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March 16, 2017, 1:51 p.m. EDT

Lagging small-cap stocks are not the market warning sign you might think

The longer-term trend remains positive for small-cap stocks despite recent weakness

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By Ryan Vlastelica

Courtesy Everett Collection

A red flag in the U.S. stock market may actually be a red herring.

Investors are increasingly wondering whether Wall Street could be headed for a pullback, with valuations elevated and high levels of policy uncertainty, but an historical cause for concern—underperformance in small-cap stocks—may be a false alarm this time.

Smaller companies have struggled thus far in 2017, and while they are modestly positive on the year, broader equity gains have been led by the market’s largest companies, leading to a sharp divergence among the performance of various market cap segments.

The S&P Small-Cap 600 Index /zigman2/quotes/210599868/delayed SML +0.72%  is up a mere 0.5% thus far this year, while the Russell 2000 /zigman2/quotes/210598147/delayed RUT +0.46%  is up 1.9%. Midcap stocks, as measured by the S&P 400 Mid Cap Index /zigman2/quotes/219506813/composite MID +0.84% , have done better with a gain of 4.1%, but that rise has been dwarfed by the 6.5% advance of the S&P 500 /zigman2/quotes/210599714/realtime SPX +1.01% .

Smaller companies tend to be more growth orientated than the relative value tilt of their larger peers, which are often more established and multinational in reach. As a result, small companies tend to be more sensitive to the pace of economic growth, and weakness in the category is sometimes viewed as presaging a broader decline. However, that may not apply this time around.

“Of course small caps and large caps are going to trade places in who leads the market from time to time, but I would disagree that the rally in small-caps is over,” said Jeff Mortimer, director of investment strategy for BNY Mellon Wealth Management, who said his firm was “overweight the U.S. over other markets, overweight equities over bonds, and overweight small caps over large.”

“If large outperforms for six months, let it,” he said. “Small will come roaring back. If you trade based on one month’s move you’re always going to be chasing something’s tail.”

The tepid year-to-date moves does obscure the longer-term outperformance. Over the past 12 months, the S&P 600 and the Russell 2000 are both up nearly 30%, while the S&P 400 is up 23%. The S&P 500 is up a little less than 18% over the same period.

The divergence has been particularly stark since the election, with smaller names outperforming as investors bet they will benefit from having a less-diverse geographic footprint. In addition to benefitting from President Donald Trump’s expected policies on taxes and regulation, their U.S.-focus could isolate them from any risks arising from isolationist trade policies, global geopolitical turmoil or a stronger U.S. dollar, which erodes the profitability of multinational firms.

Components of the S&P 600 Small Cap get over 80% of their revenue from the U.S., according to FactSet data. Components of the Dow Jones Industrial Average /zigman2/quotes/210598065/realtime DJIA +0.68% , which is comprised of 30 of the market’s biggest names, get 57.6%.

The S&P 500 has lagged behind its smaller peers since Nov. 8, having risen 11.5% since then, compared with 16% for the S&P 600 and the Russell, and 14.3% for the midcap index.

Christopher Gannatti, associate director of research at WisdomTree, said that the new administration could continue lifting small-cap stocks. In addition to being insulated from the currency impact of a stronger dollar, the category could see a disproportionate boost from lower corporate taxes.

“If there is corporate tax reform, we’ve found that small-cap stocks do in fact tend to pay higher effective tax rates than large-cap stocks,” he wrote in a note to clients. “If the statutory rate for U.S. corporations is lowered from the current 35% to 25% (or lower), the biggest incremental impact could hit profitable, small-cap companies.”

“We believe further interest is justified” in small-caps, he added.

To be sure, even if small-cap performance isn’t signalling a correction, that doesn’t mean that the deceleration is over. JonesTrading noted that the number of speculative longs in Russell 2000 futures contracts had been declining since the first week of the year, when they hit an all-time high.

“While the level of speculative longs is still very high historically, the selling pressure has picked up as the level of speculative shorts has just hit an all-time high,” wrote Mike O’Rourke, the firm’s chief market strategist. “This makes the index susceptible to additional weakness should the broad market roll over.”

Courtesy JonesTrading

Despite the slowdown, investors haven’t completely abandoned the categories as a strategy. The SPDR S&P 600 Small Cap ETF /zigman2/quotes/200749058/composite SLY +0.70% , an exchange-traded fund that tracks the small-cap index, has seen inflows of $209 million year-to-date, while $1.05 billion has gone into the midcap fund /zigman2/quotes/201764887/composite MDY +0.85% . The iShares Russell 2000 ETF /zigman2/quotes/209961116/composite IWM +0.47% , however, has seen outflows of $2.2 billion.

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Ryan Vlastelica is a markets reporter for MarketWatch and is based in New York. Follow him on Twitter @RyanVlastelica.

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