5 Reasons Why Small-Cap ETFs Are Lagging Large Caps In 2017

by: Zacks Funds

Donald Trump's win in the U.S. presidential election triggered a rally in the U.S. stock market with small caps emerging as major winners. In fact, the Russell 2000 index tracking small-cap stocks recorded its longest rally in two decades post Trump win.

The President's promise of introducing a burst of stimulus by increasing the infrastructure spending package, easing regulations, offering tax cuts with an aim of accelerating economic growth, creating more jobs in the country fired up stocks, especially the pint-sized ones. More fuel was added by Trump's 'America First' rhetoric.

Since small caps generate most of their revenues from the domestic market, they are more closely tied to the domestic economy. These have lower foreign exposure and are thus less impacted by a slowdown in global growth and other political or economic issues flaring up volatility.

The Russell 2000 generates less than 20% of revenues outside of the U.S. while the S&P 500 companies fetch a third of their revenues from abroad.

However, things took a turn this year when small caps actually underperformed the large-cap indices by a fat margin. Small-cap ETF iShares Russell 2000 (NYSEARCA:IWM) has added about 2.9% so far this year (as of February 23, 2017) compared with gains of 8.4% by the Nasdaq composite, 5.6% by the S&P 500 and 5.3% by the Dow Jones Industrial Average.

Let's take a look at why small caps have lost steam and are underperforming large caps this year:

Slowdown in Earnings Growth

As per an article published in Financial Times, earnings for small-cap companies as a whole declined by about 1% year-over-year in Q4 compared with growth of 6% for large caps, according to Bank of America Merrill Lynch.

On the other hand, earnings for the S&P 500 entered into the positive territory in Q3 of 2016 following five consecutive quarters of decline. This earnings growth is expected to reach the highest level in two years. For the Q4 earnings season, the S&P 500 is expected to score 7.4% earnings growth on 3.9% revenue growth.

Inflated Valuation

Small-cap fund IWM added 13.4% last year since February 8, 2017, while the S&P 500-based SPY added 4.4%, Dow Jones-based fund DIA advanced about 7.7% and Nasdaq-100 based QQQ inched up 1.2%. This shows that small caps started 2017 at an exorbitant valuation. Investors should note that the S&P 500 composite market forward P/E now stands at 18.67 times, which in fact is being considered as high valuation.

As per analysts, the Russell is trading at about 19 times forward earnings, pretty higher than its long-term median of 15.2 times. In fact, the Bank of America Merrill Lynch believes that small caps now trade at a valuation seen in the tech bubble formed in the dot-com era.

Higher Debt Load

Years of low interest rates in the U.S. have actually increased the debt burden of small-cap stocks. Median companies on the Russell 2000 index currently trade at 30 times their free cash flows while small-cap stocks valued at less than 15 times are likeable to some analysts. With interest rates likely to pick up on increasing inflationary expectations, this debt load could be a drag on small-cap stocks.

Weakness in Greenback

The U.S. dollar, despite adding 3.2% gains in the last one-year frame, is down about 1.4% so far this year (as of February 23, 2017). If the Fed remains slow and Trump favors a low-dollar environment, the greenback is likely to stay tame in the coming days. This fact has widened the scope of outperformance for those companies that operate aggressively in foreign lands, meaning large caps.

And investors should note that though not completely abated, global growth worries are not as awful as they used to be a few quarters back. In fact, things are looking up in the emerging markets and eurozone lately. All these make the case for small-cap ETF investing weak.

U.S. GDP Growth Slows

The U.S. economy saw annualized growth of 1.9% sequentially in Q4, but fell shy off market expectations of 2.2%. There was a lower-than-expected rise in wages in January. Average hourly wage rose just 0.1%. Average hourly earnings rose 2.5% year over year, the feeblest since August. This could be another reason behind the sluggish increase in small-cap ETFs so far this year.

ETF Picks

Still, there are small-cap ETFs that offered more returns than SPY's 4.6% gain in the last one month (as of February 23, 2017). These funds are AlphaMark Actively Managed Small Cap ETF (NASDAQ:SMCP), PowerShares S&P SmallCap Health Care Portfolio (NASDAQ:PSCH) and PowerShares S&P SmallCap Information Technology Portfolio (NASDAQ:PSCT).

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