Traders Still Avoiding Small Caps

Tensions between the U.S. and Iran following the attacks on oil tankers in the Strait of Hormuz and the downing of a U.S. military drone last week has put traders on edge. Symptoms of this uncertainty have been a rise in safe-haven assets like the Swiss franc, Japanese yen, and U.S. Treasury bonds, in addition to a rise in oil prices.

President Trump has imposed further sanctions on Iran targeted specifically at the financial holdings of Iran’s supreme leader, Ayatollah Ali Khamenei, and eight other military leaders. However, because previous sanctions have been so broad, the marginal effect of further penalties seems unlikely to create enough pressure for the Iranian government to change its position on nuclear refinement. That said, additional measures may be enough to make both sides start talking more productively.

Geopolitical risks like this usually lead to an increase in oil prices as investors account for the potential of a disruption in global supply. However, investors should be very careful about assuming that the upward movement in energy prices will continue and not just drop back once a resolution has been reached.

Oil prices are also affected by the value of the dollar. If the dollar falls in value and everything else remains the same, the price of oil would rise because it requires more weaker dollars to buy a barrel of oil. The same is true in reverse when buying a barrel of oil costs fewer stronger dollars.

The effect of the dollar on oil prices can be put into perspective by comparing oil futures prices in dollars versus oil futures when priced in euros. For example, when priced in dollars, oil has risen over 12% since the close on June 12. However, when priced in euros, oil prices are up only 5%.

In my view, given that the bulk of the rally in oil prices is due to temporary weakness in the dollar and geopolitical tensions, this price spike is likely to reverse. The dollar has been incredibly strong this year, and the long-term trend seems unlikely to change. From a technical perspective, West Texas Intermediate (WTI) futures are up against the resistance level of February’s consolidation, which seems likely to hold in the short term without any fundamental changes in demand.

The S&P 500 broke out of its short-term consolidation flag on June 18 after President Trump announced that he would be meeting with Chinese President Xi at the G-20 meetings this week. The rally continued through the Fed’s announcement on Wednesday to take the S&P 500 to its highest ever close last Thursday.

While this is a valid excursion beyond the resistance of a prior high on the large-cap index, I have maintained a cautious outlook while we wait for confirmation from other indexes. Small-cap stocks have been in decline since Thursday after failing to get anywhere near their prior highs. As you can see in the following chart of the Russell 2000, the bullish close last Thursday has been completely reversed in the small-cap index. Higher prices in small caps would have been a valid confirmation of the rally, which instead is signaling inherent weakness in the market.

I have mentioned in previous Chart Advisor issues that long-term studies of merger and acquisition (M&A) activity among large-cap companies has a poor risk adjusted return. You can see my rationale in the issue on Feb. 22 here.

Today’s decline in the expected value of the Celgene Corporation (CELG) and Bristol-Myers Squibb Company (BMY) merger is another point in favor of my argument. Bristol-Myers Squibb plans to divest itself of one of Celgene’s successful medications for psoriasis in order to get regulatory approval for the merger, which further weakens their prospects for success as a combined entity. Both stocks were down significantly on the news.

Despite the historical evidence against the value of large M&A deals, analysts point to this activity as a sign of confidence because acquisitions are risky and expensive. The logic is that management teams would not seek to pursue a merger without confidence that it will pay off in the longer run assisted by a strong market.

There is some evidence that M&A activity is at least correlated with rising prices, and that declines in M&A activity sometimes leads corrections in market prices, which means investors should be cautious this year. Even with the additional announcements today of Caesars Entertainment Corporation (CZR) being acquired by Eldorado Resorts, Inc. (ERI), and Del Frisco’s Restaurant Group, Inc.’s (DFRG) acquisition by a private equity firm, M&A activity is on track to miss 2018’s numbers by a wide margin.

You can get some historical perspective for M&A activity in the following chart. As you can see, after the frenzy for M&A activity peaked the market was poised to decline in 2001 and 2008. In my opinion, the current deal flow looks similar to what I would expect to see before the market flattens or corrects.

In addition to potential trade news from the G-20, this is an important week for corporate announcements. I think the FedEx Corporation (FDX) earnings report will go a long way in defining the market’s direction in July. The shipping company reports earnings tomorrow after the market closes and is a bellwether for industrial activity and retail spending. As one of the few major components of the S&P 500 to report before the end of the calendar quarter, FedEx is a key market indicator to watch.

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