• Bank of America considers small-cap stocks to be a key indicator for monitoring the broader stock market.

• High concentration in a handful of stocks and high valuations limit the stock’s upside, BofA said.

• Small-cap stocks face the challenges of high interest rates, which affect unprofitable companies.

Bank of America said in a note on Friday that a key area of ​​the stock market will help determine whether the bullish rally will continue.

Michael Hartnett, an investment strategist at the bank, said that while the influence and policies of President-elect Donald Trump could provide a safety net for the stock market, upside is limited by the high concentration in a handful of stocks, high valuations and stretched positioning by the bank. investors

Hartnett noted that the bank’s fund manager survey in December showed investors holding a record overweight position in US stocks.

The key signal for a continued rally, according to Hartnett, is whether small-cap stocks can rally above a key resistance level set in 2021.

Small-cap stocks briefly broke above resistance after Donald Trump’s election victory in November, but have since given up most of those gains and are trading around resistance as investors they care about interest rates stay higher for longer.

Higher interest rates are especially painful for small-cap stocks because they are more sensitive to changes in borrowing costs. About 40% of the companies in the Russell 2000 index are small caps they are useless that is, debt financing often plays an integral role in financing their operations.

If the cost of debt rises and remains higher when a company with little or no profit must pay down debt to refinance, could eventually lead to insolvency.

According to Hartnett, it’s all systems go if small-cap stocks can decisively break above their 2021 resistance level. However, if not, it could signal broader market weakness and he would expect asset allocators to trim their overweight positions in the stock market

Hartnett recommends investors buy bonds with Treasury yields potentially peaking near the 5% level and rate-sensitive stocks often found in the financial, utilities and homebuilding sectors.

Read the original article at Business Insider