For most of 2018, it paid to be small, as investors flocked to shares of midsize and small U.S. companies, hoping to protect themselves from the ravages of a trade war, and to capitalize on a U.S. economy that was outperforming the rest of the world.
By Aug. 31, the Russell 2000 (.RUT) had returned 7.5%, double that of the S&P 500 (.SPX).
But the end of summer marked a turning point for small-caps, which entered correction territory last week, closing at 1,546.68 on Oct. 12, down 11% from its recent high. The index has since taken back some of the lost ground, rising 3.24% so far this week, outperforming the S&P, up 1.6%, and the Dow Jones Industrial Average (.DJI) up 1.8%.
But small cap firms are still underperforming their larger cousins year-to-date, a state of affairs that caught Jim Smigiel, head and chief investment officer of absolute return strategies at SEI, off guard. "It's a little surprising in an age of rising concerns over trade," he said.
Indeed, the thesis that propelled small-cap stocks for most of 2018 relied on the idea that the Trump administration's push for higher tariffs would hurt large, multinational companies more than smaller firms with fewer international customers. Furthermore, corporate tax cuts were supposed to benefit small, domestic-focused firms more than multinationals, which typically already paid lower effective tax rates.
But as George Pearkes, macro strategist with Bespoke Investment Group, pointed out in a note to clients Tuesday, earnings estimates for the Russell 2000 didn't reflect the same optimism that these factors would grow future earnings — at least since summer.
"Since late June, Russell 2000 estimated next 12 months EPS have moved sideways, despite further growth for large cap EPS," Pearkes wrote. "Small cap earnings optimism has cooled as large cap earnings optimism has continued to accelerate."
Another factor at play is a sea change in investor thinking toward trade concerns. The chance that President Trump would pull the U.S. out of the North American Free Trade Association and devastate the supply chains of many U.S. multinationals made small-cap stocks an essential hedge. But those fears dissipated earlier this month, when the Trump administration agreed to a new North American trade pact with only minor revisions.
"The biggest development in this area has been Nafta," said Shawn Cruz, manager of trading strategy at TD Ameritrade. "That gave investors hope that we'll see deals pan out with China and Europe."
The final nail in small-caps' coffin was rising rates, as the yield on the 10-year Treasury note rose more than 20 basis points over the past month.
"Small-caps do carry some good amounts of leverage and debt on their balance sheets, and you start to see rates go higher without higher economic growth, that can really hit small cap performance," Cruz said. "A lot of these companies raised a lot of money when rates are low, and now they are going to have to roll that over into a higher rate environment."
Despite these concerns over higher rates, analyst said there may be reason to believe small-caps have found a bottom.
Pearkes pointed out that divergences between large-caps and small-caps are quite common, and usually reverse themselves in short order. The recent struggles for both large and small-cap indexes, according to Pearkes, is about readjusting expectations of forward earnings, and small-cap stocks simply had more readjusting to do.
"We think it's fair to describe the recent underperformance of small caps . . .as a healthy correction from one extreme to another, as opposed to the start of something more significant," Pearkes wrote. "That would suggest small-caps are worth a look here both on an absolute basis and relative to large-caps."
Another factor that could help power small-caps in coming months are the hundreds of billion of dollars multinational companies have been bringing back to the U.S., as the result of recent tax reform.
Craig Hodges, chief Investment officer of Dallas-based Hodges Capital, argued this money could be a tailwind for small-caps going forward.
"Big companies come up against the law of large numbers," he said. "A great way to power revenue growth is through acquiring smaller and midsize companies."
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