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What you may not know about small cap stocks

Summary:
This is one in an occasional series of articles highlighting the hidden investing factor exposures, starting with small cap stocks. Small caps have been on an absolute tear lately, both on an absolute basis and relative to large caps.  Does that mean you should jump on the small cap momentum train? Momentum is evident even from a fundamental viewpoint. Analysis from Yardeni Research reveals that small cap earnings estimates have been rising faster than large caps, even after the tax cut earnings surge. If you squint, you will see that the slope of small cap EPS revisions is steeper than large cap revisions.  Hidden USD factor exposure However, small cap outperformance can be partly explained by their USD exposure. The correlation between the size factor and the USD is evident

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This is one in an occasional series of articles highlighting the hidden investing factor exposures, starting with small cap stocks. Small caps have been on an absolute tear lately, both on an absolute basis and relative to large caps.
 

What you may not know about small cap stocks

Does that mean you should jump on the small cap momentum train?

Momentum is evident even from a fundamental viewpoint. Analysis from Yardeni Research reveals that small cap earnings estimates have been rising faster than large caps, even after the tax cut earnings surge. If you squint, you will see that the slope of small cap EPS revisions is steeper than large cap revisions.
 

What you may not know about small cap stocks

Hidden USD factor exposure

However, small cap outperformance can be partly explained by their USD exposure. The correlation between the size factor and the USD is evident in the chart below.
 

What you may not know about small cap stocks

While correlation isn’t causation, there are valid fundamental reasons for this relationship. Large cap companies tend to be more global in nature, and therefore more sensitive to fluctuations in exchange rates. A rising USD hurts large cap earnings, but domestically oriented small caps earnings improve on a relative basis.

From a technical perspective, some caution is warranted on the USD. The USD Index is currently testing a key resistance level, while exhibiting a negative RSI divergence.
 

What you may not know about small cap stocks

Under such bearish USD circumstances, investors are cautioned to give some second thought to the continued outperformance of small cap stocks.
 

About Cam Hui
Cam Hui
Cam Hui has been professionally involved in the financial markets since 1985 in a variety of roles, both as an equity portfolio manager and as a sell-side analyst. He graduated with a degree in Computer Science from the University of British Columbia in 1980 and obtained his CFA Charter in 1989. He is left & right brained modeler of quantitative investment systems. Blogs at Humble Student of the Markets.

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