Market Memo: The small-cap case is solid


Even though U.S. small caps lagged the broader market in 2017’s exceptional year for equities, we believe current support for the asset class is strong. In fact, given their historical outperformance relative to larger caps over long periods of time, small caps could be poised to outperform this year, aided by three key drivers:

  1. Trumponomics should have an outsized positive impact on small caps relative to larger cap stocks. Here’s why:

    Recently enacted tax reform should provide a bigger boost to small caps, most of which had been paying a higher effective rate. Because of numerous loopholes, the effective rate for large corporations is already lower than that of their small-cap counterparts.
    Repatriation of foreign cash is expected to be used to make strategic acquisitions, which happen mostly at the small-cap level. Larger companies pay share price premiums to acquire smaller companies in order to solicit shareholders' approval of the deal.
    Infrastructure spending, assuming some sort of bill eventually passes, will happen at the local and regional levels, supporting the stocks of small businesses that operate at these levels.
    Regulatory relief is helping many small businesses, including regional banks that are no longer required to spend money on compliance with regulatory mandates. Lower costs should drive earnings growth for companies under looser regulations.
  2. There may be room to go in this small-cap business cycle. The average small-cap business cycle lasts an average of 750 trading days and has resulted in cumulative returns of 134%.1 The current cycle began on Feb. 11, 2016. As of Feb. 6, 2018, it has lasted 504 trading days and has produced a cumulative return of 63%. We believe this cycle could last longer and generate above-average returns given Trumponomics and recent underperformance of small caps.
  3. Valuations are attractive based on relative P/E ratios. The P/E ratio of small caps relative to large caps was 0.99 as of Jan. 31, 2018, more than one standard deviation below its historical average of 1.15.2 In other words, small caps are relatively cheap from a P/E perspective. 

All told, we believe the current small-cap cycle is set for a rebound. With an overall positive economic backdrop and the benefits from tax reform and deregulation taking hold, we see the Trump trade likely to accelerate, driving momentum for small caps with it.

1 Source: FTSE Russell, from December 1978 to current. A small-cap business cycle is measured from the bottom of a more-than-20% correction in the Russell 2000 Index to the next peak.

2 Source: Morningstar.