The Russell 2000 index of small-cap stocks which surged 14% from November 8th through end of 2016 beating the S&P 500 index, and continued its climb into 2017, has been selling off as their prospects have been dimmed by the turmoils in the Trump administration. U.S. small-cap equity funds saw outflows of $950 million in the past week and has seen more than $10 billion worth of funds fleeing the space since beginning of the year. Year to date, small cap index is now trailing the S&P 500 index by ~2 percentage points.

Lack of visible progress on corporate tax reform is likely the principal reason for the underperformance of small caps. Tax reform is a policy initiative that would positively impact smaller firms in far greater proportion than it would larger companies – small cap companies pay an effective tax rate of 32% versus 26% for large cap companies. Nine months after the election, tax reform and other business friendly policies such as infrastructure spending and deregulations have yet to happen and the market is increasing factoring in the possibility that it may not happen in foreseeable future.

The bigger issue that investors have to grapple with is that small caps tend to perform best early in the cycle and the recent sell off could be a sign that the economy is slowing. If that were the case, and higher growth is more likely abroad than in the US, the traditional sweet spot in a mature economic cycle would shift to large caps.

Future Wealth’s View

While small caps are certainly having a rough time, all areas of the stock market linked to Trump’s proposed policies are coming under pressure. But, many who have been trained through the years, look at any pullback in the stock market as an opportunity to simply buy on the dip. There is some danger in this Pavlovian experience. Those who appear to know how to play this game have been right so often, that they will not see it when they are wrong, until they are very wrong.

The revolving door of senior staff at the White House and the erratic tweets and messages from the President could ultimately reverse any improvement in economic expectations. The looming debt ceiling distraction that could most likely involve a last minute compromise, is likely to add to the delays in implementing the economic measures that are critically needed to deliver higher and more inclusive economic growth. In the meantime, persistently low inflation is vexing lots of people, primarily the Fed members, who have huddled in Jackson Hole, Wyoming this week.

At Future Wealth, we opine that deeper and more sustained adverse shocks, be they internal or external, would be required to shake the markets into a correction over the near term. However, over the longer term, one cannot obviate the need for a more sustainable engine of value creation to continue the bull run of the markets beyond its 9th year.