Dramatic small-cap recovery rally caps historic week

Kevin Pendley | Oct 10, 2008 4:29pm EDT | Comment

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Small-cap stocks stormed higher in the final 45 minutes of trading, shooting higher on optimism for a big weekend announcement out of G7 finance leaders. The comeback move was likely heightened by oversold conditions ahead of the weekend. Until the late rally, stocks remained in collapse mode for most of Friday as investors pulled money out of equities fearing a prolonged recession amid the global credit crisis. The Russell 2000 (NYSE:IWM) gained 23.28, or 4.66% to 522.48, shooting nearly 12% off an intraday trough that marked the lowest point since August 2003. In what will be forever remembered as a historic week for the stock market, small-caps still shed 96.92, or 15.6% in an unprecedented collapse this week. For the year, the Russell is now down 31.7%, while the Dow is off 36.2% and the S&P 500 is down 38.7%. Small caps are now down 39% from the 2007 record highs, and at the lows today were fast approaching typical declines in the 50% range seen in previous recessions over the last 40 years.

From a charting and index perspective, the late recovery move in stocks today was paced by small caps, which was an encouraging sign. Small caps have been underperforming on the way down in this collapse after over performing their large-cap brethren for years on the way up. If small caps start to show a leadership role in the coming days, it could be a sign that a bottom, or at least stabilization is nearby. All that said, one could argue that it would have been surprising to see the stock market NOT have an oversold bounce ahead of the weekend with the potential promise of a G7 finance statement in the works, so there will still be a desire next week for the market to show that today’s recovery has traction.

This week’s collapse gained momentum despite dramatic moves by central bankers around the world to unclog credit lines. For the first time since the recession gripped the nation in the shadow of the 9/11 attacks seven years ago, central bankers gift wrapped a coordinated rate cut for the market, with the United States, United Kingdom, Eurozone, Swiss, Canadian, Swedish and Chinese authorities all slashing rates together. That was followed by central bankers in South Korea, Taiwan and Hong Kong also slicing lending rates. The market had been clamoring for a coordinated global response from central bankers, but when they got it, nothing happened. In fact, interbank lending rates (LIBOR) actually shot higher, reflecting a lack of trust among banks to lend money at fair rates to each other. LIBOR has become the new poster child for the credit crisis, but there is clearly more to the markets’ ails than the rate of interbank lending.

A key part of this week’s collapse has been the investment public making a decision that the U.S. economy is headed toward a deep recession and they’d rather not sit around and wait for things to get worse. Market pundits are calling it a “panic” and new buzzwords like “irrational pessimism” are making the rounds. But for investors who got out last week 20% higher, were they irrational? Another element in play is that the contagion has clearly spread throughout the world and has also infected almost every asset class – equities, credit and even commodities. If the world goes into recession, then where is the safe-haven? Right now, investors appear to be saying they would rather sit on cold, hard cash and wait for a sign that things are getting better.

From a world perspective, things certainly didn’t seem better on Friday. Trading on stock bourses on opposite ends of the world were halted as one-day declines hit the 10% barrier. Places such as Iceland and Indonesia halted trading, as did exchanges in Russia, Romania and Ukraine. There were even calls from market watchers for the United States to impose a forced one- to two-day “holiday” on stock market trading, which seems like a very dangerous idea to others. Liquidity is seen by some as the best option to avert panic. As we’ve seen in recent weeks, actions to crimp liquidity (such as banning short-selling) won’t necessarily stop the market from going lower. Banks in the United States will actually get a holiday break on Monday for the Columbus Day holiday, but exchanges are slated to remain open.

Looking ahead to next week’s action, the market will obviously be fixated on what the G7 ministers say about the credit crisis, LIBOR values, more central bank rate cuts and whether or not a “capitulation low” can be forged in stocks. All of the uncertainty in the air over those issues will overshadow a busy week on the data front, with key reports on consumer spending, inflation and manufacturing on tap. The most important economic report could well be Wednesday’s retail sales release as the market starts to brace for the first quarterly decline in consumer spending in 17 years — a troubling indicator for an economy that is two-thirds driven by spending.

As noted above, the distrust of equity markets has also spread into other asset classes. Usually when the stock market is in freefall mode, we’ll see money moving into Treasury markets, and also into things like gold. Although gold funds did have some attraction at various points this week, commodities in general have also been in collapse mode. Crude oil prices tumbled 10% today to fresh one-year lows and the International Energy Agency downgraded its worldwide demand forecast to the lowest rate since 1993. The Commodity Research Bureau Index, which tracks price behavior on a basket of 19 commodities markets, tumbled 6% today and is now at the lowest point since January 2007.

Individual small caps of note on the upside today included Dorman Products Inc. (Nasdaq:DORM), which soared 52%, recapturing a huge portion of a massive slide from the previous day. Ardea Biosciences Inc. (Nasdaq:RDEA) jumped some 39%, also recovering from new move lows set Thursday. United America Indemnity Ltd. (Nasdaq:INDM) was up 22%, rejecting major new lows set during the morning freefall. Alaska Air Group Inc. (NYSE:ALK) soared about 30%, gaining momentum from the decline in energy prices and the recovery move in small caps late in the day.