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Small-cap stocks have been on fire lately, but will soon face a major test

Key Points
  • Small-caps have been leading the market, but they face potential earnings season turbulence because they're not expected to be able to show earnings growth.
  • The small-caps have rebounded most on corporate tax proposals since they pay more taxes on average than S&P multinationals.
Traders work on the floor of the New York Stock Exchange (NYSE) in New York as the Dow surpasses 22,000.
Bryan R. Smith | AFP | Getty Images

Small-cap stocks have led the latest leg of the stock market rally, but they may hit turbulence during earnings season when small companies are expected to report shrinking profits.

The major stock market indices closed at record highs for a second day Tuesday, with the Russell 2000 up just barely to 1,511 for an eighth day of gains. But the formerly lagging Russell has been outperforming and is up 11.2 percent since its Aug. 21 low, while the S&P 500 is up just 4.3 percent in that period.

The promise of tax reform has lifted the smallest stocks more dramatically than the rest of the market because small-caps pay among the highest tax rates, averaging around 33 percent compared with the average of 27 percent for big multinationals.

Can the rally in small caps continue?

But the fact that the group is expected to see an earnings decline this quarter could make for some bumps in the next couple of weeks, once earnings reports start rolling in later in the month. The trend has been negative.

"Earnings growth looks negative 2.4 percent in the third quarter. Second quarter was minus a half percent. No earnings growth, but the market is going higher," said Steven DeSanctis, small- and mid-cap equity strategist at Jefferies.

DeSanctis said the small-cap price-to-earnings ratio is also the highest it's been in 16 years, at 21.3 times forward earnings. "If you remember in 2001, you had 9/11 compression of earnings so valuations looked a lot higher because the earnings number looked a lot worse," he said. "That pushed it up … but once earnings kicked in, it went back to normal levels."

DeSanctis said earnings should improve by the fourth quarter, gaining 13 percent for a total 5 percent gain for the year.

His target for the Russell is 1,410 for the year, and he has not changed it despite the index's rally. "If the earnings numbers are better than forecasts, I would say I'm wrong," he said.

The market is revisiting some of the reflationary trades it made shortly after Trump was elected. "It's basically a little frothy, just as we saw in the fourth quarter last year. We get awful frothy on what's going to happen in Washington," DeSanctis said.

He said a risk to the market is that it is being boosted by the promise of tax cuts. "I think obviously the earnings season is a big thing because then we get to fundamentals. That's the next week or two. The tax plan will get more details," he said. Headlines from Congress could be negative if legislators disagree on what the tax bill should contain. However, if it is approved as expected, earnings growth should pick up, a positive for the group.

Small-cap leadership is typically viewed as a good thing for the market. "I think it's a positive sign. As the adage goes, the soldiers lead the generals," said Marck Luschini, chief market strategist at Janney Montgomery. But Luschini said the group is overbought, and it would make sense if they took a pause or traded sideways for a while in the near future.

Wednesday's market is watching ADP employment data at 8:15 a.m. There is also services PMI at 8:45 a.m., and the ISM nonmanufacturing data at 10 a.m. ET.

Earnings are expected from Monsanto and Pepsico.

Fed Chair Janet Yellen makes remarks at 3:15 p.m. at the fifth annual Fed/CBCS community banking conference.

 WATCH: Talk of tax reform spikes Russell 2000

Talk of tax reform spikes Russell 2000