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The message of small cap stock performance

Small-cap stocks took off like rockets immediately after election day, soaring to a peak of +18% in mid-December. Over the ensuing three months, however, the small-cap benchmark Russell 2000 has gone to ground, while at the same time the big-cap benchmark S&P 500 has shot up 6%.

The market is always talking to us in some form or another, and it’s our job to shake our biases and hear the message. So what is the message?

The always astute analysts at boutique research firm TIS Group in Minneapolis argue that the market is telling us that the White House tax reform package will be delayed by as much as a year.

Here’s why: The Trump deregulation and tax reform plan should be more beneficial to smaller companies than to larger companies because larger companies have a million ways to avoid taxes and skirt regulations. Smaller firms don’t have the same resources. So the price action in U.S. stocks suggests is that corporate tax reform, which would benefit small caps most, is not imminent.

The analysts note that there is a school of thought in Washington that that tax cuts for companies may not be all that important anyway. Large companies, especially multinationals, pay relatively low tax rates anyway.

The analysts go on to posit that it’s possible that large-cap stocks are rising disproportionately because they are anticipating synchronize, global growth instead. This is not a consensus view, so it bears attention.

This actually makes sense because the tax reform package may not pass Congress until the first quarter of 2018. So investors can’t be pricing in higher earnings for the third or fourth quarter of this year.

The TIS analysts conclude by observing that dragging out the timeline may not be bearish for equities. They note that a study of the S&P 500 since 1950 shows that when the first 50 days of trading exceed a 55 gain, then 95% of the time stocks continued to rise by an average of 12% the rest of the year. And they note that gains continued in every year when the market started with a 5% gain, except for, gulp, 1987. And even in that year, which suffered a crash in October, stocks continued to run into late August.

The nuanced message of the market then could well be to stay in at least through the end of August, with a style tilt toward large caps.

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