Small-caps stir as tax reform takes shape

Tax reform, given up for dead a few months ago, is now seen as an increasingly likely reality—at least in some form.1 It’s still a big “IF,” but IF Washington is able to pass legislation that contains the corporate-friendly policies that have been touted by both the House and Senate, the stock market should respond favorably, since lower corporate tax rates = higher profitability = higher share prices. That’s the theory, anyway.

Of course, anticipation of lower corporate tax rates has arguably already been a factor in the market rally that kicked off in November 2016. Now that the House has finally passed its bill and the Senate has moved its version out of committee, attention is focused on the final form the proposed law will take and when it will take effect. Regardless, a successful overhaul will be a juicy news story—and even if that news has already been priced into the market to a certain extent, another euphoric bump is still possible.

So, what to trade? Not all areas of the market are expected to benefit to the same degree, but most industry insiders agree small-caps are on the short list of stocks that will.1 One reason: Small-caps as a whole derive more of their revenues domestically than do large-caps, making them more responsive to tax policies.2

YTD relative performance of RUT, NDX, and SPX as of November 29

Source: E*TRADE (Data)

Enter the Russell 2000 index (RUT)—the small-cap index. The chart above compares the year-to-date performance (midway through yesterday’s trading session) of the Russell, the Nasdaq 100 (NDX), and the S&P 500 (SPX). The chart clearly shows RUT has been the weak link this year, thanks in large part to a couple of periods (marked with rectangles) when it turned down with greater force than the SPX or NDX (July–August), and then turned down when the other two were actually moving higher (October–November).

Now take a look at the following chart of the December E-Mini Russell 2000 futures (RTYZ7), which highlights the sharp rally the small-cap index has made since mid-November. The Russell rocketed off its November 15 low and formed a brief consolidation (aka, a “flag” pattern) near the level of its early October highs, then burst out of it on Monday.

December E-Mini Russell 2000 futures (RTYZ7), 6/20/2017 – 11/29/17

Source: OptionsHouse

The Russell has jumped from laggard to leader—at least over the past couple of weeks. If tax reform eventually happens, there’s a chance for prolonged staying power. The following table compares RUT, NDX, and SPX year-to-date returns through November 15 and their returns from November 15 through yesterday:
Indices before and after November 15

Source: E*TRADE (Data)

Traders interested in small-caps can choose from the Russell futures and options, or individual stocks. Those going the latter route can use the E*TRADE stock screener to find stocks that fit their trading profile. You can filter for stocks according to market cap and a wide range of fundamental and technical criteria.

But don’t forget: While the odds currently appear in favor of some kind of tax reform being passed, we all know how things can change on a dime in Washington—in which case the Russell may be a leader to the downside on the disappointment.


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1 The Tax Reform 80% Likely by Early 2018, Goldman Says. 11/14/17.

2 Investopedia. 5 Ways Tax Reform May Boost Stocks. 10/5/17.

3 These stocks will benefit the most from tax reform: Goldman Sachs. 9/28/17.