Small caps rally as oil sinks; FOMC no worry

Kevin Pendley | Aug 05, 2008 4:38pm EDT | Comment

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Small-cap stocks put together a solid rally Tuesday, essentially recapturing the lost ground from Monday’s sharp decline. The market got an early boost from sinking crude oil prices, and extended those gains after the FOMC report failed to spark any fresh concerns. The Russell 2000 (NYSE:IWM) closed up 16.90, or 2.40% at 721.04. In the last three weeks, the market has generated one-day rallies of more than 2% on four occasions, which is an unusually large number of singular big-rally days jammed into such a short time frame.

Foreign exchange markets seemed to say that the Fed was on the right path, with the U.S. dollar jumping more than 100 basis points against the euro, and the dollar index climbing to the highest point since mid-June. In general, at this stage of the economic cycle, a strong greenback is seen as a sign of strength for the U.S. economy, and should encourage foreign asset flow into the U.S. stock market.

As for today’s big FOMC report, there was some mild intraday volatility associated with the statement, but the overall response was one of comfort. There is still a diversity of opinion about whether the Fed is in a position to fight inflation with tighter policy because of rising unemployment and soft economic conditions, but there also is a sense that the recent pullback in energy prices and other commodity markets may have provided the FOMC members with some valuable time and breathing room to combat a difficult situation.

“The Committee is now in a wait-and-see mode to see how the economy and inflation unfold during the second half of the year,” Steven Wood, chief economist with Insight Economics, said in an email. “The key question now is whether weak economic activity will dampen inflation or high energy and commodity prices will keep inflation uncomfortably high. We believe that as the summer progresses energy prices will stabilize or retreat slightly. This will relieve some of the pressure on the Fed but may still not be enough to cause them to cut rates further unless a recession develops, a possibility we do not rule out.”

Economic data earlier this morning on the services sector showed that things are better than expected, but still not very strong in general. The ISM non-manufacturing survey came in at 49.5%, which topped the forecast of 48.5%, but which was still below the 50.0% contraction line.

Even though much debate will center on the economy and the reading of the FOMC “tea leaves,” the big impetus for stocks right now remains the energy market. Crude oil prices slipped below $120 dollars a barrel while hitting an intraday trough at 3-month lows. Crude oil prices are now down about 19% from the summer record high, providing relief for consumers at the gas pump and for businesses with high fuel input costs. As one might expect, a primary beneficiary of the slide in fuel prices was the airline industry, as the AMEX Airline Index jumped nearly 9% today. Small-cap carrier US Airways Group Inc. (NYSE:LCC) soared 18%, hitting the highest share price since late May.

There was also some hope that consumer spending would move from the gas pump to the store, and the S&P Retail Index rallied 5%, with big names like Target Corp. (NYSE:TGT) up almost 7% and Wal-Mart Stores, Inc. (NYSE:WMT) up over 3%. Small-cap stores Stage Stores Inc. (NYSE:SSI) was up more than 6% and Bon-Ton Stores Inc. (Nasdaq:BONT) rose nearly 6%.

Within a list of top-performing sectors, specialty stores and general merchandise stores ranked near the top today. Also on the rise were tire and rubber shares, insurance stocks, office supplies, hotels and household appliances. As one might expect given the recent downward spiral in commodities, the worst performing areas came from sectors like gold, agriculture, metals and mining, coal and fertilizer.

Small caps on the move today were highlighted by The Dixie Group Inc. (Nasdaq: DXYN), which jumped 25% after reporting solid earnings. Castlepoint Holdings Ltd. (Nasdaq:CPHL), gapped higher on unusually heavy volume and climbed 28% on news that the firm will be acquired by Tower Group for some $490 million. Lin TV Corp. (NYSE:TVL) rallied 16%, tied to earnings news. Unable to join the overall market rally, Global Industries Ltd. (Nasdaq:GLBL) tumbled nearly 27% as earnings disappointed. Innophos Holdings Inc. (Nasdaq:IPHS) was down 12% and has rapidly given back a large chunk of a recent upward spike tied to earnings news.

Looking ahead to Wednesday’s action, the market is unencumbered with any blockbuster economic reports, which should allow the focus to remain on crude oil price gyrations and earnings surprises. The chart picture for the Russell remains somewhat ambiguous as the market is trapped in a trading range between 726 and 694. A decisive breakout in either side of that range would carry a 32-handle target move and is the key chart dynamic to watch this week. In addition, the market is testing trendline resistance off both the June and July highs, and the late pop above 720 resistance was an impressive show of strength.