Small caps soar amid resurgent dollar, rosier inflation picture

Kevin Pendley | Aug 08, 2008 10:02pm EDT | Comment

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Small-cap stocks took flight Friday, soaring amid a huge rally in the U.S. dollar, which helped deflate commodity prices, thereby brightening the inflation picture. The Russell 2000 (NYSE:IWM) jumped 20.89, or 2.93% to 734.30, notching the eighth-largest one-day gain of the year.

The U.S. dollar jumped 318 basis points, or more than 2% against the euro, which lifted the greenback to the highest daily close since late February. With many of the world’s key commodity markets priced in dollar terms, a strengthening buck often pulls down physical markets because they become more expensive to purchase. A great case in point is the crude oil market, which collapsed 4% Friday, slipping to $115.20 dollars a barrel. Crude oil prices are now down 21% from the record highs set in July – and remember, a 20% decline off the highs is recognized as entering bear market territory. After consumers had to fork out more than $4 dollars a gallon for gasoline at times this summer, a bear market in energy would be a welcome relief to pocketbooks. That relief extends to the grocery store as well, where soaring commodity prices were also biting into consumer spending capabilities. Corn prices hit a 5-month low today, and the Commodity Research Bureau Index, which tracks 19 commodities markets, tumbled to 4-month lows.

The dramatic move in the dollar and in crude oil prices helped ease investor worries about the credit crisis moving back to the fore. Financial stocks were hammered during Thursday’s stock market decline, but fought back today, with the Financial Select SPDR rising 3.4% and the PHLX Banking Index rising 3.4% as well. Clearly, retailers smiled at the thought of a consumer who wasn’t in a dour mood from a trip to the gas station, as the S&P Retail Index jumped 6.2%. The story surrounding a reversal in commodities isn’t just one for the consumer, either; the downtrodden airline business embraced the slide in jet fuel costs with a hearty 8.3% surge on Friday. In fact, about the only equity sectors that weren’t in the plus column revolved around the commodities theme, with coal, gold, oil exploration, oil drillers and gas utilities all in the red.

However, one financial sector that still struggled Friday was thrifts and mortgage finance firms, with Fannie Mae (NYSE:FNM) tumbling 9% after the government-sponsored mortgage giant posted a huge quarterly loss and slashed dividends. While the stock market was able to finish off a nice rally week on Friday amid the good news on the inflation front, there are still potential storm clouds on the horizon in the form of a housing recession and rising joblessness. Despite the preponderance of positive news Friday, it’s difficult to ignore the fact that the unemployment rate is now at 5.7%, the highest rate in more than 4 years, and weekly unemployment claims this week climbed to a six-year peak. Looking ahead to next week’s data, it’s possible that the weekly claims report on Thursday morning could be the most-watched piece of economic data, even though retail sales and CPI would normally dominate the releases.

Individual small caps of note today were highlighted by PowerSecure International Inc. (Nasdaq:POWR), which jumped 42%, gapping higher and trading on unusually heavy volume following positive earnings news. Another stock riding a positive earnings wave Friday was Fuel Systems Solutions Inc. (Nasdaq:FSYS), which jumped 29%. On the eve of the Olympics, it only seems fitting that China Yuchai International Limited (NYSE:CYD) joined in on the market rally, climbing 22% while announcing operating results from one of its key subsidiaries. Speaking of China, stock markets there were pummeled overnight just ahead of the opening ceremonies on disappointment that a plan to bolster stocks was not unveiled in conjunction with the start of the games. It will be interesting to see if things improve after a weekend of the games being seen around the world and as China gets a chance to respond to the big rally in U.S. equities Friday and the huge move in currency markets around the world. China isn’t the only country on trader radar screens for next week as Russia and Georgia broke out into military conflict Friday, sparking a call by the U.S. Secretary of State Condoleeza Rice for Russia to cease the attacks.

From a charting standpoint, this was an important day for small-cap stocks. The Russell broke out to the upside of a consolidation rectangle, defined by the range between 694 and 726 seen in recent sessions. The breakout carries a target of 32 handles, which translate to an upside target near 758, which would put small-caps back on a test of that big double top from early June. Speaking of double tops, today’s rally in the Russell also smashed a potential double top near that 726 line. Now, 726 will need to hold up next week as support on a pullback to keep the breakout validated. In addition, Friday’s action left a bullish outside reversal on daily charts, which provides a little extra bullish power for the breakout argument.