We’re entering the home stretch of what’s been a surprising year for the equity and bond markets. Although large-cap stocks of the kind in the Dow Jones Industrial Average and the S&P 500 have logged numerous all-time highs this year, small-cap stocks such as those in the Russell 2000 have come under heavy selling pressure.
The divergence between large caps and small caps is one of the biggest stories of the year, and it likely will be one of the biggest stories to watch in Q4. That’s because often it is small caps that set the tone going forward. Traditionally, at the beginning of a bull market, we see traders willing to roll the dice on more speculative, smaller companies. Conversely, when a bull market gets tired, small caps tend to be the first casualties.
The weakness in smaller stocks is something all investors need to watch as we wrap up the final quarter of 2014, but it’s by no means alone.
Here are five more of the biggest stories to watch in Q4.
Biggest Story to Watch #1: Fed Rate Hikes and the End of QE
Chair Janet Yellen and her merry band of central bankers have made good on their commitment to taper quantitative easing at measured pace. The Fed’s bond-buying activity will likely come to an end in October, and that alone makes this one of the biggest stories in Q4. How the market reacts to the complete elimination of QE is something all of us are watching.
Yet perhaps more important will be the signals the Fed puts out on when interest rates are likely to rise. Will it be mid-2015 or well beyond? So far, comments from Yellen and various other Fed officials have been pretty dovish on the future of interest rates, but that could all change with an altered tone in the fourth quarter.
Biggest Story to Watch #2: Will the Bond Bull Keep Bucking?
One of the biggest stories to watch in Q4 also is one of the biggest surprises this year, and that is the continued bull market in long-term Treasury bonds.
The iShares Barclays 20+ Year Treasury Bond ETF (TLT) has delivered a whopping 13.9% gain YTD. That performance is roughly double the S&P 500, and it clearly shows the appetite investors still have for the safe haven that is U.S. Treasury bonds. Yet with the Fed about to end QE, will Q4 show us the first sign that the bond bull’s bucking frenzy is about to come to an end?
Biggest Story to Watch #3: Geopolitical Risk and Bombs over the Levant
It seems as though everywhere we look these days, there are bellicose tensions. The invasion of Ukraine and the annexing of the Crimea region by Russia; war between Israel and Palestine, and of course, bombs over the Levant designed to takeout ISIL terrorist strongholds in Syria and Iraq have combined to provide a geopolitical risk overhang on financial markets.
Yet in the face of these flaring global hot spots, the market has been relative sanguine. Could that all change in Q4 if the U.S. plunges into a more intense conflict in the Middle East, or if Russia expands its encroachment of Eastern Europe? The short answer is “yes,” and if this happens, it would be one of the biggest stories of the year.
Biggest Story to Watch #4: Commodities Crater
We’ve already covered the divergent performance of large caps and small caps, but one of the biggest stories of late, and what could be one of the biggest stories in Q4, is the commodities crater. Over the past three months, the benchmark measure of the commodities sector, the PowerShares DB Commodities Index Tracking Fund (DBC), has plunged more than 12%.
That drop isn’t the kind of bullish indicator you’d like to see if the global economy were truly humming at a robust pace. In fact, the commodity price crater could be the first real sign of deflation rearing its ugly head, and that is something market bulls definitely don’t want to see in Q4.
Biggest Story to Watch #5: Emerging Market Fail
In addition to the small-cap equity slide and the commodity price crater, there’s also been the beginning of a breakdown in emerging market equities. Over the past month, stocks in the iShares MSCI Emerging Markets Index (EEM) have tumbled 6%.
The selling in emerging markets comes after a substantial price move of nearly 22% from February through August. The changing appetite for riskier emerging market equities, particularly after their strong run, is another one of the biggest stories to watch in Q4. If commodities and small-caps join emerging markets — two other segments where risk capital tends to flow — then it won’t be long before we could see risk capital run for the exits in the most widely held blue chips.
As of this writing, Jim Woods did not hold a position in any of the aforementioned securities.