Investment dollars have flooded into U.S. small-cap stocks this year, bolstering both the Russell 2000 Value and Growth indices. This is largely due to investor demand for exposure to the U.S. equity market, favorable tax policies and a 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?
Investors' love affair with small caps comes as no surprise. Consumer spending has been better than economists anticipated, and meanwhile, 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 Federal Reserve is shrinking its balance sheet, liquidity is tightening and interest rates are beginning to move. 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 reveals that much of the recent investment in small caps wasn't driven by an investment thesis. Instead, investors' enthusiasm has largely depended on daily market moves and news. Ultimately, we believe fundamentals will increase in importance again, leading away from broad-based stock price appreciation in small caps.
Right now, 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, it hasn't yet attempted to slow economic growth, focusing instead on interest rate normalization. Meanwhile, corporate debt is as high as ever, and corporate balance sheets are not in great shape. As a result, higher rates and tighter monetary policy will have a negative effect.
Assuming the Fed continues to incrementally increase the fed funds rate in 2018 and 2019, over-leveraged small-cap stocks will suffer the consequences. Corporations have taken advantage of the sustained low rates and plentiful liquidity, and it will take time to pay down debts. In this environment, bankruptcy becomes a real possibility.
(More: Small-cap stocks unfazed by trade tensions)
Factors on the horizon
The rate of U.S. corporate growth acceleration will be a key factor in small-cap valuations. The market expects acceleration through the remainder of 2018, but we disagree.
The Fed is behaving as if it is behind the curve and becoming incrementally more aggressive, leading to a classic end-of-cycle, but we feel other factors will drive down the market.
For one, while decent economic growth, solid consumer spending and modest income growth have offset higher input costs, we believe the U.S. will ultimately experience the same slowdown in industrial activity as the rest of the world, which plays a significant role in the performance of the U.S. stock market.
In addition, higher oil prices will affect U.S. economic growth. Rising labor and transportation costs will continue to crimp corporate sales margins, and recently imposed tariffs have already begun to do the same by tightening supply chains. While that may have increased demand during the first half of the year, it will leave a gap in the second half. And any benefits from tax reform have already largely been priced into the market.
(More: Barclays joins Morgan Stanley in questioning small-cap rally)
Positioned for a resurgence of fundamentals
We believe small-cap stocks remain challenged as a whole. 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 will 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 will allow companies to reinvest more and accelerate organic growth. Selective stock pickers can take advantage of that.
There are profitable companies with businesses based on real secular trends and real initiatives that don't currently support high valuations but that do have good balance sheets. With the passage of time, these companies will generate attractive returns for patient investors who seek the best values among undervalued stocks.
It behooves asset managers to make investment decisions based on what a business is worth today, its opportunities and its 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 to see an investment thesis to fruition.
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Daniel Hughes is client portfolio manager at Vaughan Nelson Investment Management.
