Stock-picking environment favors mid- and small-cap stocks

The second quarter earnings season has ushered in change for the stock market. The timing of this change may be somewhat coincidental, but I also believe that the relative strength trend shifts in many stocks is attributable to a more critical appraisal of earnings growth prospects. For weeks, investors have grappled with the impending tapering of the Fed's Quantitative Easing mission. Some observers were quick to react to this, deeming it a major turning point in the central bank's long standing monetary accommodation. True to its admirable policy of transparency, the Fed did sound an early warning for Wall Street that some monetary policy adjustment would be forthcoming. But, it remains unlikely that interest rates will embark on a secular uptrend based on jobs data, inflation readings and other economic barometers. While the Fed's alert may have been a triggering mechanism for the current consolidation, correction has been orderly and characteristically similar to most other pullbacks in this cycle with sharp, but brief, retreats and rotational backing and filling price movements among the market's leading categories. Unlike other downturns since March 2009, the prevailing retreat has introduced a more stock picking-focused environment that favors medium and small capitalization stocks. The Russell 2000 (RTY) Index, which is comprised of the 2,000 smallest companies in the Russell 3000 Index, has outpaced the DJIA on a total return basis by more than 500 basis points year to date with most of the relative strength strides occurring since June 30. While this movement toward medium and small cap stocks has accelerated in recent months it has not meaningfully altered sector leadership which remains impressively broad and diverse. Some of the heightened focus on sub-blue chips is not atypical of the characteristics evident in the advanced stages of other market cycles. I view this migration toward smaller-cap stocks as a bullish potential for the stock market since it seems to underscore a greater willingness among investors to move from the perceived safety of blue chips to the earnings leveraged opportunities more readily found in lower-cap stock tiers. It reinforces technical factors and lends greater credence to the notion that investor confidence is steadily improving. A somewhat narrowing and selective stock market might be construed as a speculative, risk oriented one. I do not believe that stock leadership is contracting aggressively at this juncture nor to such an extent that the market is in danger of being driven by micro-thematic factors that might render it vulnerable to headline risk. The leading sectors continue to benefit from reasonably good depth of individual stock performers and this does not appear to be in jeopardy of being substantially altered anytime soon. The broad leadership theme of T.H.E.M. (Technology, Health care, Energy and Manufacturing) remains intact and continues to be complemented by other categories including consumer discretionary, consumer staples and financials. The shift in focus that I refer to pertains mainly to investors seeking earnings-leveraged stock opportunities rather than established earnings mainstays. This could spur significant rallies in stocks that have somewhat higher price-to-earnings ratios (P/E's) than the S&P 500 multiple which stands currently at 15.8. To be sure, this is not likely a looming sequel to the technology cycle of the late 1990s when stocks with astronomical P/E's vaulted higher leaving 'traditional' stocks and sectors far behind. It is similar only in as much as seemingly untethered earnings growth candidates will likely perform better than the established earnings growers. This is not a call to abandon blue chips, but rather an alert that from both bottom-up and top-down perspectives medium-cap growth has taken a performance lead over mega-caps that could be maintained through the remainder of this cycle. Therefore, equity allocation adjustments may be warranted for those investors over weighted in large-cap value strategies.

Sturdy energy stocks

Energy stocks continue to exhibit sturdy longer term technical characteristics. My positive outlook for the group is based, in part, on the strength of its sub-categories including integrated oil, domestic oil and gas exploration, off-shore drillers and oil service. Like other leadership sectors, energy is populated with large and mid/small cap stocks, with the latter exhibiting improving relative strength characteristics. This is particularly evident among the medium-cap service and offshore drillers. Oil recently broke out into two year high territory amid escalating geopolitical tensions, dateline Syria. While this headline event spurred the latest oil rally just as currency fluctuations and other global events have caused reactive movements in the past, it is the long term uptrend in oil that is most telling. Similar to the stock market, the underlying bullish force for oil seems closely linked to investors' expectations of economic expansion. Not surprisingly, oil price trends and the stock market indices are correlated in this cycle. Therefore, while the latest gains in oil are event related, the outlook for energy is strengthened with this move and that should bode well for the stock market's longer-term bullish potential. My six-month target range for West Texas Intermediate Crude Oil is $97-$115. This generally coincides with my stock market forecast for this same period inasmuch as I anticipate a trading range bound market (DJIA 14,500-16,000) with expansive trading swings that highlight the technical merits of individual stocks. Eugene E. Peroni Jr. is senior vice president of equity research at Advisors Asset Management. This commentary originally appeared on the firm's website.