The post-election rally in small cap stocks has slowed dramatically as investors grow concerned that President Donald Trump's promises of corporate tax cuts and infrastructure spending face delays, the Wall Street Journal reports. These programs were anticipated to have a disproportionately positive impact on small businesses. Since the start of 2017, big cap stocks have taken over leadership of the market.

Role Reversal

From Election Day until the end of 2016 - a span of less than two months -  the small cap Russell 2000 Index soared by 14% while the large cap S&P 500 Index (SPX) rose a still impressive 4.6%, the Journal notes. So far in 2017, the Russell is up by 2.5%, less than half of the S&P's 6.2% gain, as of the open of trading on Monday.

Another troubling sign is that trading in Russell 2000 index futures is further registering a flip towards bearish sentiment, according to the Journal. In the first week of 2017, speculative long positions reached a record 209,000 contracts, per data from the CFTC​. By March 14, this figure had dropped to 141,000 while speculative short positions hit their highest mark since 2008, at 166,000 contracts.

Source: The Wall Street Journal

Policy Impacts

Since small companies typically pay higher effective corporate tax rates than large multinationals, Trump's proposed tax cuts should boost average earnings per share (EPS) among Russell 2000 companies more significantly than for S&P 500 corporations. Delays in enacting this program are leading to disappointment among investors, the Journal says, and perhaps also some degree of skepticism.

Consensus is building among Wall Street analysts and strategists that tax cuts, even if passed, will not take effect in 2017. Meanwhile, Republican leaders in Congress have given health care overhaul a higher priority than tax reform, according to the Journal. Moreover, the Republican leadership does not want tax cuts to swell the federal budget deficit, and the Republican rank and file is far from a consensus regarding details of how the tax code should be revised, the Journal adds.

As the Federal Reserve moves to raise interest rates, small cap companies are being hurt more than larger corporations. Equity strategist Dan Suzuki of Merrill Lynch, a division of Bank of America Corp. (BAC), told the Journal that the fastest increase in debt burdens relative to earnings growth recently has been among small cap firms. He also has found that small cap stocks lagged large caps in four of the five previous cycles of credit tightening by the Fed since 1987. (For more, see also: The Fed, Wall Street, Economists Love Rate Hikes.)

A Secular Down Cycle For Small Caps?

Since 1925, small caps typically have long bull or bear cycles lasting a decade or more, Suzuki told he Journal. Apart from their post-election surge, he added, small caps have lagged large caps for about five years, raising the possibility that their spectacular performance at the end of 2016 was only a temporary reversal of trend.

 

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