In recent weeks, U.S. small caps have become a resurgent asset class. For example, the widely followed Russell 2000 Index is up 7.5% over the past month, while the S&P SmallCap 600 Index is higher by almost 9% over the same period. In addition, several small-cap exchange-traded funds (ETFs) hit all-time highs on Tuesday, and investors have recently been flocking back to some of these funds. With those points in mind, investors would be right to ponder if they have missed the recent bounce in small caps or if there is more upside to be had with smaller stocks.
The Trump Administration's tax reform efforts have previously been viewed as a catalyst for small-caps stocks and ETFs, but markets may have already priced that news in, leaving some market observers to opine that smaller companies need more than a tax overhaul to move higher. (See also: An Introduction to Small-Cap Stocks.)
"U.S. small caps enjoyed a performance boost after the November election on hopes of a corporate tax cut and pro-growth policies," said BlackRock in a note out Tuesday. "But they failed to capture an edge on U.S. large caps until August, when prospects for tax reform regained momentum. U.S. small-cap returns have outpaced those of their large-cap counterparts by more than seven percentage points since Aug. 21. But the earnings outlook is less bright. Analysts have been downgrading small companies' earnings expectations throughout 2017. In short, we believe a sustained run in U.S. small caps will require more than lower taxes."
Still, investors are displaying enthusiasm for small-cap ETFs. For the week ended Oct. 9, the iShares Core S&P SmallCap ETF (IJR), which tracks the aforementioned S&P SmallCap 600 Index, added $331 million in new assets, a total surpassed by just seven other ETFs. In the third quarter, IJR and the iShares Russell 2000 ETF (IWM) added $1.6 billion and $1.59 billion, respectively, in new assets. (See also: A Big Battle Among Small-Cap ETFs.)
Small caps could be vulnerable, particularly if tax reform does not materialize, because these stocks have other issues with which to contend. Those issues include the weak dollar and sagging earnings.
"Strong global economic growth and a weaker dollar are boons for large multinationals, which derive more of their profits overseas," said BlackRock. "Small-cap earnings estimates also are lagging. Analysts have revised down their 2017 and 2018 estimates by 8% and 6%, respectively, year to date. This compares to downgrades of just 1% and 2% for large caps. The trend is not new. Analyst downgrades of small-cap earnings estimates have outnumbered upgrades since 2011." (See also: 5 Ways Tax Reform May Boost Stocks.)