Market Memo: We're still bullish on small caps

09-19-2017

Small companies have been challenged recently as the much-anticipated Trump-inspired rally based on tax cuts, infrastructure spending and deregulation has stalled. Although up 4.4% year-to-date through August, the small-cap Russell 2000 Index was down 1.3% for that month, trailing the positive return of 0.3% for large caps as represented by the Russell 1000 Index. The pullback was driven by an abundance of rhetoric out of Washington centered on the conflict with North Korea and the possibility of a government shutdown. A weak dollar also favored large multinationals.

All that said, we see several factors that support a small-cap rebound:

  • Although delayed, Trump’s agenda will progress. Job security is a powerful incentive and Republicans know they need some legislative accomplishments if they want to keep their jobs and maintain control in Congress.
  • Latest research supports small caps. Renaissance Macro, a respected third-party research firm, is forecasting greater than 20% earnings-per-share growth for small caps versus less than 10% for large caps.
  • Small caps are attractively valued.  Small caps are some 10% undervalued based on the relative price-to-earnings ratio for the trailing 12 months.  The average ratio is 1.07, but was at just 0.96 at the end of August.
  • This small-cap cycle has room to run. According to a FTSE Russell study on small-cap business cycles since 1978, the average duration of a cycle is 700 days with cumulative returns of 107%. A cycle is defined as the bottom after a greater than 20% decline until the next peak. The current small-cap cycle began on Feb. 11, 2016. That is just over 400 trading days, and the cumulative return has been only 49%, as of Aug. 31 of this year. That means we are just over halfway through this cycle with a lot of upside remaining.

All told, we believe the current small-cap cycle has been interrupted, not stopped. With earnings expected to improve, an overall positive economic backdrop and prospects for tax reform ahead, we see the Trump trade likely to resurface, driving momentum for small caps with it.