The four main US stock barometers all logged record closing highs on Friday, marking the first grand slam in two months as small capitalisation stocks have caught up to their larger brethren.
The S&P 500, Dow Jones Industrial Average and Nasdaq Composite were already trading at all-time peaks before Friday, propelled higher by the relatively strong performance of large capitalisation stocks, leaving the Russell 2000 index lagging behind.
“Small-caps had a huge rally and were definitely taking a breather,” said Nicholas Colas, chief market strategist at Convergex.
He said that comments on Thursday from US President Donald Trump indicating that a “phenomenal” tax package could be announced in as soon as two weeks revived some of the enthusiasm.
The Russell, which is made up of companies with market values typically ranging from $300m-$2bn, surged by almost 14 per cent from the election of Mr Trump in November until the end of 2016. The performance easily topped the S&P 500, the most closely watched large-cap gauge, that advanced by 4.6 per cent over the same timeframe.
The outperformance was driven by expectations that small-caps, which are seen as more domestically focused, would have the most to win from the combination of pro-US growth and protectionist trade policies that have been pitched by Mr Trump.
“Smaller companies tend to be more focused on the US market and have less foreign revenues,” Mr Colas said. “Any changes in the US tax code affect them disproportionately.”
However, small-caps lost some of their momentum at the start of this year, rising 2.3 per cent year-to-date compared with 3.5 per cent for the S&P 500.
The reversal of leadership has come as small-cap earnings for the fourth quarter of last year, which are still being released, have trailed large-caps. Earnings for small-cap groups as a whole have fallen by about 1 per cent from the previous year in the fourth quarter, compared with growth of 6 per cent for large-caps, according to Bank of America Merrill Lynch strategist Dan Suzuki.
Mr Suzuki said he believes that downside in the short term is likely limited by the “Trump put” — with investors unlikely to overlook the small-cap friendly shift in policy in Washington.
But over a longer time horizon, Mr Suzuki has more concerns. Small-cap valuations have zipped higher, with the Russell trading at about 19 times forward earnings, significantly above the long-term median of 15.2 times and ominously in-line with levels struck during the dotcom era at the turn of the millennium.
“Given that small-caps now trade at tech bubble-like valuations, in our view it does not bode well for future returns,” said Mr Suzuki.
Small-caps have also taken-on debt at four-times the rate of earnings growth since 2008. With the ratio of borrowing-to-profits near all-time highs, the spectre of more aggressive Federal Reserve rate rises over the next few years might present another headwind, Mr Suzuki said.
In addition, other potential tweaks to the tax code, including a measure that incentivises exports and penalises imports, and one that would stop companies from deducting loan interest from income, might also be bearish for small-caps.
“Interest rates have already risen close to 100 basis points since last summer’s lows, and if coupled with border adjustment taxes and the removal of interest deductibility, this could meaningfully offset the positives of tax reform on small-cap earnings,” Mr Suzuki said.