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This chart of small-caps rolling over shows market rally is hinging on tax reform

  • The Russell 2000 took a big hit on Monday, falling more than 1 percent, after Bloomberg News reported that the House is considering a plan that would gradually lower the U.S. corporate tax rate.
  • Most investors figured the tax cuts would be immediate rather than gradual.
  • The sharp downturn in small-cap stocks raises a flag the market may have priced in corporate tax cuts to a greater extent than previously thought.
A man has his photo taken hanging from a bull sculpture outside Las Ventas bullring during San Isidro's bullfighting fair in Madrid, Spain.
Susana Vera | Reuters
A man has his photo taken hanging from a bull sculpture outside Las Ventas bullring during San Isidro's bullfighting fair in Madrid, Spain.

The sharp downturn in small-cap stocks on Monday is raising a flag with investors that the stock market may have priced in corporate tax cuts to a greater extent than previously thought.

The Russell 2000 took a big hit on Monday, falling 1.15 percent, after Bloomberg News reported that the House is considering a plan that would gradually lower the U.S. corporate tax rate. The plan being discussed by the House would leave the corporate rate at 20 percent by 2022. The gradual plan "has been considered" but is not final, according to the report. Most investors figured the tax cuts would be immediate rather than gradual.

The index is made up of shares of small-cap companies, which have more to gain from an immediate domestic tax cut since they are more likely to be U.S.-based and not sprawling global entities.

Below is an intraday chart of the Russell 2000 from Monday's session. In it, you can see the index rolling over at approximately 11:15 a.m. in New York, when the report hit.

"I would say a lot of it has been priced in, at least if you look at the Russell 2000 as a proxy for the beneficiary of lower taxes," Peter Boockvar, chief market analyst at The Lindsey Group, told CNBC's "Halftime Report."

Stocks, both large- and small-caps, have risen to record highs this year, with experts mainly attributing the rally to an improving global economy and a surge in corporate earnings growth. Tax reform expectations had dwindled earlier in the year as the Trump administration suffered policy setbacks and personnel changes.

But expectations of tax cuts have increased recently after the House passed a budget plan backed by the Senate last week. The budget's approval in the House lets the Senate pass legislation with a simple majority, instead of the 60-vote supermajority typically needed to end debate and move a bill to a vote.

"To the extent that tax cuts are priced in, you're going to see that in small caps," said Art Hogan, chief market strategist at Wunderlich Securities. "The problem with this is that it's a test balloon," he said, noting investors don't know what the final tax cuts will look like.

Hogan added stocks could take a hit if tax reform is scrapped. That would be "a disappointment and some of that has been priced in." He sees that as unlikely, though.

The major large-cap U.S. indexes — the Dow Jones industrial average, S&P 500 and Nasdaq composite — are up at least 14 percent in 2017. The Russell 2000 has lagged the large-cap indexes this year, but is still up nearly 10 percent and has also notched new all-time highs.

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