US small caps have become a resurgent asset class recently with the Russell 2000 Index up 7.5 percent in September, while the S&P SmallCap 600 Index is up by almost 9 percent over the same period.
In addition, several small-cap exchange traded funds (ETFs) hit all-time highs this week, with Tuesday seeing the peak as investors flock back to some of these funds.
The Trump administration’s tax reform efforts have previously been viewed as a boost for small-caps stocks and ETFs. But some observers suggest markets may have already priced that news in, leading to a view that smaller companies need more than a tax overhaul to move higher, and making the small-cap future outlook far from rosy.
‘US small caps enjoyed a performance boost after the November election on hopes of a corporate tax cut and pro-growth policies. But they failed to capture an edge on US large caps until August, when prospects for tax reform regained momentum,’ writes Richard Turnill, BlackRock global chief investment strategist, in a commentary note published online on Tuesday.
‘US small-cap returns have outpaced those of their large-cap counterparts by more than 7 percentage points since August 21. But the earnings outlook is less bright. Analysts have been downgrading small companies’ earnings expectations throughout 2017. In short, we believe a sustained run in US small caps will require more than lower taxes.’
Small caps could be vulnerable, particularly if tax reform does not materialize, because these stocks have other issues to contend with, including the weak dollar and lagging earnings.
‘Strong global economic growth and a weaker dollar are boons for large multinationals, which derive more of their profits overseas,’ adds Turnill in the commentary note. ‘Small-cap earning estimates are also lagging. Analysts have revised down their 2017 and 2018 estimates by 8 percent and 6 percent, respectively, year to date. This compares with downgrades of just 1 percent and 2 percent for large caps. But the trend is not new: analyst downgrades of small-cap earnings estimates have outnumbered upgrades since 2011.’
