Small Caps Are Flashing a Buy Signal

While celebrating Memorial Day yesterday at the family homestead, discussions of the economy and markets accompanied our consumption of beer and barbecue. U.S. unemployment is at a 50-year low, the country’s gross domestic product (GDP) growth was robust in the first quarter, and the stock market year-to-date is up by double-digits.

So why, between mouthfuls, was everyone grumbling about their investment prospects? This gloominess is mirrored on Wall Street, where bearish sentiment is rising.

The U.S.-China trade war isn’t helping. President Trump said yesterday that the U.S. was “not ready” to make a trade deal. What’s more, the decade-long recovery has peaked. The economy has nowhere to go but down.

Don’t get me wrong. You can still find growth opportunities in this market. But the easy money is behind us. You need to calibrate your portfolio toward the challenges ahead. One smart move now is to increase your exposure to small-cap stocks, which are generally defined as having market valuations of between $300 million and $2 billion.

Below, I highlight the virtues of small caps and why they can help you mitigate risk and maximize growth.

But first, let’s look at the unmistakable red flags that you should heed…and why they underscore the virtues of the small fry.

The red flags…

Consumer spending accounts for nearly three-fourths of the U.S. economy. When this indicator weakens, it’s an ominous portent. In the first quarter, consumer spending slowed to a growth rate of only 1.2%, down sharply from 2.5% in the previous quarter.

Political uncertainty, the threat of higher interest rates, trade war tensions, and a general sense of unease have prompted consumers to pull back, especially on vehicle purchases. Not surprisingly, several major retail outlets in the first-quarter earnings season reported slow to flat sales growth.

Business investment (spending on equipment, capital goods, and factories) rose only 3% from a year earlier, whereas spending rose about 20% in the first quarter of 2018 in the wake of the massive U.S. corporate tax cut. Managers cited the trade war with China as the main culprit, but lower business spending also is a function of slowing domestic demand.

Even the unexpectedly high year-over-year growth of 3.2% in first-quarter GDP is misleading. As always, you need to disregard the self-serving government hype and look behind the numbers. The jump in large part stems from the way corporations are responding to the trade war. As tariffs take effect, companies are excessively building up inventories to obtain materials and semi-finished goods before their costs go up. This frenzied stockpiling won’t last.

Many analysts already are predicting substantially lower growth for the next quarter. Morgan Stanley revised its second-quarter GDP growth estimate to 1.1%; Macroeconomic Advisers expects a growth rate of 1.8%. In both cases, economists blamed the trade war and the artificial buildup in inventories.

For big growth, think small…

In previous issues of Mind Over Markets, I’ve outlined tactics to take amid today’s dicey investment conditions.

Read This Story: Quarterly Earnings: Don’t Expect the Cavalry

I’ll now elaborate on why you should increase your exposure to small caps.

Trump’s “America First” policies pose a threat to export-dependent giants, but they’d actually benefit small caps. The majority of U.S. small caps derive the bulk of their sales domestically, which means that trade wars and a strong U.S. dollar tend to hurt them less.

Historically, small caps outperform during inflationary and rising interest rate environments, because they typically have low debt, making the risk of refinancing debt expense at higher rates immaterial.

Furthermore, many small companies are “disrupters” that operate in new markets where competition is initially low. They consequently enjoy the ability to raise prices easier than large caps, which paves the way for high profit margins.

America’s growth engine…

Over the long term, small caps tend to outperform the broader market. The chart shows the 20-year price appreciation of the small-cap benchmark Russell 2000 index versus the S&P 500 index:

Every portfolio should have exposure to small caps. Now’s a good time to start.

Small businesses represent 99.7% of all U.S. employers. They employ half of all private sector workers. They account for up to 80% of the new jobs created annually in the country.

It’s a truism that small companies form the heart of the country’s job creation. They also generate breakthrough technologies.

In this decade-long bull market, mega-cap market leaders are poised to become laggards. Inflated expectations will catch up with them. Conversely, several tailwinds position small stocks as safer havens for investors.

For one thing, the tax bill signed by President Trump in December 2017 confers many benefits on smaller companies. Profitable firms in the Russell 2000 tend to pay higher taxes than global behemoths. The big boys are adept at lowering their rates through expensive lobbyists and accountants; they also avoid taxes by squirreling their profits overseas.

The tax bill slashed the top corporate rate to a flat 21% from the highest 35% rate. The benefits of the tax bill are fading for large companies but they’re more lasting for the smaller fry.

The tax overhaul included numerous changes to the taxation of income from pass-through entities such as S corporations, limited-liability corporations and partnerships. In general, the new law allows businesses to exclude 20% of their net income from taxation, subject to certain limitations. The deduction also can be limited or disallowed for specified service trades—such as lawyers, doctors and accountants—based on an income threshold.

Overall the changes to the taxation of pass-through entities already are beneficial to many small business owners. That’s a big (and long-lasting) shot in the arm for the country’s innovators.

Another advantage for small companies is how Trump’s laissez-faire cabinet members and agency heads are lessening regulations against the financial services sector. That in turn is making it easier for regional banks to give loans to small companies.

To be sure, small caps entail greater risk. But they also confer greater upside potential. America’s small companies are positioned to outperform their larger brethren and provide much-needed adrenaline to an economy that’s probably on course for a downturn. In a year abounding with investment peril, the entrepreneurial “little guy” just might save the day.

Questions about small-cap stocks? Drop me a line:

John Persinos is the managing editor of Investing Daily.