This year's 'best' trades still deeply in the hole as crowd rushes in

Key Points
  • Corporate tax cuts benefit smaller companies, and value stocks are a better bet when the economy is accelerating and rates are rising.
  • Despite forecasts, these popular market plays are already deep in the hole for 2018, and it's still only January.
  • The momentum of the 2017 market trends carrying into this year has been strong as record amounts of money rush into equities.
Traders work on the floor at the closing bell of the Dow Industrial Average at the New York Stock Exchange on January 17, 2018 in New York.
Bryan R. Smith | AFP | Getty Images

Some of the most popular market plays for 2018 are already deep in the hole, before January is even two-thirds over.

A broad consensus had formed among strategists and money managers heading into the year along a couple of fronts: Small-cap stocks should begin outperforming big ones after lagging in 2017, and cheaper value stocks would close the performance gap with growth.

The reasoning was simple and clear: Corporate tax cuts will disproportionately benefit smaller companies with more domestic operations. And value stocks — which tend to be more cyclical — are a better bet when the economy is accelerating and rates are rising.

It's early, but neither trade is working well. And the fast start for the broad benchmarks means the performance differential is already pretty stiff.

Here's a look at how the very largest stocks, in the form of the Vanguard Mega-Cap Growth ETF (MGK), have easily outpaced the small-cap iShares Russell 2000 ETF (IWM).

Large versus small-cap stocks (MGK is blue, IWM is green)

The growth-over-value split is slightly narrower, but still pretty pronounced so far, with the iShares Russell 1000 Growth ETF (IWF) outpacing its value counterpart (IWD) by more than two percentage points so far in 2018.

Growth versus value stocks (IWF is blue, IWD is green)

So what did the crowd get wrong?

For one thing, the momentum of the 2017 market trends carrying into this year has been strong as new money has rushed into equities, at what Bank of America Merrill Lynch says is the heaviest four-week inflow in history. Investors are simply chasing the strength in the market and want broad exposure, rather than nuanced bets on particular segments linked to particular tax-exposure factors or style bets.

As a broad rule, stock sectors don't follow a policy script all that closely. For instance, when taxes on dividends were cut dramatically in 2003, dividend-rich stocks didn't outperform a rising market. Also, very large stocks often lead in the later phases of a bull market. And while the earnings-growth boost from lower taxes will be significant for many smaller stocks this year, that doesn't mean the market has decided to shun the giant growth stocks that promise double-digit profit gains for years to come.

That also explains why value stocks have done fine, but haven't kept pace with Big Tech and other growth leaders.

It might take substantially higher interest rates to get financial stocks — a huge chunk of value indexes— on a sustained surge, and to finally compress the valuations of those richly valued "organic growth" FANG-type names.

Not every popular call has come up short this month, of course. Strategists in general have been preaching the wisdom of tilting toward non-U.S. stocks, which as a group have been slightly outperforming the U.S. indexes. This also is a "tell" that the sped-up rally lately has been about a lot more than the Republican tax cut.

And banks are also a broadly loved group, for many obvious reasons relating to taxes, deregulation and higher rates. They've slightly outpaced the so far after lagging a bit last year.

Much can change as a year goes on; the leadership profile of the market shifted hard and unexpectedly in the first quarter last year from deeply cyclical and financial stocks to FANG-like growth giants.

As they say in sports, that's why they play the games.