Why Small-Caps “Trumped” Large-Caps Last Week

November 16, 2016 | Nat Kellogg, CFA, President

The election of Donald Trump last week caught the market by surprise and created a significant amount of volatility and dispersion across the U.S. equity market. One area of note was the huge outperformance of small-caps (up 7.7% from November 8–11) vs. large-caps (up 1.2% November 8–11). The Republicans made it a clean sweep Tuesday night, winning the White House and maintaining control of the House of Representatives and the Senate. While there is a lot of policy uncertainty as a result of this election, the market now believes there is a high likelihood of corporate tax reform being passed some time in 2017. Donald Trump’s plan calls for a reduction of the corporate rate from the current level of 35% (one of the highest rates in the world) to just 15%. Paul Ryan previously put forward a plan for corporate tax reform that would lower the rate to 20%.

While a cut in corporate taxes is likely to benefit all companies, our chart of the week shows that small-cap companies pay a much higher effective rate (i.e., the rate they actually pay after deductions and credits) than their large-cap peers. This is primarily because large multi-national companies generate a significant portion of their earnings in lower tax countries, while small-cap companies tend to be domestically focused, and thus pay very close to the U.S. statutory rate.

If the corporate tax rate is cut to 20%, this will result in a much larger increase in earnings for small-cap companies compared to large-cap firms (shown by the green dots on the graph). Optimism that this increase in earnings from a tax cut will materialize at some point next year is one of the key factors that drove the outperformance of small-caps last week.