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Small caps could be sending a warning for the whole stock market

  • Large cap companies in the S&P 500 are having a solid earnings season with double digit profit growth, but small caps are seeing a flat quarter at best, according to Jefferies.
  • Analysts say the difference is that S&P 500 companies benefit from dollar weakness and growth outside of the U.S.
  • Small cap companies are more domestically focused.

The second quarter earnings period has been a dud for small caps, and that could be a warning for large cap names, which have seen a surprisingly strong quarter with profit growth near 12 percent.

"The large cap multinationals are getting a tailwind from currency and they're getting better growth outside the U.S., and small caps are more domestically focused," said Steven DeSanctis, small- and mid-cap analyst at Jefferies.

In contrast to the double digit gains for S&P 500 company profits, DeSanctis said the small cap S&P 600 was expected to see earnings decline 2.5 percent, a number that could be closer to flat, when counting companies that have already reported.

"I'm thinking the best we're going to do for the quarter is maybe flat," said DeSanctis. According to Thomson Reuters, the profit growth for the large cap S&P 500 for the second quarter is near 12 percent, when including those companies that reported along with estimated results.

Even though the small cap Russell 2000 is up just 4 percent for the year, the index is trading on an earnings multiple of 20 times forward earnings. DeSanctis expects the Russell 2000 to end the year at 1410. The Russell closed Monday at 1414.

"They're hovering very close to our overall target. We got to 1,430 and then they pulled back. I just don't see the upside in small, given the earnings numbers. You're going to need sustained earnings growth because we have a multiple of 20 times. You can see performance tracing earnings growth, but there is no earnings growth," DeSanctis said.

Credit Suisse U.S. equity strategist Lori Calvasina notes that the divide is clear, and small cap companies are also lagging mid caps. Of medium cap companies, 74 percent have beaten earnings forecasts, but just 61 percent of small cap Russell 2000 stocks have beaten.

"We think this is at least partially explained by the more positive impact of a weaker dollar on mid and large caps, which have higher international exposure than small caps," Calvasina wrote. Of small and large cap companies, she said, 70 percent of the companies with high international exposure beat consensus sales expectations, compared to 59 percent of domestically focused companies.

"The only way you get double digit earnings growth for small cap is the economy grows closer to 3 percent [GDP] growth, and we just don't see that," DeSanctis said. He said the small cap names usually beat estimates by three to four percent, but that's not happening this quarter, and it could weigh on the group.

"You think you're out of this earnings recession, and you look at Q2 and small cap has fallen back into an earnings recession. The question is, are they the canary in the coal mine, where their earnings slowed in the last two quarters, relative to large and does large start to face that same thing?" said DeSanctis.

He said earnings growth was in the mid-single digits, compared to about 15 percent for the S&P 500 in the first quarter. Third quarter forecasts are coming in at about 3 percent growth, but they were about 8 percent in June, he said.

Calvasina said reporting season has been challenged for small cap energy in particular, but the results for financials were solid. The companies left to report in small and mid cap this week are largely consumer, dominated by retail, industrials, tech and health care, especially biotech, she noted.

In a recent note, Barclays analysts said they expect earnings growth and fundamentals to improve for small caps, as the year goes on. They have a target of 1440 on the Russell 2000, saying that top line growth should be helped by a recent pickup in capital spending and leverage.

DeSanctis said small cap ETFs last week saw inflows of over $2 billion , reversing outflows in three prior weeks. But he expects to see outflows again based on earnings, and also on possible volatility due to Washington this fall.

Like the broader stock market, small caps could feel the ill effect of any budget battle when Congress returns from its break in September. The debt ceiling also needs to be raised, and it's yet to be seen whether there will be drama around that.

On the other hand, if Congress were to work on tax reform, that could potentially be a positive for small cap companies.

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