U.S. SMALL CAPS FACE TURBULENCE

Russell 2000 snaps eight-week winning streak in sign cooling off period is starting

AFTER a strong rally that saw the Russell 2000 notch a record in three straight sessions last month, small cap stocks may be showing signs of slowing down, leading some market participants to question whether their recent bulletproof performance is starting to crack.

After hitting lows on February 8, the Russell 2000 has risen more than 12 per cent, far outpacing the gain of 5.2 per cent in the large cap S&P 500 index.

The small cap index on Friday snapped an eight-week winning streak, however, posting its largest weekly decline since late March, which could indicate the start of a cooling off period.

“We are seeing an inverse relationship between size and value, the bigger stocks are the better bargains and the smaller stocks aren’t,” said Craig Callahan, president at ICON Funds in Denver.

“That would make me sceptical that over the next full year the small caps could keep leading.”

Investors have rushed into small caps this year, and the trend continued last week. Lipper data on Thursday showed small cap growth funds attracted US$595 million (RM2.4 billion) of inflows for the week, their seventh straight week of gains.

“The big thing has been the amount of money into small caps in general, we have seen an awful lot of money just come pouring in,” said Steve DeSanctis, equity strategist at Jefferies, here.

Small caps have become attractive to investors for a number of reasons. Since they are mostly domestically focused, investors reason they are more insulated from a potential trade war than a larger company with more of a global footprint.

Treasury Secretary Steve Mnuchin said on Friday a report by the Axios news website, which cited sources as saying President Donald Trump wanted the United States to withdraw from the World Trade Organisation, was wrong.

That domestic focus is also beneficial to small caps in the face of a strengthening US dollar, which can dent overseas profits of larger multinational companies. After declining nearly 10 per cent last year, the greenback has rebounded in the second quarter with a gain of more than five per cent against a basket of major currencies.

Smaller names are also expected to see a bigger benefit from the tax cuts announced by the Trump administration, with the effective tax rates for small caps changed to 21 per cent from 28 per cent, while large caps will only see their effective rate move down from an average of about 24 per cent, according to Julian Emanuel, chief equity and derivative strategist at BTIG, here.

“The price action is confirming the fact that everything is now in small caps’ favour,” said Emanuel.

“If you look at the small business confidence chart it is hard to make the case you are going to go higher, and if you don’t, it is hard to make the case that small caps stocks aren’t going to underperform, then you throw on top of it the seasonality,” he added.

Even with these headwinds, small caps may still perform better on a relative basis than larger names should trade worries persist, according to Lori Calvasina, head of US equity strategy at RBC Capital Markets, here.

RBC recently upgraded their neutral view on small caps to one of preference over large caps.

“We are waking up in 2018 figuring out that the protectionist rhetoric from the summer of 2016 is real. It is a real underlying philosophy of this administration so I don’t think it is unwise to position accordingly,” said Calvasina.

“We don’t think there are any winners in a trade war, but it a question of who the relative losers are — small caps lose less.”