US small-caps guru Ellenbogen warns over post-election rally

US small stocks guru Henry Ellenbogen is concerned that the ferocious post-election equity rally could unravel unless the economy accelerates sharply to justify the frothy valuations, warning that most of gains were powered by fickle inflows into exchange traded funds.

So-called “small-caps” — or smaller capitalisation stocks, midsized companies whose heft falls short of

warranting inclusion in flagship equity market indices like the S&P 500 — have outshone large-cap stocks since Donald Trump’s victory in the presidential election.

The rally has been driven by expectations of more aggressive, inflationary fiscal spending and large-scale corporate tax cuts, which benefit smaller, largely-domestic companies that cannot lower their effective tax rates through overseas legal subsidiaries. Moreover, they are largely insulated from the stronger dollar.

Although the Russell 2000, home to small-cap stocks, has failed to make a new high since early December, its almost 14 per cent advance since the US election is close to double that of the S&P 500. Mr Ellenbogen, manager of T Rowe Price’s $16.7bn New Horizons small-caps fund and one of the industry’s best-known names, is worried that valuations have become too elevated again, after slumping into a bear market in early 2016.

“Small-caps are trading at a significant premium. To believe that that can continue you have to believe that US economic growth can accelerate significantly over the next few years. I’m not sure about that,” the told the FT.

Mr Ellenbogen, who late last year was promoted to chief investment officer of T Rowe Price’s US equity growth business, said “you can’t ignore the US election” and the message it sent in favour of aggressive fiscal spending to reflate and reinvigorate the economy, which should benefit small-caps.

Indeed, analysts polled by Bloomberg forecast that earnings per share for the Russell 2000 index will almost double to $54.91 in the coming year. However, Mr Elllenbogen is sceptical of how much further an already-ageing bull market run can continue.

“I do believe that we are heading towards a reflation period that will be good for equities and especially small-caps. The question is how much is already in the price,” he said. “We’re not at the top of historical valuation levels, but we’re not that far from the highs. We’ll need to see significant earnings acceleration as there is a lot priced in now.”

The small-caps specialist — whose New Horizons fund has beaten 97 per cent of its peers over the past five years, according to Bloomberg data — is particularly concerned at the role of ETFs in pumping up the market.

Over $20.6bn has gushed into US small-caps ETFs since early November, according to EPFR, while dedicated small-caps mutual funds have actually suffered some outflows, underscoring the role of passive investment vehicles in the move.

“When you have those kinds of flows into an illiquid asset class, you can really drive performance. Stuff that was outside the index has been roughly flat, while everything in the index has risen significantly,” Mr Ellenbogen said. “If there is a setback, the fund flows that drove small-caps higher will be just as aggressive on the way out.”