After a strong rally that saw the Russell 2000 notch a record in three straight sessions in June, smallcap 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 percent, far outpacing the gain of 5.2 percent in the largecap S&P 500 index. The smallcap 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 skeptical that over the next full year the smallcaps could keep leading."
Investors have rushed into smallcaps this year, and the trend continued this past week. Lipper data on Thursday showed smallcap growth funds attracted $595 million of inflows for the week, their seventh straight week of gains. "The big thing has been the amount of money into smallcaps in general, we have seen an awful lot of money just come pouring in," said Steve DeSanctis, equity strategist at Jefferies in New York.
Smallcaps 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. US 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 Organization, was wrong.
That domestic focus is also beneficial to smallcaps in the face of a strengthening US dollar, which can dent overseas profits of larger multinational companies. After declining nearly 10 percent in 2017, the greenback has rebounded in the second quarter with a gain of more than 5 percent 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 smallcaps changed to 21 percent from 28 percent, while large caps will only see their effective rate move down from an average of about 24 percent, according to Julian Emmanuel, chief equity and derivative strategist at BTIG in New York.
"The price action is confirming the fact that everything is now in smallcaps' favor," said Emmanuel. But, Emmanuel cautions that the Russell 2000 has underperformed in July, relative to the S&P 500, as trades from the late June Russell rebalancing of its indexes unwind. Since 2000, the Russell has underperformed the S&P by 1.1 percent in July, according to BTIG.
And with May data from the National Federation of Independent Businesses showing its small business optimism index registering the second-highest reading in its history, a pullback is more likely, leaving not much room for further increases. "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 smallcaps stocks aren't going to underperform, then you throw on top of it the seasonality," said Emmanuel.
Even with these headwinds, smallcaps 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 in New York. RBC recently upgraded their neutral view on smallcaps to one of preference over largecaps.
"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."
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