Can small-cap outperformance continue?

Several drivers suggest that small caps may be able to continue their recent dominance over large caps

Can small-cap outperformance continue?

Nick KalivasTime to read: 3 min

Small caps have materially outperformed large caps in 2018, with the S&P SmallCap 600 Index outpacing the S&P 500 Index 7.80% to 2.58% between Dec. 29, 2017, and May 25, 2018.1 Below, I highlight the drivers of small-cap returns this year, and why I believe the trend could continue.

Tax cuts have benefited small caps. In the three years ending December 2017, the companies in the S&P SmallCap 600 Index had an average effective tax rate 4.3% higher than the S&P 500 Index.1 Investors looking for stocks that may experience improved profitability due to US tax reform have turned to the small-cap sector.

Trade tensions may favor small caps. 2018 has been a year of trade tensions, but smaller companies have less overseas exposure than larger companies. S&P SmallCap 600 Index companies generated 78.8% of their revenues from the US compared to 70.9% for the S&P 500 Index.2 The difference was even more dramatic in the growth style box, where S&P SmallCap 600 Growth Index companies produced 80.6% of their revenue from the US compared to 65.1% for S&P 500 Growth companies. 2 The recent political tensions in Italy and Spain and the potential threats to economic growth in the eurozone may prompt investors to reduce their overseas exposure and benefit small caps relative to large caps.

The trend in earnings estimate revisions favors small stocks over large. Earnings estimate revisions have been strongest in the small-cap sector. Forward earnings estimates for the S&P SmallCap 600 Index have risen by more than 28% compared to 18.7% for the S&P 500 Index over the past six months.3

The US economy has shown relative strength. More recently, the US economy has continued to display strong growth, while economies in Europe and Asia have softened. The IHS Markit Eurozone Manufacturing PMI has declined from a peak of 60.6 in December 2017 to a recent low of 55.5 in May 2018, while the Nikkei Japan Manufacturing PMI has eased from a January 2018 high of 54.8 to a recent low of 52.8 in May.4 In contrast, the IHS Markit US Manufacturing PMI was just below its cycle high at 56.4 in May.4

Investors may be choosing small caps over emerging markets for their risk sleeve. Investors have become uneasy over emerging markets due to geopolitical tensions (the Turkish lira crisis, instability in Venezuela, and Russian sanctions, for example), a rising 10-year Treasury yield, and a firmer dollar that has rallied from its February low. The risk sleeves of portfolios may have tilted toward small caps.

Small-cap valuation has become more attractive. Some see better value in small caps as the price-to-earnings (P/E) ratio has compressed on the S&P SmallCap 600 Index, suggesting that small caps have cheapened in recent years. On a forward earnings basis, the S&P SmallCap 600 Index is currently trading at 20.1 compared to 17.0 for the S&P 500 Index. The ratio of 1.18 is down from a peak of over 1.33 in July 2009.5

Small-cap valuation has become more attractive

The technical picture is supportive. Using technical analysis can be a risky proposition, but the technical set up of the S&P SmallCap 600 Index looks very bullish, in my view. The index has broken out of consolidation to the upside in a near textbook ascending triangle. The target of the triangle projects over 1075 based on the depth of the formation (this measure is approximate – this is an art not an exact science). Another target would be the top of a channel formed off the lows of the triangle. This is a moving target, but much higher than current levels and consistent with the 1075 level.  However, the small-cap sector is overbought in the near term given the Relative Strength Index was recently over 73, but pullbacks to the hold highs in the 980 area may have the potential to provide support. Old resistance levels tend to become supportive (the top of the triangle).

Small-cap solutions

Invesco has a wide range of small-cap ETF solutions including small-cap growth, small-cap momentum, small-cap value, small-cap low volatility high dividend, small-cap low volatility, and small-cap quality. For more information, see our list of small-cap ETFs.

1 Source: Bloomberg L.P.

2 Source: S&P Dow Jones Indices, “ How Global are the S&P 500, the S&P Midcap 400, and the S&P Smallcap 600 Style Indices?” Feb 28, 2018.

3 Source: Bloomberg, L.P. as of May 24, 2018

4 Source: IHS Markit

5 Source: Bloomberg, L.P. as of May 31, 2018

Important information

Blog header image: watchara/Shutterstock.com

The S&P 500® Index is an unmanaged index considered representative of the US stock market.

The S&P SmallCap 600® Index is a market-value weighted index that consists of 600 small-cap US stocks chosen for market size, liquidity and industry group representation.

The S&P SmallCap 600® Growth Index consists of small-cap US stocks categorized as growth using three factors: sales growth, the ratio of earnings change to price, and momentum.

The Eurozone Manufacturing PMI® (Purchasing Managers’ Index®) is produced by IHS Markit based on original survey data collected from a representative panel of around 3,000 manufacturing firms. National data are included for Germany, France, Italy, Spain, the Netherlands, Austria, the Republic of Ireland and Greece.

The US Manufacturing PMI® (Purchasing Managers’ Index®) is produced by IHS Markit based on data collected from a panel representing the entire US manufacturing economy. IHS Markit’s total US Manufacturing PMI survey panel comprises over 600 companies.

The Nikkei Japan Manufacturing PMI® (Purchasing Managers’ Index®) is a composite index based on questionnaires sent to purchasing executives for manufacturing companies in Japan.

Price-to-earnings ratio measures a stock’s valuation by dividing its share price by its earnings per share.

Technical analysis is an investment methodology that analyzes stocks based on historical market activity, such as price movements.

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

Growth stocks tend to be more sensitive to changes in their earnings and can be more volatile.

Nick Kalivas

Senior Equity Product Strategist

Nick Kalivas is a Senior Equity Product Strategist representing the PowerShares family of exchange-traded funds (ETFs). In this role, Nick works on researching, developing product-specific strategies and creating thought leadership to position and promote the smart beta* equity line up.

Prior to joining Invesco PowerShares, Mr. Kalivas spent the majority of his career in the futures industry, delivering research, strategy and market intelligence to institutional and high net worth clients centered in the equity and interest rate markets. He was a featured contributor for the Chicago Mercantile Exchange, and provided research services to a New York-based global macro commodity trading advisor where he supplied insight on equities, fixed income, foreign exchange and commodities. Nick has been quoted in the Wall Street Journal, Financial Times, Reuters, New York Times and by the Associated Press, and has made numerous appearances on CNBC and Bloomberg.

Nick has a BBA in accounting and finance from the University of Wisconsin – Madison and an MBA from the University of Chicago Booth School of Business with concentrations in economics, finance, and statistics. He holds the Series 7 and Series 63 registrations.

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