Analysis: Stocks Primed to Fall, but These Small Caps Will Prosper

I first warned subscribers in the August edition of Small-Cap Profit Confidential that stocks would pull back sharply as a result of rising inflation rates and subsequent increases in lending rates.

The major U.S. stock market indices did fall sharply on Oct. 4 in response to the yield on the 10-year U.S. Treasury Note, which rose to its highest level since July 1, 2011.

My research indicates that U.S. interest rates will continue to move higher during the coming months in response to further increases in inflation rates.

As a result, I expect stock prices in general to trend lower through the end of this year.

Fortunately, investors who’ve followed my advice to allocate a large portion of their financial market assets to cash-like investments (i.e. money-market funds) are well-positioned for such a downturn.

My currently recommended small-company stocks have already pulled back considerably, due primarily to a broad sell-off in small-company stocks in general. Yet my research indicates that there’s minimal risk of those stocks declining substantially from here.

That’s because, unlike many small-company stocks, the underlying companies of my recommended stocks are in a position to withstand an economic downturn due to their strong financial condition and favorable outlook for revenues and earnings.

As an example of their strong financial condition, the cash holdings, short-term bank deposits and marketable securities alone of all of my recommended companies cover those companies’ total financial obligations — both their short-term liabilities and long-term liabilities.

Therefore, I’m advising our subscribers to continue to hold all of my currently recommended stocks.

In regard to the performance of our model portfolio, I expect the value of our portfolio to remain near its current level but for the S&P 500 to trend lower over the next few months.

Because I plan to soon recommend several new small-company stocks which I expect to appreciate substantially over the next 18 months, I’m confident that our model portfolio will outperform the S&P 500 Index by a considerable margin during the year ahead. Therefore, I’m not at all concerned about the recent underperformance of our model portfolio.

Economic developments

In regard to recent economic developments, the U.S. housing market has continued to show signs of weakening. That bodes poorly for the future direction of the U.S. economy and stock prices in general.

For example, sales of previously owned U.S. homes (existing home sales), which account for approximately 90% of all U.S. home sales, remained unchanged during August after declining during each of the four prior months.

The number of contracts signed by prospective buyers of previously owned homes declined for the second consecutive month during August, indicating that sales of such homes continued to decline during September.

Although sales of newly constructed homes rose modestly during August after declining during each of the two prior months, recent interest expressed by prospective buyers of such homes suggests that new home sales declined during September as well.

As I discuss in prior editions of Small-Cap Profit Confidential, weakening in the U.S. housing market is significant because economic activity in that sector historically has served as a reliable leading economic and stock market indicator.

On a positive note, manufacturing activity in the United States, as well as in other major regions of the world, has continued to expand over the past few months, albeit at a slower pace.

In addition, the U.S. employment situation improved considerably during September.

Automatic Data Processing, which provides payroll services for thousands of companies around the world, reported on Oct. 4 that U.S. employers created the most private-sector jobs during September since February of this year.

Meanwhile, Americans in the aggregate have continued to be very optimistic about the direction of the economy and stock prices as a result of the Tax Cuts and Jobs Act of 2017; reductions in government regulations of U.S. businesses; and the actions that President Trump has taken to persuade foreign countries to conduct fairer trade with the United States.

As an example of that optimism, The Conference Board reported on September 25 that its Consumer Confidence Index, which is based on monthly surveys of Americans regarding their personal financial situations, job prospects and outlook for the U.S. economy, rose during September to the highest level in 18 years.

This indicates that most Americans remain optimistic about those factors.

Commenting on The Conference Board’s September survey, Lynn Franco, the Board’s Director of Economic Indicators, wrote: “Consumers’ assessment of current conditions remains extremely favorable, bolstered by a strong economy and robust job growth.

“These historically high confidence levels should continue to support healthy consumer spending, and should be welcome news for retailers as they begin gearing up for the holiday season.”

Separately, the National Federation of Independent Business (NFIB) reported on September 11 that its latest survey of owners of U.S. small businesses indicates that those persons became the most optimistic about their business prospects since at least July 1983, when the NFIB first began conducting this survey.

Writing about the NFIB’s September survey of small business owners, its president and CEO wrote: “Today’s groundbreaking numbers are demonstrative of what I’m hearing every day from small business owners — that business is booming. As the tax and regulatory landscape changed, so did small business expectations and plans.

“We’re now seeing the tangible results of those plans as small businesses report historically high, some record breaking, levels of increased sales, investment, earnings, and hiring.”

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