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  1. Home
  2. / Investing

Small-Caps Are Hot, Playing Ball With China, Trading Nvidia: Market Recon

The bond market is running the show? The answer would be... as much if not more than anything else... again.
By STEPHEN GUILFOYLE
Sep 12, 2019 | 08:22 AM EDT
Stocks quotes in this article: XLF, KBE, KRE, TWTR, SSNLF, ZTCOY, ERIC, QCOM, XLK, XSD, NXPI, NVDA, MLNX, KR, AVGO, ORCL, ROST

Wading Through Weighting

I had been wondering. I bet most of you had been as well. With the S&P 500 and the Dow Jones Industrial Average having taken their respective 50 day SMAs roughly a week back, when would this rotation that has become so much more visible in recent days, permit small caps to take a real leadership role in this equity market. Think about it. The dollar has been strong. Domestic firms should be impervious, at least on the revenue producing side to exchange rates. Yes, there are of course supply chain issues for many firms. Trade war related rhetoric seems to be cooling. Any kind of trade deal (good or bad) removes for the time being the largest overt drag on global economic performance.

That input in turn... has allowed traders to sell longer term debt slightly more aggressively than shorter term debt. This relaxes the yield curve, meaning that it steepens ever so slightly as both the long end and the short end move in the same direction.

So... what about those small caps? The Russell 2000 scored impressive gains of 2.1% on Wednesday, as did the S&P 600. This came two days after, for the S&P 600, that 50 day line had indeed been taken. The hold part of a "take and hold". The Russell took and seemingly held in one aggressive move. What's beneath the surface? Why are the small cap indices leading the way (along with the transports)? It really is as simple as understanding the relationship between the recent environment for credit over time, and sector weighting. Sarge, you mean the bond market is running the show? The answer would be... as much if not more than anything else... again. That never should surprise.

The S&P 500 gained 0.7% on Wednesday. I just told you that the Russell 2000 picked up 2.1%. On the surface, one may look at performance for the financial sector and see a 0.57% gain for the Financial Select Sector SPDR ETF (XLF) . Dig deeper, and we see that within that sector, the SPDR S&P Bank ETF (KBE) and the S&P Regional Banking ETF (KRE) both experienced increases of 1.2%. This suggests both that banks are benefiting form the changing slope of the yield curve and this benefit does not abate in the least as the subject of our focus moves form large, diversified money centers to smaller banks focused on servicing smaller to mid-sized clients through traditional banking.

Then we look at weighting. The Financial sector bears a 12.69% weighting upon the S&P 500, the second largest allocation, but far smaller than the Information Technology sector at 21.2%. Taking a look at the Russell 2000, we see that Financials make up 17.07% of the index, smaller than in years past, but still number one. Health Care would be number two, and Information Technology is third. The Industrial sector, also very hot of late, weighs 14.45% upon the Russell 2000 (fourth largest allocation), but just 9.48% on the S&P 500. Remember gang, interpreting the information is all about understanding just how that information is delivered. Are small caps hot? Yes. Do they appear hotter relative to the broader market than perhaps they should simply due to the way these indices are sliced and diced? Also... yes. That also means in reverse that small caps appeared weaker in relative terms all year than what was reality.

Gomer Pyle

I can hear the voice of Jim Nabors in my ears this morning. "Surprise! Surprise! Surprise!" Well, no kidding sports fans. Remember just a short ways back, when the Chinese Ministry of Commerce seemed so excited about announcing the mid-October trade negotiations planned for Washington, DC? Remember how I may have suggested in print and on national television that this might be a ploy by the Chinese side just to get President Trump to delay the imposition of an increased schedule of tariffs on Chinese goods come his October 1st deadline, also a key date of commemoration for the communist regime in control of mainland China?

Well, assuming I was right, and we do not know that I was... they may have received what they were looking for. Kind of. The U.S. president announced through his Twitter (TWTR) feed that at the request of Chinese Vice Premier Liu He (due to the regime's 70th anniversary party), the U.S. would as a gesture of goodwill, push these increases back two weeks. While not quite granting the Chinese side the propaganda tool that I had suspected them of seeking in order to make President Xi look stronger going into that holiday, this move by President Trump does show a willingness to play ball. That is what's key here to everyone with a portfolio... or a job for that matter.

Bear in mind that these October 1st, now mid-October tariff increases are simply an increase from 25% to 30% on $250 billion worth of goods not likely to put an immediate whammy on U.S. consumers. The first tariffs that would hit the consumer were implemented on September 1st, with a more severe tranche slated for December 15th. That's the problem for the Chinese side here. Nobody knows how much the Chinese economy is slowing, because nobody trusts the "doubtful" numbers. Likely the Chinese don't really know the truth themselves, as headline level economic data is dependent upon subordinate data that itself is believed to be suspect. The regime already looks a little wobbly as protesters in the streets of Hong Kong wave American flags while singing "The Star Spangled Banner." Then there is the autonomous island of Formosa (Taiwan). Not just the only part of China still controlled by the nationalists (Key to keep in focus, the communist victory in 1949 was never complete, it's a sore spot.), but an island clearly trying to build up it's own military capabilities where there is really only one threat they might be concerned about.

About The U.S. 10 Year Note

My bet is that most of you have already taken a look at Wednesday's auction of $24 billion in U.S. 10 year notes. Very interesting, I thought. While weakness for the curve, but the long end in particular has been the story of September thus far, what we witnessed yesterday was a return to trend or better for the series as interest rates (the yield awarded) returned to levels above that paid at the August 7th auction.

The yield awarded (1.739%) at this particular auction did not stop the 10 year from selling off later in the day on Wednesday, but did seemingly provide overnight support. Then there are the 2.46 bid to cover, the best seen for 10 year paper since June, and the fact that 75% of the entire issue was taken down by non-dealers, which is above the 2019 year to date average. All in all, this was a slightly above average auction, which is interesting at these levels, especially with the European Central Bank (ECB) deciding on policy later this morning.

What If?

What if as a result of negotiations between the U.S. and China, really big trees are shaken? I'm not talking soybeans and hogs. We're pretty sure the Chinese will offer to buy a whole lot of agricultural products. They always do. Getting them to follow through on their word is the issue there. What if, as part of a trade deal, Huawei were willing to sell access to existing 5G patents to western (U.S.) companies? The idea was brought up in a piece in The Economist on Wednesday. What if a U.S. company could pay a one time fee to Huawei (believed to be a clear leader in 5G technology) for patents that include licensing, code, and production know how, and then was able to modify whatever it has to in order to deny the Chinese government (or Huawei) access after the fact?

Crazy? Maybe not so much. After all, the leaders in 5G patents just in numbers are Samsung (SSNLF) , Huawei, ZTE (ZTCOY) , and Ericsson (ERIC) . A U.S. firm does not show up until you see Qualcomm (QCOM) at number five. Price could be an issue. My thought on that is that this is a home run if price is the only issue. Word is that my middle aged brain can not anticipate the changes to lifestyle that 5G might bring about. An innovation the likes of Gutenberg's printing press in 1439 is what I'm told. The ability to compete won't come cheap, but wouldn't a free market price paid in order to compete globally and lead domestically be just dandy?

Chances Are...

As prospects for a U.S./China trade peace improve, so does performance across the semiconductor industry. While the Technology Select Sector SPDR ETF (XLK) score a 1.04% gain on Wednesday, the SPDR S&P Semiconductor ETF (XSD) ran 2.03% for the day.

Taking this line of thought one step further, in the wake of the deal between Qualcomm and NXP (NXPI) that fell apart due to slowdowns in regulatory approval in China, the pending deal between Nvidia (NVDA) and Mellanox (MLNX) very likely becomes a pawn in the game. Over the past five day period, the S&P 500 has moved 2.1% higher. The XSD ETF has gained 5.8%. Nvidia has scored a five day gain of 9.2% Epic. Somebody is betting on something big.

One sees quickly that NVDA has now taken the first pivot... orange line number one just below $180. Positive momentum provided by trade related headlines could easily target either the second pivot (around $194), or the 38.2% Fibonacci retracement level at $200. The shares are currently still benefiting from a golden cross (%0 day SMA over 200 day SMA) in mid to late August). Listen gang, Mellanox is expected to be a nicely accretive addition to Nvidia's abilities. The deal already has U.S. approval, and the feeling is that approval in Europe is not far off. China is the key here, and if all goes smoother than rougher, Nvidia would like to get this thing on the tape before the new year. Think it will happen? Somebody does. Nvidia closed on Wednesday at $184.33, Mellanox at $110.45. Charting one share on NVDA over one share of MLNX in ratio format, the spread looks like this since the March announcement.

This ratio is an eyelash away from seeing a golden cross of it's own. It is believed that Chinese regulators are now taking a serious look at this deal. Mellanox if acquired makes through the firm's low-latency technology, and the acquirer a better competitor for the corporate data-center.

What am I doing. I've been trading this name for months. The volatility has been there. For the buy and hold crowd, I bid you a "nice job." For traders like me, I think it's time to buy a few and hang on for the $200 level. A risk averse trader could buy a November 15th (NVDA reports on November 14th) $185/$195 bull call spread for a net 5, and nearly pay for the trade with the sale of a November 15th $165 put. That does expose oneself to potential equity risk at a 10% discount to Wednesday's last sale while making allowance for upside benefit.

Economics (All Times Eastern)

08:30 - Initial Jobless Claims (Weekly): Expecting 216K, Last 217K.

08:30 - CPI (Aug): Expecting 1.8% y/y, Last 1.8% y/y.

08:30 - Core CPI (Aug): Expecting 2.3% y/y, Last 2.2% y/y.

10:30 - Natural Gas Inventories (Weekly): Last +84B cf.

13:00 - Thirty Year Bond Auction: $16B.

14:00 - Federal Budget Statement (Aug): Last $-119.7B.

The Fed (All Times Eastern)

FOMC Blackout Period Through September 17th.

Today's Earnings Highlights (Consensus EPS Expectations)

Before the Open: (KR) (.41)

After the Close: (AVGO) (5.15), (ORCL) (.81), (ROST) (1.01)

(Nvidia is a holding in Jim Cramer's Action Alerts PLUS member club. Want to be alerted before Jim Cramer buys or sells NVDA? Learn more now.)

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At the time of publication,  Stephen Guilfoyle had no position in the securities mentioned.

TAGS: Bonds | Investing | Markets | Options | Small Cap | Stocks | Technical Analysis | Trading | Semiconductors & Semiconductor Equipment | China

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