Small-caps were surging along with the broader market Thursday as the House passed its tax bill, and for the sector to keep rallying, tax reform needs to look like it will get through Congress.
"This week and recently, the reason for the decline was people were increasingly wary that the tax deal would not pass," said Sam Stovall, chief equity analyst at CFRA. Stocks rallied sharply Thursday after a week of choppy trading, and the decline in small-caps was particularly worrying as traders watched to see if it was a harbinger of a bigger sell-off.
"I think if we do get a tax cut, that's going to give [small-caps] a shot in the arm because they would be the biggest beneficiary of a tax cut," said Stovall. "It's sort of like the divergence between transports and industrials. If you have a divergence between the small-caps and large-caps, they could end up dragging down or curtailing the large-cap move. Seeing them rebound is encouraging for me."
Steven DeSanctis, equity strategist at Jefferies, said small-caps took off when President Donald Trump discussed tax reform in August and have been trading on tax hopes ever since. But DeSanctis is more negative on the group and said the small stocks may defy their long-term trend of rallying into the end of the year because of the gains they have already made, their lack of earnings growth and uncertainty from Washington. He also believes they could decline from current levels.
"Third-quarter reporting season has not been anywhere near that of the large-caps," said DeSanctis. He said the earnings for Russell 2000 companies are flat to up just 1 percent, better than the expected several percentage point decline, but well below the more than 8 percent earnings gain in third-quarter S&P 500 companies.
The pattern for small-caps since 1996 on average has been to rally in the last two months of the year, in an early January effect, and continuing to rise into January. The small-cap Russell 2000 was up 1.6 percent Thursday, but is up just 9.5 percent year to date, compared to the 15.5 percent gain in the or the 26 percent gain of Nasdaq.
The small-caps, lower quality stocks and market laggards for the first 10 months usually bounce back in November and December, with follow-through into January. DeSanctis said a January effect takes place after tax loss selling season ends and it typically coincides with the end of the mutual fund fiscal year Oct. 31. But it's unclear what has happened to tax selling this year as details of a final tax plan are awaited.
In years where small-caps trailed after 10 months of the year, they continued to lag into November and December with a potential for a big pop in January. But DeSanctis said what will happen at the end of the year or January is still unclear.
"Now you're [Russell 2000] trading at 21.5 times earnings with no earnings growth, so everything goes back to the tax proposal and the boost those stocks should get, but you just don't know what that will be," said DeSanctis.
The small-cap group, however, may have some technical strength in its corner currently.
"Two days ago the small-caps looked a lot more concerning but so did the market," said Scott Redler, partner with T3Live.com. Redler follows the short-term technicals of the market and says the recent weakness in the Russell looks transitory. He tracks the iShares Russell 200 ETF, IWM.
"If we're going to get that end-of-the-year move, there's no reason why the small-caps won't participate. After looking a little vulnerable, it looks like the small-caps reclaimed most moving averages and are back on the radar," he said. Redler said the Russell turned positive first on Wednesday, showing some strength while the Dow was down sharply, and that was the first sign of relative strength in the Russell in awhile.
The House approved its version of the tax bill Thursday afternoon, as stocks traded near highs of the day. The Senate version of a tax-reform bill has yet to be voted on, and then the two will have to be sorted out in conference. Small-caps have been the positive poster child for tax reform, since they stand more to gain from a proposed 20 percent tax rate than large-caps. Small-caps on average have a tax rate of more than 30 percent, while large-caps are closer to 25 percent.
DeSanctis said the overall market would be a lot weaker without the promise of tax reform. The Russell closed at 1,486 Thursday. "Our target is 1,410. That would give you about a 5 percent return for this year, but we're up 8 or 9 percent," he said.
DeSanctis said the market should track earnings growth, which is expected at about 5 or 6 percent for 2017, if there's a rebound in fourth-quarter earnings. Next year's earnings growth is expected to be above 20 percent, but DeSanctis said the forecast, which doesn't include tax-cut benefits, is too optimistic.
Small-cap earnings didn't have the benefit from energy companies that helped large-cap profits. DeSanctis said the small-cap services firms were still seeing losses. Meanwhile, S&P energy profits rose 150 percent in the third quarter, according to CFRA.
"They've [small-caps] lagged by a pretty wide margin, and generally when you lag by a pretty wide margin, you continue to underperform," DeSanctis said. "Frankly, December has a lot of potential issues, whether it's budget, tax reform, the debt ceiling. We have the Fed raising rates in December."
Nili Gilbert, co-founder and portfolio manager with Matarin Capital, said her firm has developed a forecast of relative returns between small-cap and large-cap stocks, and it currently looks "almost perfectly neutral between the two — we expect small- and large-cap stocks to perform similarly in the intermediate term."
Gilbert said the market drivers that favor smaller stocks are on the basis of sales and cash-flow yields. She said the positive longer-term trend in the dollar is also positive for smaller stocks, which earn more revenues domestically.
"But in our view, these drivers are balanced out by other indicators which are more favorable for larger stocks. Some of these include the fact that we are forecasting a reversal in credit spreads after a long-term narrowing cycle, and also the fact that we see intermediate-term momentum favoring large over small after such a strong large-cap rally this year," she said in an email.
According to Strategas, 33 percent of the Russell 2000 stocks are not profitable. Unprofitable companies as a percentage of the Russell reached highs of 44 percent and 39 percent around the last two recessions.
WATCH: The last time the Russell 2000 did this was in 2015, and the market paid a price
