4 reasons to weight your portfolio toward small-cap growth stocks in 2017
Investors have been piling into financial stocks since Election Day, but the Russell 2000 has been blasting past the S&P 500.
- BY JEFF REEVES,
- MARKETWATCH
- – 12/22/2016
With the stock market at all-time highs and all the headlines about Dow 20,000, investors are buying U.S. stocks with confidence and optimism once again.
However, not all stocks are created equal — and some trades are more popular than others.
Many pundits are touting financial stocks as a tactical opportunity thanks to the hope of more favorable regulations out of Washington and better margins thanks to higher interest rates. Investors seem to be buying that narrative, based on a stunning 18% gain for the Financial Select Sector SPR ETF ( XLF
) since Election Day vs. just 5.9% gains for the S&P 500 ( .SPX
) in the same period.
However, the nonstop run has made the financial sector a bit of a crowded trade. And some investors (myself included) are urging caution now that many banks such as Wells Fargo ( WFC
) and Bank of America ( BAC
) have run up too fast.
So if you’re not interested in overbought financial stocks, where should you look if you’re still eager to take advantage of this raging bull market and tap into the reflation of the U.S. economy?
Try small-cap growth stocks.
After all, financial stocks have only recently gotten their groove back; the vast majority of the XLF’s gains this year have come since the election. However, the iShares Russell 2000 ( IWM
) has outperformed the large-cap S&P 500 index handily in 2016, up 21.2% to 10.8% this year through Wednesday.
The Vanguard S&P Small-Cap 600 Growth ETF ( VIOG
) has done even better, climbing 21.7% this year — and its post-election gains of 16.25% through Wednesday have outstripped those of the iShares Russell 2000.
That’s in part a response to this asset class being oversold in 2015 and bottoming out. But it’s also because of big growth opportunities in small-caps that were taking shape before the Trump trade and now are looking even brighter after Election Day.
Despite this, the small-cap resurgence isn't getting quite as much attention as the run for financials. And that means there could still be an opportunity to stake out a claim in individual picks or broad-based index funds without overpaying.
2017: The year of small caps
The narrative that has fueled the broader stock market rally is, in fact, tailor-made for small-cap stocks. It goes something like this:
Better credit availability: While lenders have been getting all the love, let’s remember that more favorable financial regulations can be good for borrowers, too. If capital restraints are loosened and allow for better credit availability, smaller companies that don’t have the deep pockets of blue chips will benefit as they find it easier to get cash to fuel their growth.
Fiscal stimulus: While the details remain hazy, President-elect Donald Trump and many of his Republican partners in Congress are eager to inject a massive stimulus into the economy. For megacap stocks, $10 million in extra contracts may not matter… but when you’re a small-cap stock doing a only few hundred million in total revenue annually, that adds up in a big way.
Return of “risk-on” trades: Rising rates are making longer-duration bonds less attractive, and that has forced a rotation of cash into stocks. And at the same time, the 10-year Treasury yield is finally back above 2.5% while the typical S&P 500 yield is only about 2.0% right now. That makes sleepy large-cap dividend payers much less attractive, and sets the stage for investors to favor more volatile but more “growthy” small caps in the new year.
Enjoy the ride while it lasts: Of course, the euphoria may not last forever and eventually the old narrative of stagnant global growth could return. So if you want to strike while the iron is hot, take advantage of smaller companies that can ramp up faster and are much “simpler” companies — particularly those focused on domestic opportunities instead of juggling the complex operations of a multinational operation. The current rally will inevitably lose momentum, so take enjoy the ride while it lasts in smaller stocks best positioned to profit.
8 stocks to consider for 2017
If you're researching investments for the new year, take a look at these eight growth stocks.
It all adds up to a compelling reason to weight your portfolio toward small cap growth in 2017, either through individual names or with a broad-based play like the iShares Russell 2000 ETF.
Valuations are still fair; momentum is still strong
You may be wondering why I consider small-caps an opportunity but see financials as overbought, considering they share many of the same growth narratives and roughly the same outperformance.
However, it’s pretty difficult to ever consider a bank as a true “growth” stock even in an environment of short-term improvement in fundamentals thanks to macro conditions. And after the sentiment pop fades in financials, there’s not much staying power vs. a growth narrative in a small company that will last.
And beyond that, the advantage of small caps lies not just in growth potential, but in valuation.
Smaller U.S. stocks had largely been left for dead in 2015 thanks to a number of factors, including the crash in commodity prices that threatened a wave of junk-bond defaults in smaller miners and energy companies. At the same time, uncertainty around the presidential election at home and Brexit in Europe caused many investors to steer away from riskier small-caps for much of 2016.
However, even before Election Day investors started to view the sector as oversold — and even now, after a big run, the forward P/E of the Russell 2000 ( .RUT
) is trading 20.1 times expected 2017 earnings compared with a forward P/E of 19.6 for the Nasdaq 100 and 19.0 for the S&P 500.
That a very small premium to pay on faster-moving small-caps, which have much higher growth potential then blue chips.
Fund flows show investors are clearly interested in the risk-on equities trade right now; According to Morningstar, the SPDR S&P 500 ETF ( SPY
) topped all passive index funds with inflows of $7.5 million on the month, but in second place was the small-cap focused iShares Russell 2000 ETF with $6.2 million — just above the $6.1 million sucked up by the Financial Select SPDR that has been so popular in recent weeks.
That in itself is a very bullish sign, since small-cap stocks are frequently momentum names that ride as much on sentiment as they do on any underlying growth metrics.
In other words, take what the market gives you and join in this small-cap rally while it lasts. Not only is it equally powerful for investors as the rise in financial stocks, it will likely prove much more durable.
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