Co-CIO Francis Gannon looks at the earnings picture for small-caps versus large-caps and sees a silver lining for earnings-focused active managers.

Concerns have surfaced recently in the pages of the Wall Street Journal and Financial Times about the ongoing strength of small-cap earnings on both an absolute basis and relative to their large-cap peers.

The first line of reasoning in each piece more or less parallels what we argued earlier this year—that policies designed to reinvigorate the U.S. economy, including a reduction in the corporate tax rate, infrastructure spending, and deregulation, stood to give a greater boost to domestic small-cap stocks, which saw the lion’s share of gains in the postelection rally.

However, with earnings season just getting under way, small-caps face a potential obstacle to earnings growth in the form of the stalled policy agenda of the new Administration, which is invoked in both stories as one of the primary reasons large-caps are likely to push past small-caps this year. Another reason is the renewed strength of the global economy.

With U.S. fiscal policy on hold and the global economy showing encouraging signs of life, the argument is that large-caps are better positioned for robust earnings growth than their more domestically oriented small-cap peers.

Recent returns arguably show that many investors would concur—the small-cap Russell 2000 Index has been essentially flat since hitting a 2016 high on December 9th while the large-cap Russell 1000 and S&P 500 Indexes have advanced.

However, it also merits mentioning that small-caps were in very good shape from an earnings and market performance perspective prior to the election, with the Russell 2000 comfortably ahead of both large-cap indexes year-to-date in 2016 as we headed into the election.

So we don't see small-caps as being in great danger of a significant correction or a major earnings slump. Perhaps more important is our contention that the articles may well be correct in their respectively downbeat assessments of the overall earnings picture for small-cap and large-cap stocks over the short term. Large-caps—as a whole—may do relatively better in the months ahead.

As bottom-up small-cap specialists, however, we are much more focused on the earnings potential of individual companies, not the small-cap index, and our expectation is that most of our holdings, lodged as many of them are in economically sensitive cyclical areas, should be all right. To be sure, in many cases their strong earnings history or potential to recover was a major reason for their appeal to us.

This is especially the case for those companies with a global reach of their own—these businesses are as excited as any of their larger counterparts about the prospect of an expanding global economy.

We also own several companies that are domestic suppliers to bigger U.S. firms which themselves have wide-ranging global businesses. So while our holdings appear strictly domestic on the surface, their end markets are worldwide and thus can also potentially participate in any acceleration in global growth.

Many of them are tech-based component makers that are already participating in the global technology buildout that encompasses artificial intelligence, autonomous driving, public and private cloud storage, and the expansion of the semiconductor industry in China.

So even with increased uncertainty about the short-term pace of domestic growth, we are still highly encouraged by the earnings potential for many small-cap companies.

Stay tuned…

Important Disclosure Information

Mr. Gannon's thoughts and opinions concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

The Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The Russell 1000 index is an index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 index. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Investments in securities of micro-cap, small-cap, and/or mid-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) Investments in foreign companies may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see "Investing in International Securities" in the prospectus.)

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