Market Commentary

Bigger Isn’t Always Better

By Rob Sigler, MBA

November 8, 2024

The clear investment winner from the Trump victory in our opinion will be U.S. small capitalization equities (represented by the Russell 2000 index). Four quick points help explain why.

1. Small cap companies derive the bulk of their revenue domestically, and thus are less impacted by the President-elect’s campaign promise to raise tariffs.
2. Small caps are extremely leveraged to changes in interest rates. Unlike large capitalization equities found in the S&P 500 index, most small caps don’t have the cash flow consistency to access the long-term, fixed-rate debt markets.  They are confined to short-term bank loans where interest rates float.  BlackRock estimates that the average S&P 500 company is financed for the next 10 years at a rate of less than 3.5%.  By contrast, most small cap equities are financed for the next 2-3 years at rates between 6% -11%.  Here is the good news.  The Federal Reserve is amidst a campaign to lower interest rates, having reduced Fed Funds by 0.75% in the past three months.  As loans reset for small caps, their interest expense will fall and that delta will bolster profitability.
3. Small caps are extremely sensitive to tax rates. While the House of Representatives election outcome is still being tabulated, most media outlets believe that Republicans will retain legislative control.  If that is the case, it opens the door for Trump to enact one of his campaign promises, namely lowering the U.S. corporate tax rate further from 21% to 15%.  While large capitalization names generate revenue all over the world, and thus are subject to different tax regimes, small capitalization names are largely domestic in nature.  Thus, they tend to feel the full extent of the tax reduction.  This will drive faster earnings growth within the small cap universe relative to large caps.

4.  Finally, while past performance is no guarantee of future results, small capitalization equities have dramatically outperformed large cap equities over the long-term (see Dimensional chart below).

That said, the opposite has been true over the past 10 years.  According to JP Morgan Asset Management, the 10-year annualized return of large cap growth (indicative of the S&P 500) has outpaced small caps by over 7.5% annually.  That delta is unprecedented and has been driven by a concentrated group of equities.  To illustrate, the top 10 names within the S&P 500 account for nearly 36% of the index weight and have accounted for over 50% of performance.  Their collective Price/Earnings ratio is a whopping 31x.  That is 150% of average since 1996.  To say that has left large cap companies quite rich relative to historical standards is an understatement.  We believe the aforementioned points above will prove to be the catalyst to drive mean reversion.

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