By Ryan Irvine, Contributing Editor
Markets generally benefited from Donald Trump’s win earlier this month, with small caps specifically experiencing a bump. While that bump has since leveled, the Vanguard Small-Cap Index Fund ETF remains around 4% higher in the wake of the US election results.
Although that’s noteworthy, it is important to remember that, no matter which party wins, the markets typically move higher following a US election. This is likely driven by the fact that stock investors love certainty, rather than any favourable policies expected to be implemented by the incoming President.
You have no doubt heard many theories about the effects a second Trump Presidency will have on the stock market. You’ve probably also witnessed many pundits picking winning sectors and individual stocks that they believe will outperform based on how they see Trump’s second term playing out.
There is a commonly held belief that Trump is good for commodities such as oil and gold. Many believe his leadership will be a significant positive for smaller companies, good for cryptocurrencies, and bad for vaccine stocks.
For well documented reasons, I am generally skeptical of the value of economic policy “predictions” in terms of adding real returns to long-term portfolios. Nevertheless, let’s look at some current forecasts, including the potential for small cap outperformance under Trump.
Why did small caps move higher?
In the immediate aftermath of the Trump victory, investors began buying up stocks of banks, smaller US companies, and cryptocurrencies, as they speculated about the potential winners from Trump’s preference for higher tariffs, lower tax rates, and lighter regulation.
As opposed to the Canadian financial market, which is dominated by five banks, the US is littered with hundreds of smaller regional banks, many of which are public and, themselves, small caps. Talk of lower regulation propelled investor buying in financials, but due to the sheer number of small US banks, small-cap indexes have benefitted disproportionately from this bump. Looser regulation also tends to make mergers and acquisitions easier in the financial arena – a tangible potential boon for these smaller banks.
Additionally, higher tariffs are thought to be positive for smaller US companies. Industrials are also heavily weighted in small-cap indexes and could be another driver of small-cap gains, thanks to Trump’s policy focus on the domestic economy. In theory, small to mid-sized manufacturers that compete with China (those scant few that are left) should be benefactors.
The impact of tariffs
Generally, a significant increase in tariffs will make many goods more expensive. This has the potential to create inflation, which is bad for most companies, but could be good for commodities. However, with surging costs, it’s unclear whether this will translate to better cash flow in commodity stocks. Low-cost providers are best positioned to benefit from Trump’s tariffs.
In October, gold surged past a record US$2,700 per ounce. Many link this rally to aggressive central bank buying, rising global tensions, and concerns about inflation. The gold-inflation relationship isn’t an exact science. Initially, gold actually moved lower in the wake of Trump’s win – go figure.
Energy stocks
Energy stocks, including oil exploration and drilling companies, have rallied since Donald Trump won the election. With his “drill, baby, drill” campaign slogan, many pundits believe Trump to be friendly to higher petroleum production. While it’s an extremely short period, crude has declined since the election.
We caution that, unless costs are reduced massively, a “drill, baby, drill” policy could be a significant negative for producers if oil prices drop on higher supply. A robust drilling environment will help energy service companies, but in almost every period of falling energy prices in the past, drilling naturally declines. This is bad for energy drillers and service stocks. It remains to be seen what effect, if any, Trump will have on oil companies near-, mid-, and long-term.
Defence companies
It has also been reported that Trump favours defence spending, which should in turn be good for defence stocks. However, the Donald has also stated that he has a plan to end the conflict in the Ukraine and other regions. That’s great for soldiers and people who are dying in the conflicts, but not great for the defence business.
In the end, every prediction is dependent on each of Trump’s policies having the desired effect – easier said than done. In an interconnected world, despite protectionist efforts, global events like pandemics, wars, or a debt crisis will massively affect a sitting government’s policy. Predicting how that will play out over the next four years is a fool’s game.
We advise investors to focus on the earnings quality of the business they are buying rather than a pundit’s prediction about the results of government policy. In most cases, your holding period, even in small caps, should vastly outlast the staying power of a President or Prime Minister and his or her policies.
As for small caps specifically, the outperformance trend was already in place. Small caps have been quietly gaining momentum for the better part of a year. The stock market’s gains are no longer concentrated in a handful of mega-cap technology stocks, and ‘de-globalization’ has been a market buzzword for months.
As we wrote last year (issue no. 22335), the opportunity in small-cap stocks has been centred around the valuation gap between small and large stocks. While that gap has narrowed, driving the outperformance in 2024, average multiples on profitable small-caps remain at a significant discount to their large-cap and mega-cap brethren.
Purely from a numbers perspective, the multiples continue to favour the small. The ten largest constituents in the S&P 500 account for about 36% of the overall index and trade at a forward p/e of 32x. The remaining 490 stocks in the S&P 500 trade at a forward looking 20x. The S&P 600 Small-Cap Index currently trades around 15.5x.
For the first 20 years of this century, small caps traded with premium multiples relative to large caps. If this ratio were to reverse, there remains plenty of room for growth in high quality small-caps, Trump bump or not.