- As volatility has picked up in equities, it’s become increasingly important to identify specific areas of the stock market poised for strength.
- Bank of America Merrill Lynch is highly constructive in the near-term on one group that has everything going for it at the moment.
When market selloffs hit, it’s usually the smaller, less liquid stocks that get hurt the most.
But last month, when the stock market suffered its first 10% correction in years, the opposite happened. Large-cap companies actually fell more than their small-cap counterparts, bucking conventional wisdom.
And if they didn’t already have enough going for them, small-caps proceeded to beat their larger peers on the way back up. Now, the group’s double dip of resilience and good fortune has it poised to shatter records.
So how did small-caps find themselves in this situation? Bank of America Merrill Lynch equity strategist Dan Suzuki has identified three main drivers.
First, he notes that the relative illiquidity seen in small-caps actually benefited them during the early-February market meltdown, which was worsened by forced selling in volatility products. Since small-caps are more thinly traded, they weren’t as vulnerable to sharp, sudden price movements.
Second, Suzuki highlights tax reform as having an outsized positive impact on small-caps. He says the group, on average, paid higher taxes before the cuts, and will therefore see a bigger profitability boost.
Third, he argues the escalating prospect of a global trade war will favor more domestically focused companies, such as small-caps. It’s a dynamic that’s already played out since President Donald Trump first announced tariffs on steel and aluminum, with small-caps outperforming broader indexes.
Beyond those three factors and looking forward, Suzuki says small-caps are more appealing on a valuation basis. He bases this on how much small-cap prices have contracted since November, noting that both mid- and large-cap indexes have seen more moderate pullbacks, making them expensive by comparison.
Don’t believe Suzuki? Well, he has company on Wall Street, with Goldman Sachs also espousing the positive characteristics of small-caps. In the weeks following February’s 10% correction, Goldman highlighted small-caps as one of the two best stock market bets, on an investment factor basis.
“We maintain our tactically bullish stance on small-caps over large-caps given the accelerating economic and corporate profit outlook,” Suzuki wrote in a client note. “The near-term risks appear firmly to the upside.”