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US small-caps play catch-up with fresh highs

Optimism that the Trump administration is close to proposing a series of business-friendly tax reforms sent the main barometer for US small-cap stocks to a fresh high on Monday for the first time in more than two months.

The Russell 2000 index, which tracks companies with market values of roughly $300m to $2bn, climbed as much as 0.7 per cent on Monday to 1,398.6, knocking out its December 9 2016 peak.

Enthusiasm over small-caps has re-emerged after easing earlier in 2017 after Mr Trump said last week that he will soon unveil a “phenomenal” business tax reform package.

Since Russell 2000 companies generally have less access to international tax havens, they typically face an effective rate of 32 per cent, compared with 26 per cent for the S&P 500, according to calculations by Credit Suisse.

That means they may have more to gain if Mr Trump is successful in pushing Congress to reduce the corporate tax rate from 35 per cent, which is among the highest across the developed world.

“Small-cap stocks are the likely beneficiaries of a Trump tax cut and infrastructure-spending bill,” noted Sam Stovall, chief investment strategist at CFRA.

They surged more than 13 per cent between Mr Trump’s election and the end of 2016, comfortably eclipsing the 4 per cent gain for the S&P 500 index, the primary gauge for large-cap stocks.

However, small-caps lost some of their sparkle at the start of this year as investors questioned whether Mr Trump would be able make good on his promises to reform the tax code and unleash a vast spending programme aimed at rebuilding the arteries of American commerce, like roads, bridges and airports.

As a result, the S&P 500 hit an all-time peak just four trading days into 2017, more than a month before the Russell caught up.

While the Russell has climbed higher in recent days, and is up 2.7 per cent for 2017, some investors are growing wary that small-caps are beginning to look expensive.

“Prices appear to be well ahead of fundamental forecasts and may therefore be vulnerable to downward readjustment,” Mr Stovall warned.

To that point, the Russell is valued at 23.9 times expected earnings over the next year, up sharply from 20.1 times last February, FactSet data show.

Small-cap valuations are in line with those that were hit during the dotcom bubble at the turn of the millennium, something that “does not bode well for future returns”, added Dan Suzuki, a strategist at Bank of America Merrill Lynch.

Echoing that concern, Henry Ellenbogen manager of T Rowe Price’s $16.7bn New Horizons small-caps fund, told the Financial Times earlier this month that he had become more anxious that valuations have bubbled up ahead of fundamentals.

“Small-caps are trading at a significant premium. To believe that that can continue you have to believe that US economic growth can accelerate significantly over the next few years. I’m not sure about that,” he said.

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