US Markets

This part of the stock market is riding high as most companies struggle under trade war tensions, other worries

Key Points
  • The small-cap benchmark Russell 2000 index is up 3 percent so far this year and is just 2 percent away from a record.
  • Jefferies believes earnings growth for small-cap companies could be as high as 20 percent for the first quarter, bigger than the 17 percent increase expected for large.
  • Exchange-traded fund investors pulled nearly $20 billion out of two flagship large-cap stock index ETFs for March, according to FactSet data. While the iShares Russell 2000 ETF added more than $2 billion over the same period.
Betting on small-caps

Small-cap stocks are beating their larger peers so far this year and approaching all-time highs as the first-quarter earnings season gets underway.

Investors believe this trend should continue as smaller companies enjoy a bigger economic boost from the tax cut than larger multinationals. Plus, large exporters could be further undermined this year if President Donald Trump keeps pursuing his aggressive trade policies. Smaller companies, more likely to serve domestic markets, could be spared.

And investors are putting money behind this belief, yanking money from large cap exchange-traded funds and putting it into ones with a smaller company focus.

The Russell 2000 index – a benchmark for smaller companies – is up 3 percent so far this year and 2 percent away from its high made before a sell-off earlier this year that took stocks of all sizes down. The is up less than 1 percent since the start of January and still more than 6 percent from its own record.

Steven DeSanctis, small- and mid-cap strategist at Jefferies, told clients on Wednesday that Wall Street's earnings growth projections for small-caps — already at a high 18 percent for the first quarter — may still be too low. The strategist added that the market may, in fact, be looking for a number closer to 20 percent growth for the period.

"If we do see 20 percent earnings growth for small [-caps], it would be the best showing since the second quarter of 2011," he wrote in a note. "Earnings growth should be better down cap as the year progresses thanks to better economic growth."

Large-cap profits, meanwhile, are expected to grow at 17 percent, he said.

Exchange-traded fund investors ditched large-caps in March, pulling nearly $20 billion out of two flagship large-cap stock index ETFs for the month, according to FactSet data. The iShares Russell 2000 ETF, meanwhile, added more than $2 billion over the same period.

The SPDR S&P 500 (SPY) led the S&P 500 outflows as investors cut exposure to larger names, shedding more than $10 billion over the month. The iShares S&P 500 ETF (IVV) saw more than $9 billion in outflows in March as the Trump administration stepped up its protectionist stance on trade.

Small-cap funds have "taken in $4 billion to $5 billion in the last month," DeSanctis told CNBC later Wednesday. The move is driven by "earnings growth due to the improving economy and due to tax cuts."

American tariffs on steel and aluminum, in addition to China-specific taxes, have spooked investors away from large-cap companies with significant overseas markets. Dow Jones industrial components like Caterpillar and 3M – two companies with large international exposure – are still trying to post a positive return for the year.

"I think it has something to do with trade. In general, the small names are insulated from trade policy, and given the dramatic exchange that's been going on, I think investors have decided to reduce that trade war exposure and move to small companies," said Jack Ablin, chief investment officer at Cresset Wealth Advisors.

Companies in the Russell 2000 derive 21 percent of their sales from overseas, on average, while the large-cap S&P 500 obtains 30 percent from outside the U.S., according to data from Bank of America Merrill Lynch.

Trump made the tariffs announcement on March 1 and a week later signed two proclamations levying a 25 percent tax on steel imports and a 10 percent tariff on aluminum imports. Mexico and Canada — two key U.S. trading partners — were exempt from the tariffs.

The president also signed an executive memorandum later in March that would impose retaliatory tariffs on up to $60 billion on Chinese imports.

Pedestrians walk outside the New York Stock Exchange in the U.S.
Daniel Acker | Bloomberg | Getty Images

But the relative outperformance of small-cap stocks may also be thanks to Trump's tax cuts, which likely have a greater impact on smaller companies.

The new legislation slashed the corporate tax rate to 21 percent from 35 percent as well as temporarily cut the tax burden on most individuals. The reduction, in turn, likely benefits smaller companies to a greater degree.

Jefferies' DeSanctis, for one, said the cuts could add meaningfully to financial reports.

"Tax cuts will mean a double-digit boost to small-cap earnings, and large-caps get a boost of about 5 percent," he said.

Companies in the Russell 2000 paid a median effective tax rate of 31.9 percent, while companies in the S&P 500 paid a median effective tax rate of 28 percent, according to 2017 Thomson Reuters data. That means small companies have more to gain as rates come down to 21 percent for everyone.

Relative outperformance from small caps is "tied to the tax cuts, but that's also in combination with the geopolitical concerns. They have a lot less international exposure; they would be less adversely affected," said Sam Stovall, chief investment strategist at CFRA.

Stovall said that the recent outperformance is more likely attributable to trade tensions. He noted that large-cap names fell more than 10 percent at their recent lows, while small-caps fell only 9.1 percent.

"In many ways, it's the optimism for the further-out quarters and expectations that GDP growth is expected to do fairly well," Stovall added. "It's really an acceleration."