Small caps edge to full-blown correction territory

The more small-cap stocks get scorched, the more problematic some analysts say they could become for big caps.

But as of now, there aren’t a lot of calls for a major downdraft despite the near 10 percent decline in the Russell 2000, and some analysts see the large cap indexes as more likely trapped in a sideways correction for a while, barring any macro catalyst. The Russell is down 9.5 percent from its March 4 high, and a double-digit decline is viewed by some traders as an official correction.

Stocks seesawed Thursday, and the Nasdaq and small cap Russell 2000 were the worst performers. The Russell fell nearly a percent to 1,097, and the Nasdaq was off 16 points or 0.4 percent to 4,051. The Dow was 32 points higher at 16,550, while the S&P 500 was slightly lower, off 2 points at 1,875.

The bond market had its share of hiccups Thursday, with a weak 30-year note auction sending the long bond yield higher. Other yields moved lower, including the 10-year, which was at 2.61 percent late in the day.

“It just underscores that bonds are in a bubble. This Treasury market is in a bubble. I think rates can go up and not upset the equity market too badly,” said Jack Ablin, CIO of BMO Private Bank. “Stocks are cheap relative to bond which also suggests the 10-year yield can rise 1 percent without upsetting equities too much.”

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Traders have been fretting about the low yields at the long end of the Treasury curve, and the flattening that has taken place, bringing longer duration and shorter term yields closer together. Flattening is a sign of a weakening economy.

Ablin, however, is not worried about the selloff in small caps, and he thinks the big cap indexes can withstand the selloff that is also sweeping through momentum internet, social media and biotech names on the Nasdaq.

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“They just got too far out of whack,” he said. “I think this is just a hedge fund unwinding. They beat that drum too hard and now there’s no skin left on it…I think we got a 30 percent return on a market that should have given us 10 percent last year. Now, we need earnings and revenues to catch up. Probably, the best outcome of this scenario is stocks tread water and the economy accelerates to keep pace with investor expectations.”

Getty Images Traders on the floor of the New York Stock Exchange.

Getty Images
Traders on the floor of the New York Stock Exchange.

Gina Martin Adams, institutional equities strategist at Wells Fargo Securities, said there are a series of warning signs for the stock market, but her biggest concern is the decline in the Russell.

“Given that small caps have consistently outperformed the large caps for the last five years, and historically lead the large caps, it’s a little disconcerting,” she said.

But she doesn’t think the large caps will necessarily follow the sharp drop in the Russell from its March all-time high.

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“The bulk of evidence in my opinion does not suggest the S&P is in for a major breakdown,” she said. “More likely it probably treads water here until the broader economic and earnings data gives a clearer signal. You’re getting diverging results in the economic and earnings data as well.”

She noted that forward guidance from companies continues to point to slower earnings growth. “I think the combination of all these conflicting signals means nobody knows what to do. We’ll stay in a holding pattern until we get more clarity.”

Adams said she has a “buy on the dip” mentality but the market needs to dip more for her to recommend putting more money to work.

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Analysts say it’s difficult to predict how much further there is to go in the momentum selloff. “When price momentum turns, it can turn for a long time,” Adams said. “The price trend of the S&P is still very strong. It’s nowhere near testing the trend line. It looks like the price action of the S&P is signaling consolidation and the market trades sideways, and underneath the hood, there’s a lot of action.”

What to Watch 

There is wholesale trade data and JOLTs, job opening and layoff data, both at 10 a.m. Friday.

Earnings are expected from ArcelorMittal, Telefonica, Alcatel-Lucent, Petrobras, Liberty Interactive, and Ralph Lauren.

The USDA releases the World Agricultural Supply and Demand Estimates report at 12 p.m.

Minneapolis Fed President Narayana Kocherlakota speaks at 8:10 a.m.

—By CNBC’s Patti Domm.

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