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Face Off: Small Versus Large Cap ETFs

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As the Fed hawks behaved like doves in their March meeting, implementing a modest 25 bps rate hike, the third in a decade, and hinting at no acceleration in policy tightening procedure, a section of investors must have turned more aggressive (read: See How ETFs React When Hawks Act Like Doves).

The next hike is now expected inJune, meaning several days of cheap dollar in hand, causing stocks, mainly risky and aggressive in nature, to soar. Bond yields fell. The yield on 10-year benchmark U.S. Treasuries dropped to 2.50% on March 17 from 2.62% before the start of the Fed meeting on March 13, 2017.

Many took this market behavior as the start of another small-cap rally. This is especially true given the fact that the U.S. economy has gathered steam. Investors should note that the small-cap representative Russell 2000-based IWM has beaten large-cap ETFs like the S&P 500-based ETF SPY in the initial rally after Trump’s win.

The president’s promise of introducing a burst of stimulus by increasing infrastructure spending package, easing regulations, offering tax cuts with an aim of accelerating economic growth, and creating more jobs in the country fired up stocks, especially the pint-sized ones. This was further fueled by Trump’s `America First’ rhetoric. This is beneficial for small-cap stocks as these reflect the conditions of the domestic economy.

Still, small-caps lagged large-caps in the last three months (as of March 17, 2017), with IWM returning about 2.3% and SPY gaining about 5.8%. This makes us think if it is the time is right to bet on large-cap stocks rather than the smaller ones.

Dollar Strength Limited

The latest dollar weakness following the Fed’s dovish guidance should also favor large-cap investing. Dollar ETF PowerShares DB US Dollar Bullish ETF (UUP - Free Report) is down about 2.2% so far this year (as of March 17, 2017). Since large-cap stocks have more foreign exposure, these perform better in a weaker dollar environment (read: What Makes These Large-Cap Value ETFs Good Plays Now).

Global Economy on the Mend

Since large-caps rely heavily on foreign economies, the health of the Euro zone, Japan and emerging economies are very important in taking investing decision. Investors should note that the Euro zone silently surpassed the U.S. economy on the growth front in 2016. For 2016, GDP growth of the Euro zone outdid the U.S. by 1.7% to 1.6%.

The Japanese economy grew 0.3% sequentially in Q4 of 2016, maintaining the same clip of the prior period. It was the fourth successive quarter of growth. Emerging markets, as a whole, are also much better placed in recent times. All these point toward better demand from foreign economies.

Compelling Valuation of Large-Caps than Small-Caps

After a stupendous rally in 2016, small-caps now have stretched valuation, which will take time to normalize. The Russell 2000, a commonly used measure for small-caps, has a forward price-to-earnings ratio of 25.4, marking its highest level since 2009. Its 10-year average is 20.7.

In comparison, the S&P 500 trades at about 17.8 times forward earnings, though above its long-term average, but lower than small-caps’ valuation. In fact, the Bank of America Merrill Lynch believes that small-caps now trade at a valuation seen at the time of the tech bubble formed in the dot-com era (read: 5 Reasons Why Small-Cap ETFs Are Lagging Large Caps in 2017).

Better Earnings Growth in Large-Caps

As per an article published on Financial Times, earnings for small-cap companies as a whole declined about 1% year over year in Q4 compared with growth of 6% for large-caps. The figures are of Bank of America Merrill Lynch.

Analysts now expect an expansion in the bottom line for the S&P 600 – another small-cap gauge – in the first quarter of 2017, but at a much lower rate than that of the S&P 500.

Bottom Line

From the above analysis, it seems that the doors for small-cap investing could be open after a few more days when overvaluation risks ebb and earnings growth picks up. As of now, large-caps seem to be better bets.

Below we have highlighted a few large-cap ETFs, which can be tapped for gains (see all large-cap ETFs here):

First Trust NASDAQ-100 Equal Weighted ETF QQEW – Zacks Rank #1 (Strong Buy)

First Trust Large Cap Core AlphaDEX ETFFEX – Zacks Rank #2 (Buy)

Vanguard Russell 1000 Growth ETF VONG – Zacks Rank #2

iShares Russell 1000 Growth IWF – Zacks Rank #2

PowerShares S&P 500 Quality ETF SPHQ – Zacks Rank #2

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