Can small caps keep living large? Probably not

By Marley Jay
AP Markets Writer

NEW YORK (AP) — The smallest companies have packed twice the punch of their bigger brethren in the last few months, but it might not last.

Rising trade tensions between the U.S. and China have battered the stock market overall recently, and the S&P 500, which tracks large U.S. companies, has yet to recover the steep losses it took as investors worried about a possible trade war that could slow the growth of the global economy.

Within the market’s recent bout of turbulence, however, smaller companies have fared much better than larger ones. Since the market’s recent low on Feb. 8, the Russell 2000 index of small company stocks is up 11 percent, almost double the gain of the S&P 500. And the Russell, like the S&P Small Cap 600, has set all-time highs in the last few days.

Brent Schutte, the chief investment strategist at Northwestern Mutual Wealth Management in Milwaukee, said the difference can be attributed to the fact that investors anticipate that smaller companies, which are far more U.S.-focused than large multinationals, are less likely to suffer if tensions with China and other trading partners escalate.

Schutte doesn’t expect small companies to continue to outperform, however. With interest rates rising and the U.S. economic expansion maturing, he said larger companies will do better than their smaller peers over a longer time frame.

Answers have been edited for length and clarity.

Q: Why have small caps recovered from their losses more rapidly than other stocks?

A: The belief is that small caps are more domestically focused and therefore they wouldn’t be impacted by any tariffs or trade issues. I think this is a shorter term phenomenon. People suggest that if the dollar is strengthening, that hurts large cap multinationals more and that small caps are the way to go. But from 2002-2007, small caps outperformed large caps and the dollar actually weakened. I’m not so sure that that holds, but I do believe that’s why small caps have had a decent rally here compared to large caps.

Historically speaking, when monetary policy is too easy and the Fed is trying to push down the price of risk, that favors small caps because you, as an investor, will take more risk. When the Fed is pushing up monetary policy and trying to increase the price of risk, large caps outperform small caps. As we move toward the end of this (economic) cycle, that would tend to favor large caps over small caps.

Q: The tax cut helped the stock market broadly. Why was it so favorable to these stocks in particular?

A: Small cap companies have less options available to them to minimize their taxes. And domestic strength in the U.S. economy vs. other markets ties in with tariffs, other tax cuts, and the potential that global trade may slow down, which pulled investors back into the U.S. after they had been abroad for some time. I think those are all shorter-term, one-time things that will potentially give way to people focusing on the economic cycle and favoring the S&P 500 over small caps.

Q: How should investors respond to the recent weakness in larger companies and strength in smaller ones?

A: I would suggest investors be disciplined in how they allocate their investments. I worry that in today’s world, people become too confident in their abilities and chase shorter term themes that are less likely to play out longer term.

I’ve continued to advise investors to make sure they were invested in commodities because I believe the one variable that puts the recovery at somewhat of a risk is inflation spikes, and that may cause the Fed to react more aggressively than what the market can handle. And to me, you can’t have inflation in this country without some kind of a commodity tailwind. I’m fearful that investors, after 3 or 4 years of poor and subpar commodities returns, have abandoned the asset class altogether.