The Prospects For Tax Reform Fuel Small-Cap Rally

There’s a long road ahead for the tax plan rolled out by Republicans this week, but small-cap stock investors are inclined to buy now and ask questions later.

Companies in the small-cap Russell 2000 Index have trailed large caps (Russell 1000) this year, but the tide has turned over the last month. The iShares Russell 2000 ETF (IWM) is up nearly 8% through yesterday’s close (Sep. 28) vs. the month-earlier level, far above the 3% gain for the iShares Russell 1000 ETF (IWB) during that stretch. It could be noise, of course, but some analysts think the recent chatter about tax reform in Washington has been a gift for small stocks that will keep on giving. notes that “small cap stocks tend to be more sensitive to corporate taxation rates, mostly because, unlike top-tier companies, they are unable to shift cash to overseas jurisdictions to avoid the long arm of the Internal Revenue Service.”

“It’s pretty clear from a corporate perspective that small caps are set to benefit the most” from the GOP tax plan, Katie Koch of Goldman Sachs Asset Management told CNBC yesterday. A key aspect of the logic for this view is the proposed reform’s reduction in the corporate tax rate to 20% from the current 35%. According to CNBC, the benefit for small caps is moderately higher relative to large caps:

Companies in the small-cap Russell 2000 pay a median effective tax rate of 31.9 percent, while the larger, multinational companies in the S&P 500 pay a median effective tax rate of 28 percent, according to Thomson Reuters data. The median for the 30 mega-cap stocks in the Dow Jones industrial average is just 23.8 percent.

Enacting the tax plan as currently designed, however, faces several challenges that could alter the legislation or perhaps send it to the political graveyard. One of the more contentious issues is the projection of how a hefty tax cut will impact the US deficit.

Treasury Secretary Steven Mnuchin says the tax plan will pay for itself on the assumption that cutting taxes leads to faster economic growth. “We think there will be $2 trillion of growth,” he said on Fox Business via Politico. “So we think this tax plan will cut down the deficits by a trillion dollars.”

More than two-dozen economists surveyed Bloomberg think not. Instead, if the plan in its current form becomes law they project that the budget deficit will widen over the next decade.

No matter, the crowd is enthused about the potential for relatively strong small-cap returns going forward, or so recent history suggests. But while small company shares have been red hot over the past month, this corner of equities is still behind large caps for year-to-date results: the large-cap IWB is up 13.5% so far in 2017 through yesterday vs. a 10.7% rise for IWM.

The gap, however, is closing fast, and by some accounts the future for small-cap performance remains bright. The Leuthold Group’s Jim Paulsen, writing in Barron’s this week, outlines six factors that he thinks will give small stocks a tailwind going forward. “So far in 2017, small Cap stocks have had a difficult time but several coincident indicators seem poised to turn more favorable.”

Upside momentum for IWM in recent weeks certainly looks encouraging.

But to the extent that a new bull market in small-caps is dependent on enacting the Republican tax plan in its current form, the obvious caveats apply. It’s anyone’s guess if the Democrats can derail or radically reform the GOP tax-reform effort, but the loyal opposition will certainly try. The obvious risk: a small-cap rally that thrives on political expectations may be vulnerable if the GOP’s momentum on tax legislation fades.

An early challenge: the battle over the state and local tax deduction, which is worth $1 trillion over a decade for the budget. The Republicans want to repeal it to pay for new tax cuts, but some GOP House members from high-tax states aren’t keen on the idea.

“The members with concerns from high-tax states have to be accommodated. This has to be dealt with,” says Rep. Peter Roskam (R., Ill.), a senior member of the House Ways and Means Committee. “So, you can imagine a soft landing on this that creative people are putting much time and energy into.”

So, yes, tax reform could benefit small companies. But given the GOP’s less-than-stellar track record for passing big-picture legislation this year (think Obamacare repeal efforts), there’s reason to wonder how the new push for tax reform will fare, and in what form?

Meantime, a bit of ancient Wall Street wisdom still applies: buy on the rumor, sell on the news. For the moment, it’s all about rumor. The news, by contrast, remains a work in progress.

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