Small-cap rally could shrink on earn­ings, tax hur­dles

Kuwait Times - - BUSINESS -

NEW YORK: Op­ti­mism is sour­ing around small-cap stocks for some in­vestors, with a host of fac­tors con­spir­ing to up-end gains that have taken them to record highs.

Small-caps, which led the mar­ket’s rally just af­ter the Nov 8 elec­tion of Don­ald Trump as US pres­i­dent, are fac­ing weak earn­ings fore­casts, lit­tle progress on tax re­form and re­cent out­flows. “We have downside risk here. Earn­ings num­bers aren’t great, and val­u­a­tions are ... pretty rich,” said Steven DeSanc­tis, equity strate­gist at Jef­feries.

In­vestors had ex­pected the ad­min­is­tra­tion of Repub­li­can Trump, with his prom­ises of ag­gres­sive tax cuts and a health­ier US econ­omy, would be a boon for small-caps, which tend to be more do­mes­ti­cally fo­cused. Repub­li­cans so far have been un­able to push through bills to re­peal and re­place the Af­ford­able Care Act, the first leg of the Trump agenda. That has raised doubts about the like­li­hood of any tax re­form this year. Small-caps have higher ef­fec­tive tax rates - about 32 per­cent ver­sus 26 per­cent for large-caps, a note from Nu­veen As­set Man­age­ment showed.

The per­for­mance of both the Rus­sell 2000, a widely used gauge for small-caps, and the small-cap S&P 600 has lagged that of large-caps so far this year, but the Rus­sell is up 20.3 per­cent since the elec­tion com­pared with a gain of 15.3 per­cent for the S&P 500.

All three in­dexes hit record highs in re­cent ses­sions, just as the earn­ings re­port- ing pe­riod was get­ting un­der way. But an­a­lysts es­ti­mate earn­ings for S&P 600 com­pa­nies de­clined 8.3 per­cent in the sec­ond quar­ter, dragged down by pro­jected drops in con­sumer dis­cre­tionary, en­ergy and health care re­sults, ac­cord­ing to Thom­son Reuters data. Rev­enue is ex­pected to have risen slightly in the quar­ter.

Among con­sumer com­pa­nies, weak­ness in ap­parel, ac­ces­sories and lux­ury goods and other re­tail­ers is ex­pected to have hurt re­sults, said David Aure­lio, Thom­son Reuters se­nior re­search an­a­lyst.

In the small-cap en­ergy sec­tor, ser­vices and equip­ment com­pa­nies con­tinue to be af­fected by project cut­backs by larger com­pa­nies. The small­cap out­look is in con­trast to ex­pec­ta­tions for an­other quar­ter of strong profit growth for the S&P 500 and a sharp year-over-year jump in large­cap en­ergy.

“Small-cap earn­ings growth has been trail­ing large-caps for the last four years, and that con­tin­ues to be the case in the first half of this year,” said Dan Suzuki, se­nior U.S. equity strate­gist at Bank of Amer­ica Mer­rill Lynch in New York.

That does not bode well for val­u­a­tion met­rics for small-caps, which the bank calls “the most ex­pen­sive seg­ment of an ex­pen­sive mar­ket.” The Rus­sell 2000 is trad­ing at about 26 times for­ward earn­ings as per Thom­son Reuters Datas­tream data, above a me­dian of about 21. The S&P 500 trades at about 17.3 times, also above its me­dian.

While an­a­lysts ex­pect small-cap earn­ings to re­bound in the sec­ond half of the year, some strate­gists said those lofty ex­pec­ta­tions are not likely to hold since US eco­nomic growth re­mains slug­gish.

Large-caps have ben­e­fited from re­cent weak­ness in the US dol­lar, which makes for­eign cur­rency earn­ings for US com­pa­nies worth more in dol­lars. “This may ex­plain why mi­dand large-caps have seen a stronger bounce in earn­ings re­vi­sions than small-caps re­cently,” Lori Cal­vasina, Credit Suisse’s chief US equity strate­gist, wrote in a re­search note.

Re­cent fund data also shows a weak­en­ing trend. Ac­cord­ing to Lip­per, US-based small-cap funds have recorded five straight weeks of with­drawals. At the same time, tech­ni­cal mo­men­tum in­di­ca­tors are trail­ing the Rus­sell 2000’s re­cent push to new highs, a pos­si­ble warn­ing that its foray into record ter­ri­tory is on less than firm foot­ing. “We’re in a longer pe­riod of un­der­per­for­mance,” Suzuki said. —Reuters

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