Small-Caps Make a Comeback as Trump Trade Refugees Resurrected

(Bloomberg) -- A month-long selloff in small-cap stocks ended this week in a reversal that investors attributed to the same force that triggered the drop: President Donald Trump.

The Russell 2000 Index, made up of stocks closely tied to the president’s growth agenda, gained 1.4 percent, the biggest weekly advance since early June. The turnaround came a week after market were roiled by Trump’s political travails.

Now, with the administration expected to elevate a campaign to overhaul U.S. tax policy next week, the focus is shifting back to benefits smaller companies may get from the planned reforms. Small caps, which surged after the election, have been hurt in 2017 amid a weaker dollar and higher interest rates that make it more costly for smaller firms to borrow money.

“For small-cap companies that are essentially the ones paying the highest taxes, any positive update on Trump’s plan to lower taxes is a big deal,” said Walter Todd III, chief investment officer at Greenwood Capital Associates LLC. “This combined with the underperformance of small-cap stocks in the past four weeks now gives small caps a nice rally, though it’s too early to tell how durable the rally is.”

Tax reform could also help lift smaller companies that are seeing a weaker dollar erode profits. Small caps posted flat earnings in the second quarter, compared with a 10 percent jump for large-cap firms, according to Steven DeSanctis, an equity strategist at Jefferies.

“When everyone comes back from the holidays and the beach, what you generally see is the rationalization of earnings estimates, and quite frankly second-quarter earnings weren’t great,” DeSanctis said by phone. “We have weak earnings, a lot of uncertainty around tax overhaul and some drama with the fiscal budget and the debt ceiling, these are some real issues that could hurt small-caps.”

Small cap earnings trailed consensus estimates by 0.2 percent, the first time since the financial crisis it was in a negative zone, Jefferies’s data show. Even though the spread has shrunk since then, it is still below the historic average, DeSanctis said.

Traders added $2.6 billion to the biggest exchange-traded fund invested in small caps this week through Thursday, after two weeks of outflows.

The broader market also rebounded, with the S&P 500 Index gaining 0.7 percent, ending a two-week streak of declines. The Dow Jones Industrial Average added 0.6 percent. The Nasdaq 100 Index also gained 0.6 percent.

--With assistance from Oliver Renick

To contact the reporter on this story: Elena Popina in New York at epopina@bloomberg.net.

To contact the editors responsible for this story: Arie Shapira at ashapira3@bloomberg.net, Richard Richtmyer, Chris Nagi