Can small cap outperformance continue?Contributor David Lebovitz
Small cap stocks have underperformed their large cap brethren year-to-date, but small cap outperformance over the past couple of months has led this gap to narrow considerably. Some of this outperformance stems from a change of tune in Washington, as developments over the past few weeks suggest that the policy pipeline is becoming unclogged and that there is a chance for corporate tax cuts to become reality in the coming months. While a tax cut would benefit small cap stocks more than large cap stocks – as the effective tax rates of small companies tend to be higher than large ones – there are other reasons to be optimistic that this strong run of performance from small caps can continue into the end of the year.
First, earnings growth for smaller companies looks quite healthy. While painting with broad brushstrokes in this asset class can be dangerous, consensus estimates are for Russell 2000 earnings to grow 28.2% over the next twelve months, versus estimates of 10.9% for the S&P 500. Additionally, the strength seen in domestic growth over the summer and into the fall suggests that the U.S. economy may have recorded a second quarter of above trend economic growth in 3Q17, another tailwind for small cap equities. Finally, and as shown in the chart below, small cap stocks tend to outperform large cap stocks when interest rates are rising – given our expectation for continued policy normalization by the Fed, further tapering from the ECB next year, and a backdrop of healthy global growth, the path of least resistance for interest rates continues to be up. As such, we believe there are reasons outside of prospective policy changes to be optimistic about small cap performance into the end of the year.
Small caps tend to outperform when interest rates rise
S&P 600/S&P 100, 10-year U.S. Treasury yield, weekly
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The value of investments and the income from them can fall as well as rise and investors may not get back the full amount invested. Past performance is not a guide to the future.