• Bank of America sees small-cap stocks as key indicator to look at for the broader stock market.

• High concentration in a handful of stocks and elevated valuations limit stock market upside, BofA said.

• Small-cap stocks face challenges from high rates of interest, affecting profitless corporations.

Bank of America said in a Friday note that one key area of the stock market will help determine whether the bull rally will proceed.

Michael Hartnett, an investment strategist on the bank, said that while President-elect Donald Trump’s influence and policies could provide a security net for the stock market, upside is constrained by high concentration in a handful of stocks, elevated valuations, and stretched positioning by investors.

Hartnett highlighted that the bank’s December fund manager survey showed investors are holding a record obese position in US stocks.

The important thing signal for a continued rally, based on Hartnett, is whether or not small-cap stocks can rally above a key resistance level set in 2021.

Small-cap stocks briefly broke above the resistance level following Donald Trump’s election win in November, but they’ve since given up the majority of those gains and are trading right across the resistance level as investors worry about rates of interest staying higher for longer.

Higher rates of interest are particularly painful for small-cap stocks because they’re more sensitive to changes in borrowing costs. About 40% of corporations within the small-cap Russell 2000 index are profitless, meaning debt financing often plays an integral role in funding their operations.

If the associated fee of debt moves higher and stays higher when an organization with little to no profit has debt come due for refinancing, it could ultimately result in insolvency.

In response to Hartnett, all systems go if small-cap stocks can decisively break above their 2021 resistance level. Nonetheless, if not, it could signal broader market weakness and he would expect asset allocators to trim their obese positioning within the stock market.

Hartnett recommends investors buy bonds with Treasury yields potentially peaking near the 5% level and rate-sensitive stocks often present in the financial, utilities, and homebuilding sectors.

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