Investment dollars have flooded into US small cap stocks this year. The rush of capital reflects investor demand for exposure to the US equity market, favorable tax policy, and the perceived notion that small caps are less burdened by the uncertainties surrounding global trade. The question is: Should investors be piling into small cap stocks now?

Going Small
Investor money into US small cap assets has bolstered both the Russell 2000® Value1 and Growth2 indexes. That many investors have moved into with small caps should come as no surprise. Consumer spending has been better than economists anticipated. At the same time, there is a misperception that small caps are immune to potential trade wars. All of this has led to a market that’s driven by momentum and FOMO – fear of missing out – on the part of investors.

So how will it play out? The US Federal Reserve is shrinking its balance sheet, liquidity is tightening, and interest rates are beginning to move upward. For a broad-based index investor in small cap stocks, these developments may be a cautionary signal. Changes in monetary policy, along with other factors, could spell a potentially abrupt end to the price momentum in small cap stocks.

Behind the Numbers
Shorter-term price action in the market – whether over a day, a week, or a quarter – suggests that much of recent investment in small caps isn’t driven by an investment thesis. Investors’ enthusiasm for small cap stocks has likely depended on the news of the day, or the general price direction of the market. Ultimately, we believe fundamentals will increase in importance again. When they do, we likely won’t see broad-based stock price appreciation in small caps.

For example, five-year earnings growth expectations are back to levels similar to those of 1999 and the early 2000s. However, we believe a small cap earnings growth rate in the mid-teens over the next five years is virtually impossible. While the Fed has been raising rates, they haven’t yet attempted to slow economic growth, focusing instead on interest rate normalization. Meanwhile, corporate debt is as high as it’s ever been, and corporate balance sheets are not in good shape overall. As a result, higher rates and tighter monetary policy are likely to have an effect going forward.

Beware the Over-Levered
Interest rates have been so low for so long and liquidity has been plentiful in recent years. Corporations have taken advantage of that, and it will take time to pay down debts. Assuming the Fed continues to incrementally increase the Fed Funds rate in 2018 and 2019, over-levered, small cap stocks could suffer consequences. In this environment, bankruptcy becomes a real possibility for those small cap companies who have borrowed too much and counted on liquidity and low rates.

Factors on the Horizon
Going forward, the rate of US corporate growth acceleration will be a key factor for investors. The market currently expects it to accelerate over the remainder of 2018. We don’t believe that will be the case. The Fed is behaving as if it’s behind the curve, which could mean they will get incrementally more aggressive and may lead to a classic end of cycle. However, we believe other factors will lead to a different result.

Industrial Outlook: Slower?
A disconnect in the synchronization of global growth has led to a sell-off among large-cap stocks and multinationals this year. While decent economic growth, solid consumer spending, and modest income growth have offset higher input costs, we believe the US will ultimately experience the same slowdown in industrial activity as the rest of the world. Although industrial activity is not a significant part of gross domestic product, it plays a significant role in the performance of the US stock market.

Higher oil prices will are also likely to affect US economic growth. In fact, we believe that has already started to happen. Labor costs will continue to crimp corporate sales margins and tariffs should begin to affect margins. So far, new tariffs have merely tightened supply chains as companies try to pre-order goods. While that may have increased demand in the first half of the year, it could leave a gap in the second half.

Transportation costs are also rising. As a result, margins will be difficult to sustain, and that may surprise investors. Additionally, any benefits from tax reform have probably already been priced into the market.

Positioned for a Resurgence of Fundamentals
We believe small cap stocks remain challenged as a whole. Right now, either the current modest, very long economic expansion will continue, or we’re at the tail end of an economic expansion. If the former is true, investors may have to endure some pain over the next couple of years as liquidity conditions tighten and margins decline. Where tax reform has not yet been priced in, tax savings could allow some companies to reinvest more and accelerate organic growth. We believe selective stock pickers have the potential to take advantage of that.

More specifically, there likely remain profitable companies with businesses based on real secular trends and real initiatives that don’t currently support high valuations, but do have good balance sheets. With the passage of time, these companies may generate returns for patient investors who seek the best values among undervalued stocks. Such companies are not dependent upon protectionist measures, on Fed policy, or on investor disregard for fundamental valuations. In fact, strong fundamentals will be what ultimately draws investors back into these names.

It’s About the Business
It behooves asset managers to make investment decisions based on what a business is worth today, its opportunities, and demonstrated capital management skills. That’s because the passage of time generates returns. New investment ideas are out there, but they are a little more challenging to find these days and patience is required for those looking to see an investment thesis through to fruition.
1 Russell 2000® Value Index is an unmanaged index that measures the performance of the small cap value segment of the US equity universe. It includes those Russell 2000® companies with lower price-to-book ratios and lower forecasted growth values.

2 Russell 2000® Growth Index is an unmanaged index that measures the performance of the small cap growth segment of the US equity universe. It includes those Russell 2000® companies with higher price-to-book ratios and higher forecasted growth values.

The views and opinions expressed represent the subjective views of the contributors. They are subject to change at any time based on market and other conditions. There can be no assurance that developments will transpire as forecasted. This material is provided for informational purposes only and should not be construed as investment advice.  
All investing involves risk, including the risk of loss. There is no assurance that any investment will meet its performance objectives or that losses will be avoided. The ability of an actively managed investment to achieve its objective will depend on the effectiveness of the portfolio manager.