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This is the ‘sword of Damocles’ hanging over small-cap stocks, trader says

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Small caps’ surge has hit the brakes in April.

The Russell 2000 hasn’t hit a new high in nearly a month even as the rest of the market sits in record high territory. The group still outperforms the S&P 500 for the year, rising 13% to the benchmark index’s 10% increase.

Inflation fears could be a factor in the recent weakness, according to Boris Schlossberg, managing director of FX strategy at BK Asset Management.

“It hangs like the sword of Damocles over the small caps right now,” Schlossberg told CNBC’s “Trading Nation” on Monday. “Producer prices both from the production squeeze and just from the input costs could really have a material impact because I don’t think small caps have the pricing power right now in the marketplace to really pass that on to the consumer, and if they don’t, their margins are likely going to be squeezed.”

The U.S. producer price index for final demand increased 1% in March. On a 12-month basis, it rose 4.2% in its largest yearly gain since September 2011.

“The next big question is just how sustainable this pressure in the producer prices is. If we see a couple more months of very, very strong gains and no … rest in the future — in other words, no easing in the future from the supply chain — you’re going to see more pressure on the small caps, and that’s why I think it’s a pause at this point,” he said. “I’d rather be wary and not step into the trade just yet.”

Ari Wald, head of technical analysis at Oppenheimer, disagrees. He says weakness is the time to buy small caps, and he sees upside ahead.

“The Russell 2000 is pausing in an uptrend, so we do ultimately expect a new high above 2,360. In terms of support levels, it’s currently oscillating around its 50-day average at 2,235, followed by its 100-day average at 2,105,” Wald said during the same interview.

The small-cap index traded at nearly 2,234 by Monday’s close.

Wald says the rotation is key. Just as the Nasdaq lagged earlier this year before rebounding, he sees small caps performing similarly.

“Now that small caps have underperformed, that’s where our focus shifts, and I think within the small-cap space the standout here is small cap-growth,” said Wald.

Charting the IWO small cap growth ETF, Wald said a higher low in its daily relative strength index is a bullish development that suggests “selling intensity is abating.” That ETF has pulled back 11% from February highs.

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