By Jacob Sonenshine

Small-caps are the biggest winners of the trade deal between the U.S. and China.

The countries agreed on Monday to slash tariffs on each other's goods for 90 days while they keep trying to negotiate a lasting agreement. And that means -- presumably -- less inflation, less pressure on American shoppers, and more spending.

The three major U.S. indexes all popped almost 3% at the open, but the small-cap S&P 600 index soared 4%.

It shouldn't be a surprise that small-caps gained more. Earnings expectations for smaller companies are usually more volatile, so when markets assume greater earnings across the board, small-caps often outperform large-caps -- and vice versa.

So the S&P 600, which has lagged behind the S&P 500 all year, had its running shoes on Monday. The possibility of a tariff-driven recession -- one that would smack small-cap earnings -- has faded, sparking a reversal in these stocks.

At just over 1300, the S&P 600 finally cracked above the key 1299, where it was just before April 2 when President Donald Trump laid out his tariffs plan. Now, with a chunk of the tariffs reversed, the index is back on its uptrend that it began after hitting a major bottom in late 2023, when the entire U.S. market began a rally.

Buyers coming back in at 1299 indicates that, with this tariff deal and the improved perceptions about the economy, the market has more confidence in the outlook for small-caps.

Wall Street's confidence in these stocks stems from the sales and earnings of smaller companies.

Analysts covering S&P 600 companies expect sales, in aggregate, to rise 5.3% annually over the coming three years, according to FactSet -- a realistic estimate given economic growth forecasts in the low single-digit percentages, with inflation a tick under 3%. The companies on the index are across all sectors and are a decent gauge of the average U.S. company.

Sales growth should drive profits far higher. Many costs such as depreciation and interest expense are fixed so when sales rise, profit margins rise. To be sure, a strong economy with inflation that's not at the Federal Reserve's target 2% annual rate could keep interest rates higher could create a larger expense for smaller companies when they refinance debt. But other costs are fixed, giving many companies a chance to increases their profit margins.

Plus, many companies repurchase their stock, reducing their share counts and boosting earnings per-share. Analysts forecast the index's EPS to grow 14.9% annually over the coming three years, almost three percentage points higher than the S&P 500.

Those estimates might even be too low. Since a few days before Trump's election on Nov. 5, S&P 600 sales and earnings expectations dropped. Gross margin forecasts for smaller companies fell more harshly than for the S&P 500, according to Citi strategist Scott Chronert.

When the cost of raw materials and other product inputs rise on the back of tariffs, smaller companies have a tougher time raising prices to offset those costs. They're not as well-branded as larger brands, retailers and suppliers, and don't have as much sway with customers.

Here again, sales, margin, and earnings estimates could reverse course -- at least slightly. Second-quarter earnings reports over the summer will paint a clearer picture of what to expect.

Earnings growth would bring the stocks higher.

The S&P 600 trades at about 15.1 times expected EPS for the coming 12 months, a couple points below its peak multiple in the past three years of about 17.1 times. The current valuation is also still 28% below the S&P 500's 20.1 times, a steeper-than-average discount in the past decade, according to Barron's calculations of FactSet data.

That's a key comparison because, before markets had to wrangle with Trump's trade policy, many had wondered if this would be the year that small-caps finally caught up to large-caps in terms of valuations because of the basically sound economy.

Maybe that's a reality now. Small-cap multiples probably won't move much lower. Earnings should move higher -- and the stocks have nowhere to go but upward.

Stick with the little guys.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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May 12, 2025 13:15 ET (17:15 GMT)

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