Small Caps Down — Can They Get Up?

While the U.S. stock market continues its upward trend in 2017 (the Dow Jones Industrial Average is up 6 percent through April), investment advisors would do well to emphasize caution with client portfolios going forward – especially in certain sectors.

Case in point: while big profits come from so-called “defense sectors,” meager gains, or worse, come from the small cap universe. In fact, small caps are in serious peril for the rest of the year, said one industry insider.

So far, small caps are surviving 2017. The Russell 2000, up 1 percent through March, gained 2.4 percent in April in a one-month surge. Globally, though, large cap global equity growth funds are up 3 percent over global small cap growth stocks through April, Morningstar reported.

No matter what happened in the first four months of 2017, the remainder of the year won’t be kind to small cap investors, said Russ Koesterich, portfolio manager at BlackRock’s Global Allocation division.

“Neither large nor small cap U.S. stocks are cheap, but small caps look particularly pricey,” Koesterich wrote in a recent post on BlackRock’s The Blog. “Instead, many investors are starting to look for better bargains overseas. For those willing to take the incremental risk, at 15 times trailing earnings emerging market equities seem the more interesting play, a fact reflected in their outperformance year-to-date.”

Calling All Lawmakers

Political events in Washington, D.C. could turn the tide for small companies, but so far there’s not much evidence that either the White House or Congress is up to the task of boosting the economy, Koesterich said.

“Progress on tax reform and infrastructure spending would help convince increasingly skeptical investors that the long hoped-for fiscal stimulus will actually materialize,” he added. “In the absence of that, investors may be looking at a more modest version of the reflation trade than many discounted last autumn. Under this scenario, small caps may not regain their luster anytime soon.”

He’s not alone in expressing that sentiment, although others say lawmakers still have a golden opportunity to help small caps.

“After leading the post-election rally last year, U.S. small cap stocks have not fared as well to date this year. Valuations at the start of 2016 reflected overly optimistic expectations, particularly in the small cap value segment,” said Daniel S. Kern, chief investment officer of TFC Financial Management, a registered investment advisory firm based in Boston.

Valuations have adjusted in relative terms, as U.S. large cap stocks outperformed U.S. small cap stocks in the early stages of 2017, Kern pointed out.

“I am optimistic about the outlook for small cap stocks, as small companies will benefit from a healthy U.S. economy and policy initiatives that are likely to help small companies,” he added. “Small cap stocks would benefit from corporate tax cuts, even if Trump’s tax proposal is diluted after negotiation with Congress.

“Small companies tend to pay tax at the statutory tax rate, so any reduction in the statutory rate will provide a boost.”

Small companies also struggle with some of the regulatory burdens associated with the Affordable Care Act and certain requirements under the Sarbanes-Oxley Act, Kern said, which adds another potential burden on the sector.

“Community banks face similar challenges in complying with Dodd-Frank,” he said. “The likely easing of regulatory burdens on small companies would provide an additional boost to small company stocks.”

Many small companies are also “long on hope and short on earnings,” yet trade at elevated valuations, he added. “We're skeptical of many ‘story’ stocks that have negative earnings and trade on hope rather than business fundamentals.”

TFC Financial Management’s holdings include two value-oriented mutual funds: Walthausen Small Cap Value Fund and DFA U.S. Small Cap Value Portfolio.

“We also hold the Vanguard Small-Cap Growth Index Fund, which follows an index that we think offers a higher quality universe of small company growth stocks,” Kern said.

Signs of Hope

While small caps aren’t a good deal as summer approaches, some Wall Street money managers say the long-term view isn’t as dire as others believe.

“While small cap stocks are not a bargain at this point (which will keep mid-term to long-term returns lower), the short-term has the potential to be optimistic,” said Jim Holtzman, a wealth advisor at Legend Financial Advisors in Pittsburgh.

U.S. small cap stocks tend to outperform large cap stocks during a rising U.S. dollar, he explained.

“If interest rates in the U.S. continue to increase, this could be beneficial for small cap stocks,” he said.

The takeaway on small cap stocks? Steer clear for now, but be ready to pounce upon signs of strong economic growth in the U.S. And be on the lookout for lawmakers overhauling the tax code and burdensome regulations.

In the event of those scenarios, small caps may yet get up off the mat, and start earning big results.

Brian O'Connell is a former Wall Street bond trader, and author of the best-selling books, The 401k Millionaire and CNBC's Guide to Creating Wealth. He's a regular contributor to major media business platforms, including CBS News, The Street.com, and Bloomberg. Brian may be contacted at [email protected].

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