All good for small-caps? All aboard the Russell 2000 express train to glory? You did see the performance of said index on Friday, did you not? Year to date, the Russell 2000 has run 12.8%. A raucously good year, most years. However, 2017 is a year that has the blue-chip Dow Industrials up a monstrous 24.8%, the broader S&P 500 up a more "pedestrian" 19.5%, and the Nasdaq Composite up an almost absurd 28.9%. So, our small-caps, though outperforming the rest of the equity space in last Friday's pre-tax reform announcement euphoria, did truly underperform most of the equity space in 2017. It is not a normal year when 12% plus performance identifies a group as a serious laggard.
Now that tax reform seems likely to pass and we know what's in it, we can see that there is a provision that can be taken as a possible negative for the Russell 2000. That would be the Tax Treatment of Interest. The current law on this is quite generous. Full deduction of interest paid. Huzzah. Can't beat that. The new law will discourage heavy reliance upon debt used to grow, or maybe even just survive. We're talking limiting deductions to 30% of EBITDA (earnings before interest, taxes, depreciation, and amortization) for four years, and 30% of EBIT after that. Whoa.
Many small-caps are heavily indebted, particularly the biotechs. I am sure you have noticed the haircut that many equities in this space have seen in their share price of late. This is the "why". Now, keep in mind reduced interest deductibility in a rising interest rate environment. Uh oh. Especially across small-caps, investors are going to have to be stock pickers.
Passive (lazy) investment, such as throwing some money at a Russell 2000 index based ETF such as the ishares Russell 2000 ETF (IWM) , or Vanguard Russell 2000 ETF (VTWO) might not be enough. You are going to have to apply yourself. Not that those funds would not be useful as a way to line a portfolio specifically aimed at beating small-cap performance with a benchmark, but there will be a need in 2018 for investment in individual small-cap names alongside such a useful vehicle.
The following three charts attempt to illustrate the performance of the Russell 2000 versus the blue-chip Dow Jones Industrial Average while using the S&P 500 as a baseline as that index is the broadest, most valid measure we have of US equity market performance in my opinion.
One day chart of Friday's action shows the small-caps playing catch-up after being left behind for so long. Reminder: the stated performance is versus the S&P 500, not realized performance versus the prior close. This is for comparison's sake.
The three-month chart of the Russell 2000 displays the volatility in this index, as rumors of an eventual tax reform changed rapidly throughout the autumn, regarding not just the possibility of passage, but also what was to be included within the bill.
I think this chart just about tells it all. What weighs more for the small-caps? The reduction in the corporate tax rate and the new ease of expensing business purchases, or the far rougher treatment of interest paid? That will leave some firms already in a bit of a pickle, with a tough road to travel ahead of them.
(This is an excerpt from Stephen "Sarge" Guilfoyle's Morning Recon, which now appears exclusively on Real Money, our premium site for active traders. Click here for a free 14-day trial and receive Morning Recon every day, along with exclusive columns from Jim Cramer, James "RevShark" DePorre, technical analyst Bruce Kamich and more.)
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