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While the year 2017 was great for the broader market, large-cap stocks clearly outperformed small caps. An uptick in the global economy and a subdued greenback, thanks to occasional policy uncertainty in the United States, and muted inflation led the way higher for large-cap stocks. PowerShares DB US Dollar Bullish ETF (UUP - Free Report) was down more than 8% in the past year (as of Jan 8, 2018).

Things looked even better on the earnings front. Corporates have been strengthening not only in the United States but also in Europe and the other so-long besieged regions. The net result was 22.1% one-year gains in the large cap iShares Russell Top 200 ETF (IWL - Free Report) versus 15% advancement in the small cap iShares Russell 2000 ETF (IWM - Free Report) .

Notably, this 15% gain in small-caps came on the back of a late surge thanks to tax reform. Against this backdrop, we would like to highlight if large-caps are guilty of overvaluation and fall this year or replicate last year’s success in 2018.

2018 Scenario for Small-Caps

Many analysts including ones from Jefferies and Bank of America believe that 2018 will re-write the capitalization story of 2017 this year. The benefit of lower tax rates is likely to be outweighed by pricey valuations as well as chances of higher volatility and tighter credit conditions (read: What Do Fed Minutes Mean for the ETF World?).

Investors should also note that as per an article published on thestreet.com, the previous tax law entailed full deduction of interest paid. The new law will hold companies back from relying on debt too much. There is a provision in the tax blueprint that calls for limiting “deductions to 30% of EBITDA (earnings before interest, taxes, depreciation, and amortization) for four years, and 30% of EBIT after that.”

Per the article, many small-cap stocks are debt-reliant for their survival and lack cash. Plus, interests should increase next year given the Fed policy tightening and Trump bump. The double whammy of reduced interest deductibility and higher bond yields may actually weigh on small-cap stocks.

Bank of America Merrill Lynch also indicated that small caps normally “lag at the end of bull markets.” However, Morgan Stanley is in favor of small-cap investing (read: Tax Reform: A Boon or Bane for Small-Cap ETFs?).

2018 Scenario for Large-Caps

On the other hand, according to PWC, “the global economy may this year see its fastest growth since 2011.” UBS forecasts 3.9% global economic growth this year, which is slightly higher than last year. 2017 was only the seventh year in the past three decades in which every economy in the Group of 20 registered growth. According to World Bank, global growth is forecast to grow 2.9% in 2018-19, in line with prior projections.

Since large caps rely heavily on foreign economies, the health of international economies is crucial to an investment decision (read: Top Large-Cap Growth ETFs of 2017).

Though the S&P 500 is hovering around its 52-week high and closed Jan 8, 2018 at 2,747,71, many economists see further run-up in the key equity gauge. Cannaccord Genuity sees the S&P 500 ending 2018 at 3,200 reflecting tax cuts, while J.P. Morgan and Credit Suisse see the index leaving 2018 at 3000.

Finally, everything depends on the U.S. dollar. Its strength tells much of the performance story of large-cap stocks. If tax reform benefits and Fed tightening play out well, the greenback may shoot up and gains in large-caps may be constricted.

This is especially true given the overvaluation in the S&P 500. The January 2018 S&P500 index trades at 18.3x forward earnings versus the five-year S&P 500 average of 15.8x and a 10-year average of 14.1x. And if the greenback fails to accelerate, large caps may close 2018 with strong returns.

Bottom Line

Small caps may be popular bets amid tax cuts and large-cap stocks will also stay steady in 2018. However, due to overvaluation concerns, it is better to pick large-cap value ETFs like iShares Russell 1000 Value ETF (IWD - Free Report) , Vanguard Value ETF (VTV - Free Report) , iShares S&P 500 Value ETF (IVE - Free Report) and Schwab U.S. Large-Cap Value ETF (SCHV - Free Report) (see all large-cap ETFs here).

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