The Prospects For Tax Reform Fuel Small-Cap Rally

There’s a long road ahead for the tax plan rolled out by Republicans this week, but small-cap stock investors are inclined to buy now and ask questions later.

Companies in the small-cap Russell 2000 Index have trailed large caps (Russell 1000) this year, but the tide has turned over the last month. The iShares Russell 2000 ETF (IWM) is up nearly 8% through yesterday’s close (Sep. 28) vs. the month-earlier level, far above the 3% gain for the iShares Russell 1000 ETF (IWB) during that stretch. It could be noise, of course, but some analysts think the recent chatter about tax reform in Washington has been a gift for small stocks that will keep on giving.

TheStreet.com notes that “small cap stocks tend to be more sensitive to corporate taxation rates, mostly because, unlike top-tier companies, they are unable to shift cash to overseas jurisdictions to avoid the long arm of the Internal Revenue Service.”

“It’s pretty clear from a corporate perspective that small caps are set to benefit the most” from the GOP tax plan, Katie Koch of Goldman Sachs Asset Management told CNBC yesterday. A key aspect of the logic for this view is the proposed reform’s reduction in the corporate tax rate to 20% from the current 35%. According to CNBC, the benefit for small caps is moderately higher relative to large caps:

Companies in the small-cap Russell 2000 pay a median effective tax rate of 31.9 percent, while the larger, multinational companies in the S&P 500 pay a median effective tax rate of 28 percent, according to Thomson Reuters data. The median for the 30 mega-cap stocks in the Dow Jones industrial average is just 23.8 percent.

Enacting the tax plan as currently designed, however, faces several challenges that could alter the legislation or perhaps send it to the political graveyard. One of the more contentious issues is the projection of how a hefty tax cut will impact the US deficit.

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