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Small Caps a Hard Sell for Wall Street in 2018, Despite Tax Cuts

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(Bloomberg) -- Expectations for U.S. small- and mid-cap stocks are mixed in 2018 as equity strategists weigh the benefit of lower tax rates against expensive valuations and the likelihood of increased volatility and tighter credit conditions. The Russell 2000 Index is up 29 percent since President Trump was elected, but this year’s gains lagged large-cap peers even with a late surge on the back of tax reform. Jefferies and Bank of America expect smaller companies to underperform again in 2018, while Morgan Stanley says the sector still has more room to run.

Jefferies

  • "Even with a big boost from tax reform, valuations are way too high." Volatility is due to increase and "more Fed hikes, a narrower curve, and higher inflation all lead to another cautious outlook.”
  • Jefferies expects the Russell 2000 to rise to 1664 next year, or about 8 percent from its current level.
  • Earnings growth has also lagged expectations. Jefferies says earnings growth should have been 16 percent with GDP over 3 percent, but earnings for 2017 are set to increase only 5 percent. This raises concerns that wage inflation and higher input costs may be pressuring margins.
  • Jefferies expects small caps will lag large caps in 2018 and sees “lots of lumps & bumps along the way.”
  • In a “Miami blue sky outlook,” the Russell 2000 could see another year of double-digit growth if earnings growth exceeds expectations, record M&A activity fuels speculation in small caps, and housing continues to boost small-cap earnings.

Bank of America Merrill Lynch

  • “We continue to favor large caps over small caps, where the latter typically lag at the end of bull markets and are expensive, highly levered, and could be hurt most by tighter credit conditions, higher volatility or a more hawkish Fed.”
  • Small-cap stocks have average negative alpha of 6 percent in the last six months of the past four bull markets. That’s among the worst-performing quant factors, which also include low P/E and dividend yield.
  • Other reasons to avoid small caps include earnings growth that has lagged large caps, potential for higher volatility in 2018 and their history of underperforming in a falling ISM market.
  • “Tax reform is the biggest upside risk to small caps” since they have a higher median tax rate and more domestic exposure.

Morgan Stanley

  • “We like the outlook for SMID caps stocks post tax reform given a better earnings outlook, higher potential for margin expansion, and valuation (P/CF) that still has some room to catch up.”
  • Smid-cap stocks rally since late summer on tax reform sentiment improvement still has more room to play out. Even though the “ambitious” earnings growth estimates for the Russell 2000 will probably be revised lower, tax reform and an improving margin environment in 2018 should support better earnings growth than large caps.
  • In terms of tax cuts, Morgan Stanley notes smid-cap energy stocks in particular may “benefit significantly.”
  • Relaxing financial regulations should also spur loan growth in 2018, which may lead to “a more active and dynamic operating environment for domestically geared small caps.”

Bloomberg Intelligence

  • Small-cap value stocks have outperformed small-cap growth since mid-August. Small-cap value stocks have also seen earnings estimates increased by 6.5 percent, versus decrease of 6.3 percent for growth companies.
  • Tax reform will be a bigger boon for small-cap stocks because they have higher median tax rates. Small-cap value is dependent on domestic growth as 80 percent of its market cap us concentrated in cyclical sectors such as industrials, discretionary and info tech.
  • Domestic consumption will be big driver for the performance of small-cap value stocks next year. Specialty retail accounts for one-third of the small-cap value discretionary sector and has outperformed large-cap peers since mid-August.
  • A recovery in oil prices may not be enough to fuel the small-cap value trade as there has been essentially no correlation this year. The recent rebalancing of the S&P SmallCap 600 Value Index did increase the weighting of the energy sector to 6.3 percent, but that’s still a relatively small percentage of the index.

©2017 Bloomberg L.P.

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