John Lynch Chief Investment Strategist, LPL Financial
Small caps are having a strong year, with the Russell 2000 Index up nearly 6% year to date, versus about 2% for the S&P 500 Index. We came into this year expecting small cap outperformance, and after a slow start in early 2018 they have delivered in recent months. Many factors have aligned to drive continued potential leadership from this group. Here we highlight three keys to our small cap outlook.
THREE KEYS TO SMALL CAP OUTLOOK
Small caps continue to look very strong from a technical point of view. The Russell 2000 Index bottomed for the calendar year on February 8, 2018, and it has gained more than 11% since then, nearly doubling the return on the S&P 500 over this period. As Figure 1 shows, the February lows took place right at support on an upward sloping trend line. This successful retest of a previous resistance line is exactly what we wanted to see, and the subsequent acceleration higher bodes well for continued strength from small caps.
Another important clue that the small cap strength may be here to stay is market breadth. One of our favorite measures of market breadth is the advance/decline (A/D) line, a cumulative measure of how many stocks are participating in a market move. From a technical perspective, it is important for sustainable market index moves higher to be confirmed by rising A/D lines. Fortunately, the S&P 600 Small Cap A/D line recently made yet another new all-time high, further confirming small cap strength and increasing the potential for continued new highs [Figure 2].
From a contrarian point of view, small caps also offer an opportunity for suitable investors. According to recent Morningstar data, small cap equity funds have seen outflows for 14 consecutive months. This suggests there could be ample room for flows that could push small caps solidly higher as sentiment improves.
As we discussed in Outlook 2018: Return of the Business Cycle, small caps were one of our favorite areas for equity strength this year. A potentially higher U.S. dollar, cyclicals leading, and, most importantly, corporate tax reform were all reasons we liked the group.
We expected cyclicals to do well this year, as the economy continued to surprise to the upside, another trend we think may continue. Historically, small caps do better than large caps when cyclicals (technology, financials, industrials) do well. Moreover, the tax rate for small caps is an estimated 5% higher on average than for large caps. The tax reform passed in late 2017 is expected to continue to be a major tailwind for the group.
Here’s the catch, though: Small caps lagged large caps last year and again—by a wide margin—earlier this year. That all changed once risk of a potential trade war with China began to heat up. While risks have lurked at the edges, they started to come into focus following President Trump’s announcement of a 25% tariff on steel imports on March 1, 2018. The Russell 2000 has added nearly 8% since then, versus less than a 2% gain for the S&P 500. Why have small caps done so well with the threat of a trade war? For starters, small caps get about 20% of their revenue from overseas, compared to roughly 40% for S&P 500 companies.