Small-cap stocks have been the big election winners

As published in the Star Tribune 12/10/16.

The stock market has reacted favorably to the election of Donald Trump. The S&P 500 gained 3.4 percent in the four weeks after the election. If that were a calendar month, it would rank as the second-best of 2016.

A closer look reveals small-cap stocks — definitions vary but they are typically companies with market values between $300 million and $2 billion or so — to be among the biggest winners.

Over the same period, the Russell 2000 — a commonly used index for U.S. small-cap stocks — gained 13.2 percent, nearly four times the return of the S&P. The spread in performance between small-caps and large-caps in November was the widest it has been in roughly 14 years (April 2002).

So, why such a significant better display from small-cap companies?

Investors are placing bets that a Trump administration will focus on policy changes generally positive for the U.S. economy and less attractive for the global economy.

Small-cap stocks generate a larger portion of their revenue in the U.S. If Trump and a Republican-controlled Congress lower corporate income taxes as many predict, small-cap firms will benefit most.

Large-cap companies that operate globally, on the other hand, already enjoy more favorable foreign tax policies. Further, large-caps with a major international footprint could be adversely affected if Trump renegotiates global trade agreements. They could even find themselves subject to penalty if new laws are enacted to discourage moving business overseas.

Small-cap equities tend to be more economically sensitive. Economic data has been strong the last two quarters and with the election over, Wall Street finally seems to care about an improving economy. Increased government spending on defense and infrastructure should also help domestic growth accelerate.

The expectation that the Federal Reserve will raise interest rates has already caused the U.S. dollar to strengthen, another headwind for large companies with global operations. Small-caps operating exclusively in the U.S. avoid this problem.

It is tempting to avoid small-caps after such a significant run-up, but these trends will likely endure for the foreseeable future. Despite the postelection euphoria in the market, the uncertainty caused by new political leadership in Washington will inevitably lead to volatility. Small-caps by nature could sell off more during those pullbacks, which will create buying opportunities for the savvy investor.

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