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Energy may give further impetus to U.S. small-cap stocks

[May 21, 2018] By Caroline Valetkevitch and April Joyner

NEW YORK (Reuters) - U.S. small-cap stocks look poised to extend a breakout rally, especially if oil prices advance deeper into levels last seen in 2014 to drive further gains in the small energy companies that have provided leadership in recent week, analysts and investors said.

The Russell 2000 index of small capitalization stocks closed at a record high for a third day in a row on Friday and registered its third week of gains, sharply outperforming large-cap stocks on Wall Street, with all three major indexes posting losses for the week.

The Russell is up 11.1 percent since its Feb. 8 low for the year, while the S&P 500 is up just 5.1 percent since that date.

The S&P 600 small-cap index is also at a record high. Energy shares within the S&P 600 have led recent gains, thanks to a jump in oil prices, which analysts said should boost earnings forecasts for the sector.

The outperformance of small-cap stocks has been driven partly by the December U.S. tax overhaul. The legislation included steep corporate tax cuts that particularly benefited smaller-cap companies, which had been paying higher rates than large-cap companies overall.

Recent trade tensions have also lifted shares of small caps, whose business is largely domestic, along with stronger U.S. economic growth.

Some of those benefits have been reflected in small-cap earnings growth, which has outpaced growth of larger names. First-quarter profit growth for Russell 2000 companies is estimated at 33.8 percent, while earnings for the S&P 500 companies increased 26.2 percent from a year ago, according to Thomson Reuters data.

ENERGY SPIKES UP

The S&P 600 energy index is up 31.3 percent for the quarter so far, the best-performing group, followed by health care, up 12.2 percent.

U.S. crude futures edged lower on Friday but remained above $71 a barrel and registered a third straight week of gains, lifted by falling Venezuelan production, strong global demand and looming U.S. sanctions on Iran.

"Even though (energy stocks have) had a good run, estimates will be climbing because analysts are raising their oil forecasts. So even though the stocks go up, they can still look cheap because the earnings estimate is going to go up as fast as the stock," said Steve DeSanctis, equity strategist at Jefferies in New York, which has been overweight energy since January.

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Crude oil storage tanks are seen from above at the Cushing oil hub, in Cushing, Oklahoma, U.S., March 24, 2016. REUTERS/Nick Oxford/File Photo

J. Bryant Evans, portfolio manager at Cozad Asset Management in Champaign, Illinois, said he has been buying shares of small-cap energy service providers.

"Some of the smaller energy service providers got banged up so badly when oil went down," he said. "But the ones who survived have a real opportunity to grow and take market share now that oil is at $70 a barrel."

BANKS, HEALTH CARE ALSO FAVORED

Several investors also said they favored financials within the small-cap space, particularly regional banks, which have risen sharply this year compared with bigger banks. The S&P 500 bank index is down 0.3 percent year to date, compared with a 6.2 percent gain in the KBW regional banking index.

The prospect of regulations being reduced further for some smaller banks has been a positive.

Regulations have "been a big headwind in the last couple of years," said Anthony Saglimbene, global market strategist at Ameriprise Financial in Troy, Michigan. "Easing regulation would benefit small-cap banks."

The health care group has benefited from merger activity, including Zoetis Inc's announcement this week to buy Abaxis Inc .

Health care has been the best-performing sector within the S&P 600 so far this year, up 26.8 percent.

(Reporting by Caroline Valetkevitch and April Joyner; Editing by Lisa Shumaker)

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