Small Caps Continue to Surge

Earnings and sales growth top large caps

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Aug 30, 2018
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The stellar quarterly earnings growth recently reported by many corporations has by no means been confined only to those large companies in the S&P 500. The Russell 2000 has continued its unbroken ascent, increasing 12% since the beginning of the year and logging 28 record closes. This beats the year-to-date 8.5% increase of the S&P 500.

Indeed, a comparison of the two sectors demonstrates that not only has the Russell 2000 participated in the recent bonanza of solid earnings growth reported by larger companies, but, for some indexes, smaller caps have exceeded larger ones.

These sterling results of the small-cap index bested the S&P 500, posting increased profits and sales of 25% and 10% respectively.

One of the inherent risks for the small-cap sector is that it can be more volatile than the rest of the overall market and, hence, is subject to precipitous reversals. But for the moment, as evidenced by its continued surge, many investors, for the moment, seem to feel that any economic fallout from the trade disputes between the U.S. and China will disproportionately impact larger companies more so than their smaller counterparts.

There are a number of factors that support this view.

The rise of the small-cap index indicates investors still believe larger corporations have greater exposure to the negative financial ramifications of a trade war. Figures provided by FactSet show approximately 38% of S&P 500 companies' earnings are generated from overseas operations; for companies in the S&P Small Cap 600, that figure is 20%.

By comparison, the heady performance in the small-cap sector reflects the fact that the fortunes of these companies are more dependent on the ebbs and flows of the domestic economy than are the multinationals.

The converse, however, may also be true: on news of reduced trade tensions within the past week, the S&P 500 gained 1%, while the increase in indexes that track smaller-cap companies, including the Russell 2000 and the S&P 600, rose only 0.2%. Despite this differential, on an annualized basis, small caps still have outperformed the S&P 500.

Both large- and small-cap sectors have benefited from the reduced corporate tax rates. However, the benefits of the lower rates disproportionately inure more to smaller companies since most of their revenue is derived from sales in the U.S.

An environment of deregulation in conjunction with reduced tax rates have bolstered confidence in prospects for growth on the part of small business managers. Small companies tend to pay higher effective corporate tax rates than multinationals, so the benefits from a reduction in rates was particularly pronounced.

But there are additional reasons beyond any advantages enjoyed by small caps due to their relative immunity from deleterious effects from retaliatory responses to trade restrictions imposed by the U.S.

Smaller companies have been the beneficiary of continuing strong consumer spending and confidence as well as a robust economy that has seen 4.1% gross domestic product growth — its highest level in four years. Small business owners expect that strong sales will continue for the remainder of the year. According to Michael O’ Keeffe, chief investment officer at Stifel Nicolaus & Co., earnings for the Russell 2000 for the third quarter are expected to increase 37% over the prior year.

Given a buoyant economy and an environment of relatively low interest rates, it should come as no surprise that small business owners' outlook for the future remains as ebullient as it was for the first half of the year. The Small Business Optimism Index reached its second-highest level in 45 years, according to The National Federation of Independent Business.

The performance of the small-cap sector, for now, mirrors this confidence.

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