Small cap stocks are badly trailing their larger rivals in 2017, based on expectations that they will lag significantly in earnings growth, according to the Wall Street Journal. A large part of the problem for small caps is that they tend to derive virtually all their sales revenue from domestic customers. Meanwhile, analysts at RBC Capital, a division of Royal Bank of Canada (RY), find that worldwide economic conditions have turned more favorable for U.S. companies with significant sales abroad, per the Journal.

From the Election Day close to the close on Tuesday, two widely followed small cap benchmarks, the Russell 2000 Index (RUT) (up 15.2%) and the S&P 600 Index (up 15.3%) have outpaced the large cap S&P 500 Index (SPX) (up 10.0%) and the Nasdaq Composite Index (IXIC) (up 13.0%). However, the momentum in small caps petered out by early December. Since the start of 2017, the respective increases in these four indices have been 1.5%, -0.1%, 5.1% and 9.0%.

Earnings Growth Diverges

Earnings for the large cap S&P 500 are projected to rise 8.9% in the first quarter, versus the same period in 2016, according to the April 7 Earnings Insight report by FactSet. This is down slightly from the 9.1% growth rate previously reported by FactSet. (For more, see also: A Corporate Profit Grand Slam May Not Lift Stocks.)

By contrast, first quarter earnings for the small cap S&P 600 Index are projected to rise by only 1.4% ($8.11 vs. $8.00) from the same quarter last year, per data from Thomson Reuters I/B/E/S cited by Yardeni Research, Inc. in their Stock Market Briefing: S&P 500/400/600 Weekly Forward Earnings & Valuation report dated April 10.

 

 

Global Conditions Improve

Domestically focused small caps outperformed larger companies when the U.S. economy was growing at a faster rate than economies abroad, and when a strong U.S. dollar hurt larger, more global companies, by suppressing demand for their exports or by reducing the U.S. dollar value of earnings recorded in foreign currencies. Now the situation has reversed, the Journal says. Economic risks have dropped around the world, and U.S. companies with global sales are reaping the benefits.

The RBC Study

RBC Capital looked at the large cap S&P 500, dividing each industry sector in half, according the the percentage of sales generated outside the U.S. by each company. The analysts found that first quarter earnings for the companies with lower international sales are projected to rise only 3.3% in the first quarter versus the same period a year ago, barely a third of the robust 9.9% revenue growth projected for the companies with larger international revenue exposures, the biggest spread in five years, the Journal reports. This would be only the third straight quarter in which the more global companies led, after four years in which the more domestic companies did better, the Journal adds.

The Journal article assumes that the findings of this large cap study are relevant to small caps as well, but that is open to debate. Also, movements in exchange rates, and the accounting conventions for converting overseas revenues into U.S. dollars, have potentially large impacts on the analysis.

Other Obstacles for Small Caps

Small cap stocks also typically lag large caps during periods of credit tightening by the Federal Reserve Board, in part because their debt burdens relative to earnings tend to rise faster. Also, since small caps typically have higher tax burdens than large caps, delays in enacting corporate tax cuts promised by President Trump are leading to disappointment among investors. (For more, see also: Why Trump's Small Cap Rally Is Flaming Out.)

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