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Market View

Their domestic focus, a strong U.S. dollar, and tax cuts have all combined to give an edge to U.S. small-cap companies.

 

In Brief

  • Since February 2018, small caps have returned 3.6%, outperforming large caps by more than 6%.
  • Behind the turnaround are strong fundamentals, beneficial tax cuts, and a domestic focus that has boosted their competitiveness relative to large caps.
  • Small-cap relative valuations reached their lowest level since 2009 early in 2018.

 

According to Morningstar, large-cap stocks (as represented by the Russell 1000 Index) have significantly outperformed their small-cap peers (as represented by the Russell 2000 Index) since January 1, 2017, with the gap between large- and small-cap stock performance widening to nearly 11% by the end of January 2018.  Since February 2018, however, small caps have returned 3.6%, outperforming large caps by more than 6% and narrowing the gap since the start of 2017 to less than 4%.  Why has this turnaround occurred?

 

Chart 1. The Gap between Large-Cap and Small-Cap Performance Has Narrowed Since February 2018
Russell 1000 Index and Russell 2000 Index performance, January 1, 2017–May 1, 2018

Source: Morningstar. Large-cap stocks represented by the Russell 1000® Index. Small-cap stocks represented by the Russell 2000® Index. Past performance is not a reliable indicator or a guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Despite this year-long gap in returns, small-cap fundamentals have remained as strong, if not stronger, than their large-cap peers. As of May 18, 2018, 87% of companies within the Russell 2000 Index had reported first-quarter 2018 earnings and revenue figures, revealing blended growth rates of 42.41% and 9.88%, respectively, according to FactSet. Compare those figures to those of the S&P 500® Index, which reported a blended earnings growth rate of 24.37% and revenue growth of 8.20%.

This fundamental strength, coupled with lagging returns over the past 17 months, led the small-cap P/E premium (positive EPS only) earlier this year to reach its lowest level since 2009. And even with the strong relative performance of small caps in recent months, this premium still remains below the 2009-to-present bull-market average.

 

Chart 2.  Small-Cap Relative Valuations Reached Their Lowest Level Since 2009 Early in 2018
Russell 2000 price-to-earnings (P/E) ratio (positive EPS only) relative to Russell 1000 P/E, for the period March 9, 2009–May 25, 2018

Source: Bloomberg.  Small-cap stocks represented by the Russell 2000® Index. Large-cap stocks represented by the Russell 1000® Index. Past performance is not a reliable indicator or a guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

What might continue to drive this turnaround?

  • For one thing, there is the stronger U.S. dollar. Small caps are more levered to the domestic economy than are larger companies. They also are more likely to sell products domestically, insulating them from the currency translation impact of a stronger U.S. dollar and the resultant loss of competitiveness that their larger peers typically endure when the U.S. economy is strong.
  • In addition, their domestic focus largely insulates them from the trade uncertainties created by a U.S. administration determined to renegotiate global trade agreements—an environment that has added significant volatility to the large-cap market. While escalating trade wars stopped the broad S&P 500 in its tracks after the index hit record highs in January 2018, the Russell 2000 has held onto more of its gains, according to The Wall Street Journal.
  • Small companies also are benefiting, in part, from December’s tax cut, which slashed their average tax rate, from 35% to 21%. This compares with the effective tax rate for large-cap companies, which has fallen, from roughly 27.5% to 22.5%, according to estimates from Credit Suisse. As of May 10, 2018, companies within the Russell 2000 had paid $9.2 billion less in taxes in the second quarter of 2018, compared with the fourth quarter of 2017, as reported by International Business Times.

Conclusion
While there, of course, remain stock-specific opportunities across all market-cap segments, the burgeoning outperformance of small-cap stocks in recent months is in line with the “small-cap” premium that has been observed historically over longer-term periods.

It’s worth mentioning as well that the global economy is beginning to exit the liquidity-driven, quantitative-easing environment of 2009–15 that has been the chief catalyst for large-cap and mega-cap outperformance. In the current market environment, with earnings and revenue growth, rather than liquidity, driving equity returns, investors may be wise to consider small-cap stocks and, perhaps more important, to identify fund managers who have the flexibility to capitalize on opportunities across all market-cap segments, as fundamental strength begins to be recognized across the capitalization spectrum.

 

A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. No investing strategy can overcome all market volatility or guarantee future results.

Diversification does not guarantee a profit or protect against loss in declining markets.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. Past performance is not a guarantee or a reliable indicator of future results.

Glossary of Terms

The price to earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings.

The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.

The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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