US Small Caps Are Working. But Why?

US small cap stocks had a good week and as a result are now up on the year, unlike their large cap counterparts. The numbers:

  • S&P Small Cap 600: +1.94% for the week, up 1.87% YTD
  • Russell 2000: +2.39% for the week, up 0.98% YTD
  • S&P 500: +1.99% for the week, but still down 0.65% YTD

We regularly hear several narratives around small caps that might explain their stronger performance in 2018, including:

  • They benefit from the recently passed tax reform more than large multinationals, since they had higher structural tax rates before the recent enactment of changes to the Federal tax code. This will free up cash flow for corporate reinvestment at higher returns than large cap names.
  • Given their lower percentage of international revenues, they are less exposed to brewing trade/tariff renegotiations.
  • Being smaller, they have stronger growth potential than large cap companies and can show better earnings comps if US economic growth proves lackluster.

When you dig through the composition of small cap indices like the S&P 600 the relative merits of these arguments come into sharper focus. In fact, just three sectors explain 75% of the group’s performance last week. They are:

#1. Small Cap Technology: +3.8% over the last week and 31% of the overall small cap gain over the period.
Unlike the S&P 500, with its 25% Tech weighting, in the S&P 600 Technology only carries a 15% allocation. Small cap Tech outperformed the overall small cap index last week (+3.8% vs. 1.94%) as well as the large cap Tech sector (3.8% vs. 3.5%).

Bottom line: score one for the “small caps have better growth potential” argument, but with a meaningful twist. Small cap Tech doesn’t have the same headline risk as the usual suspects in the large cap space. That makes it an appealing “parking lot” for Tech sector investors.

#2. Small Cap Industrials: +2.4% over the last week and 22% of the overall small cap gain over the period.
This is the most important sector in the S&P 600, with an 18% weighting. It outperformed the S&P 600 last week, even though large cap Industrials (+1.7%) lagged the S&P 500 (+2.0%).

According to our friends at www.xtf.com, who track the subcomponents of PSCI (an ETF for S&P 600 Industrials), the top three weightings here are:

  • Heavy Machinery 23%
  • Commercial Services and Supplies: 20%
  • Building Materials: 11%

Bottom line: with small cap Industrials outperforming their large cap counterparts last week AND the group’s exposure to deep-cycle subsectors, we conclude that investors are revaluing domestic growth opportunities more favorably in comparison to those with international exposure.

#3. Small Cap Energy: +10.7% over the last week and, like Industrials, 22% of the advance.
Energy is a very small part of the S&P 600 with just a 4% weighting. However, since the group is quite volatile it can still impact the index. Such was the case last week.

Bottom line: without the move in small cap Energy, the S&P 600 would have only risen by 1.5% last week and dramatically underperformed the S&P 500. We can’t really chalk this up to any of the boilerplate explanations noted above. Rather, it shows how a choppy group can hijack a notionally diversified index.

Final takeaway: we’ve been cautious on small caps over the last 6 months, based in equal parts on valuation and under exposure to Technology, but both issues have gone from headwind to neutral impact. On the former point, PE multiples have come down to 17.5x from +20.0x – reasonable enough to play. On the latter, there is clear investor appetite for Tech exposure without the headache of headline risk – something the small caps offer.

As an aside: the exposure to stub-like returns in Energy should wash out over time, but for investors interested in playing, PSCE (S&P 600 Small Cap Energy ETF) is one way to go.

We still like the large caps better, but in all honesty the relative performance of those to small caps is more of a toss-up for the remainder of the year given the themes we’ve outlined here. If big cap Tech runs into more problems, then small caps are the place to be. And if trade/tariff negotiations go awry, the same applies. We continue to discount both issues, but reasonable people can differ there. And those same reasonable people probably want more small cap exposure.

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