Optimism is souring around small-cap stocks for some investors, with a host of factors conspiring to up-end gains that have taken them to record highs.
Small-caps, which led the market’s rally just after the election of Donald Trump as U.S. president, are facing weak earnings forecasts, little progress on tax reform and recent outflows.
“We have downside risk here. Earnings numbers aren’t great, and valuations are ... pretty rich,” said Steven DeSanctis, equity strategist at Jefferies.
Investors had expected the administration of Republican Trump, with his promises of aggressive tax cuts and a healthier U.S. economy, would be a boon for small-caps, which tend to be more domestically focused.
Republicans so far have been unable to push through bills to repeal and replace the Affordable Care Act. That has raised doubts about the likelihood of any tax reform this year. Small-caps have higher effective tax rates — about 32% versus 26% for large-caps, a note from Nuveen Asset Management showed.
The performance of both the Russell 2000, a widely used gauge for small-caps, and the small-cap S&P 600 has lagged that of large-caps so far this year, but the Russell is up 20.3% since the election compared with a gain of 15.3% for the S&P 500.
All three indexes hit record highs in recent sessions, just as the earnings reporting period was getting under way.
Analysts estimate earnings for S&P 600 companies fell 8.3% in the second quarter, dragged down by projected drops in consumer discretionary, energy and health care results, according to Thomson Reuters data. .
Among consumer companies, weakness in apparel, accessories and luxury goods and other retailers is expected to have hurt results, said David Aurelio, Thomson Reuters senior research analyst.
In the small-cap energy sector, services and equipment companies continue to be affected by project cutbacks by larger companies.
The small-cap outlook is in contrast to expectations for another quarter of strong profit growth for the S&P 500 and a sharp year-over-year jump in large-cap energy.
“Small-cap earnings growth has been trailing large-caps for the last four years, and that continues to be the case in the first half,” said Dan Suzuki, senior U.S. equity strategist at Bank of America Merrill Lynch.