO, Jamie Dimon, seriously when he says “there is never just one cockroach.”
- I can understand the “fire, ready, aim” reaction. That said, high-yield markets are only showing “mild concern” as HY OaS (options-adjusted spread) sit at 352bp wider, which is up from August lows but not anywhere close to the 2025 tariff-highs at 500bp-plus. This gives me some comfort that fundamentals are not deteriorating in an adverse way.
- We think the risk/reward in stocks remains positive, with the likelihood that the S&P 500 could climb as much as 5% in the fourth quarter.
- Near-term trends are bullish for SPX, and I anticipate a sharp rally to finish the month of October after an interesting period of sector rotation in recent weeks. Industrials, consumer discretionary, and small-cap stocks have begun to show notable strength this week, while financials look close to also turning higher.
- IWM has just successfully broken out above SPY, going back since 2021, which bodes well for continued near-term outperformance by small-caps.
- Regarding SPX, until trends turn down, I’m skeptical that “tariff talk” or a government shutdown will do much to derail this rally. In the short run, the rebound favors market bulls, and I suspect that a rally back to new highs is probable.
- Bottom line, Treasuries, equities, and cryptocurrencies still have a good likelihood of pushing higher into late October, while the U.S. dollar is likely to pull back sharply into November before bottoming.
- With leverage flushed, the risk of further cascades is arguably reduced. Although this does not guarantee an immediate uptrend, as markets often retest lows after major downside liquidation events, it does establish a psychological floor in the near-to-medium term.
- I remain overweight ETH and SOL relative to BTC. Tactically, my view is to suggest taking some profit on miners after large gains and adding modestly to MSTR given its discount to historical NAV multiples and potential S&P 500 inclusion catalyst.
- Credit concerns are rising, with high-yield and private credit names continuing to roll over. To me, this is a reflection of growing investor caution around potential defaults in both public and private markets. However, I view the credit and funding risks as acute, not structural: These pressures are likely temporary, as the “volatility controllers,” namely the Fed and Treasury, have the tools and incentive to intervene if credit or liquidity conditions deteriorate further.
- Today, Ukrainian President Zelensky is at the White House. Yesterday, the administration announced that Putin and Trump had talked and agreed that their teams would meet next week, and that a date would be set for the two presidents to meet in Budapest at a date to be determined by the two negotiating teams.
- Watch for headlines in the coming weeks as diplomats from China and the U.S. talk about the upcoming meeting of the Asia-Pacific Economic Cooperation (APEC) scheduled for the end of the month in South Korea.
- Leaders of both countries are scheduled to attend, and it would provide an obvious opportunity for Trump and Xi to talk about the trade issues that have emerged as part of Trump’s tariff policy.
Wall Street Debrief — Weekly Roundup
Key Takeaways
- The S&P 500 closed the week at 6,664.00, rising 1.70%. The Nasdaq rose 2.17% to 22,679.97, while Bitcoin was at $106,591.20 on Friday, down about 7.4% from Monday levels.
- Fundstrat Head of Research Tom Lee views nervous investor sentiment as a positive for the market, as it suggests the lack of ebullience even as we begin the traditionally strong fourth quarter of the year.
- Head of Technical Strategy Mark Newton is also constructive, noting in particular the recent strength of small-cap stocks.
"For the person for whom small things do not exist, the great is not great." – Jose Ortega y Gasset
Good evening,
Trade tensions between the U.S. and China, which intensified last Friday, continued to occupy investors' attention this week. The previous week had seen sentiment, as measured by the American Association of Individual Investors (AAII) weekly survey, make a tentative foray into net bullish territory, but the latest trade tensions sent sentiment reverting back to net bearish this week.
Volatility, which spiked after President Trump's truculent response to China's intensified rare-earth export restrictions, continued to rise this week as China reacted in turn. As our Chart of the Week shows, VIX is now at its highest level since President Trump launched his tariff broadside in April and May – though still significantly lower than its springtime peak.
Fundstrat Head of Technology Tom Lee and Head of Technical Strategy Mark Newton agree that these are good for stock investors. "I view this as contrarian positive," Lee wrote, pointing out that "if conviction wavers easily, that is a sign that sentiment is not ebullient."
The trade-related uncertainty was not entirely to blame for what Newton described as the "rather skittish" sentiment. Worries about the health of the U.S. credit market also played a role, as the market weighed the implications of events like the collapses of First Brands and Tricolor. The concerns were perhaps best – and evocatively – epitomized by JPMorgan CEO Jamie Dimon: as his firm disclosed a $170 million loss from the Tricolor implosion, he observed metaphorically that "there is never just one cockroach."
Is he correct to suspect that these are not just isolated events? Credit spreads widened slightly this week, suggesting that credit markets are at least considering the possibility. However, the arguably muted reaction thus far provides "some comfort" to Lee, suggesting that fundamentals are not yet eroding in a meaningful way.
Further supporting Lee's bullish view for the final quarter of the year is the underperformance of active fund managers during the first three quarters of the year, with only 22% of them beating their benchmarks, according to data compiled by Jefferies. This represents some of the worst performance by this group in decades.
That's arguably constructive to Lee. Why? Because that means "there's pressure for funds to outperform into year end," and for underperforming managers to do that, they will likely need to move cash off the sidelines and put it to work.
Small Caps
As followers of our work know, Lee has long been overweight small caps, seeing the sector as both undervalued and especially well-positioned to benefit from a Fed rate-cut cycle that now looks to have begun. Fed Chair Jerome Powell on Tuesday made remarks supportive of that thesis, reiterating the message that inflation remained largely under control while "downside risks to employment" had risen. It was the last "Fedspeak" we will hear before the Oct. 29 meeting of the Federal Open Market Committee.
As Mark Newton observed at our weekly huddle this week, "small caps officially have broken out," pushing through to new all-time highs on Wednesday before settling back slightly on Friday. As a sector, small caps (IWM 0.63% ) had a good week on an absolute basis, advancing 2.38% to close on Friday at 243.45.
Yet as Newton observed, the sector's relative performance has been impressive as well. "It's really been starting to accelerate in the last few months," he noted. While small-caps have outperformed equal-weighted S&P 500 (RSP 0.86% ) for the last six months, "what many people haven't realized is that when you look at the larger ratios of IWM versus SPY, we've now broken out of the entire four-year downtrend since 2021." On a month-to-date basis, small caps are now also outperforming both the S&P 500 and the Mag Seven.
To be sure, some of that outperformance has resulted from recent underperformance of Mag Seven stocks like Meta, Microsoft, and even Nvidia. Nevertheless, Newton views this week's small-cap action as intermediate-term bullish. "I think this persists into the year-end," he said. Aligning with Lee's outlook on the sector, Newton said: "It's right to be long small caps. It's right to overweight small caps versus large caps."
Elsewhere
The Netherlands took the "highly exceptional" step of taking control of Nexperia, a Dutch but Chinese-owned chip company, citing national security concerns and unspecified "serious governance shortcomings." Though Nexperia does not make advanced state-of-the-art chips, its knowledge of manufacturing efficiency and quality control nevertheless have value. Some news sources report that the Dutch government acted after being pressured by U.S. officials who threatened to otherwise place limitations on the company's access to or use of U.S.-originated technology. Nexperia has since warned its automaker customers that it would halt shipments of its parts, declaring a “force majeure” event.
The Pentagon embarked on a $1 billion initiative to stockpile critical and rare-earth materials even as China initiated intensified export controls on them. Such metals and minerals are vital for the manufacture of key military applications like fighter jets, submarines, precision missiles, radar, and missile detection systems.
The Supreme Court considered a conservative-led request to further gut the Voting Rights Act of 1965, which had been put in place to prevent the disenfranchisement of black voters. The plaintiffs argue that those protections are no longer necessary. If the Supreme Court agrees, the likely result will be the redrawing of Congressional electoral maps in southern states to eliminate black-majority districts currently represented in the House by Democrats.
Generation Z is flexing its political power around the world, toppling the government of Madagascar's Andry Rajoelina this week after Zoomers in Nepal forced Prime Minister K.P. Sharma Oli to resign last month. In the past year, protests by Gen Z have rocked governments in Indonesia, Kenya, Botswana, South Africa, Peru, the Philippines, Bangladesh and Morocco, often turning violent and resulting in multiple casualties and widespread injuries. While each of these protests – in many cases ongoing as of this writing – are largely unrelated, they have drawn inspiration from each other on social media, sharing a common theme of generational frustration with systemic corruption and widespread poverty.
Former national security adviser John Bolton was indicted for allegedly mishandling classified information. Bolton pleaded not guilty to the charges, which involve e-mails to relatives sent from a personal account that was later hacked. Like former FBI Director James Comey, Bolton became an outspoken critic of the president after working in the first Trump administration. While many believe the Trump-ordered charges against Comey and against New York Attorney General Leticia James are more about retribution than law or public interest, career prosecutors believe the case against Bolton has more substance. Meanwhile, Trump has ordered investigations into others against whom he holds a grudge, including former CIA Director John Brennan and former FBI Director Christopher Wray.
And finally: Is OpenAI becoming an adult? We mean this in a prurient sense: In a major policy shift, OpenAI CEO Sam Altman announced that ChatGPT users would soon — if they so chose — be able to use the generative AI to incorporate "erotica," though he did not provide details about what that might entail. Altman said the policy shift reflects the company's "treat adult users like adults" principle, as well as OpenAI's new capabilities to incorporate parental controls and safety features for those with mental-health issues.
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