Why large companies have outperformed in 2017

Since the start of the year, large cap stocks have outperformed small cap stocks in both the US and the Australian markets. In the US, this came as a big reversal for small companies, which reported huge gains immediately after the election of Donald Trump. Since the start of 2017, however, the Russell 2000, an index of small companies, has underperformed the S&P 500 and the Nasdaq by 4% and 8%, respectively.

Source: The Wall Street Journal

In Australia, the MSCI Australian Small Cap index has underperformed the ASX 200 by 3% this year. This is also a reversal relative to 2016, when small companies outperformed by about 5%.

2016 – Small Caps (black) vs Large Caps (green)

Source: barcharts

2017 – Small Caps (black) vs Large Caps (green)

Source: barcharts

So, what happened?

Part of the reason is just a correction of expectations, especially in the US. In November alone, US small caps surged by 11%, as investors expected that Trump’s tax changes and infrastructure plans would benefit smaller companies the most. Also, small caps, which tend to be less reliant on exports than larger companies, would be the least affected by potential trade wars and protectionism that could come from the new administration.

In Australia, large companies started to catch up in 2016, earlier than their US counterparts, but part of it was also due to a correction and a shift in sentiment.

The major reason, however, has to do with earnings growth. Domestically oriented companies are expected to grow slower than export oriented companies, as economic conditions improve around the world.

In Europe, Japan and China, business surveys and markets have turned more optimistic after signs that economic activity improved in the second half of last year. Oil prices increased after petroleum exporters reached an agreement to curb production, and trade protectionism seems to be on the retreat. This tends to benefit mostly larger companies.

In the US, S&P 500 companies more internationally exposed are expected to report twice the earnings growth of domestically focused companies.

Source: The Wall Street Journal

This is almost a complete reversal from one year ago, when a weak global economy was expected to hurt mostly earnings of international companies.

In Australia, the last earnings season also reinforced the small cap/large cap divide, as many previously admired small stocks announced disappointing results. Yowie Group, Genworth Mortgage Insurance and OFX group are good examples of smaller companies which missed either guidance or market consensus, and were heavily punished for it.

In the current conditions, and if most of the world continues to grow faster than domestic markets, we expect small cap weakness to persist.

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The information contained in this article is General in nature and has been prepared without taking into account your objectives, financial situation and needs.