Wall Street's Next Big Things
LIKE LITTLE ENGINES THAT COULD, SMALL-CAP STOCKS have defied conventional wisdom and considerable odds to lead the market higher this year. But their blistering run may be on borrowed time.
This is supposed to be a year when size matters, as fund managers steer money from smaller, riskier bets toward bigger companies that can better withstand a maturing rally and the looming threats of higher taxes and rising interest rates. That anticipated shift, however, has yet to materialize: Through Thursday, the Russell 2000 index of small stocks was up 16% this year, versus 9% for the large-cap S&P 500. In fact, small stocks have surged 111% since the market bottomed in early 2009, easily besting the 79% advance for large stocks.
SMALL-CAPS WERE EGGED ON RECENTLY by several factors. A fractious Europe and its strained common currency boosted the dollar and helped small domestic companies. Traders eyeing a turnaround in the labor market also lunged at financial and consumer discretionary issues that might benefit most from new hiring, and these momentarily coveted sectors make up a disproportionate 38% of the Russell 2000, compared with 27% of the S&P 500. Most importantly, the Federal Reserve has stayed benevolent, the credit market is accommodating, and the stock market has stayed so robust that momentum traders see no incentive yet to retreat from risk -- and from small stocks.
Alas, this might be as good as it gets.
"Market conditions and sentiment can't get any more in favor of small-caps than they already are," asserts Lori Calvasina, Citigroup's small- and mid-cap strategist.
Soon, individual investors gingerly returning to the market more likely will flock to the familiar large stocks that they perceive as stable. In addition, small-caps have become pricier: The Russell 2000 now trades at 26.3 times what its components are projected to earn, far richer than the 15.5 multiple for large stocks.
Within the exalted small-cap universe, shares of the smallest, iffiest companies have attracted the most money -- thanks to investors' growing appetite for junk, and the pervasive notion that the weakest stocks might rebound the most in a recovery fueled by cheap liquidity.
Steven DeSanctis, Bank of America Merrill Lynch's small-cap strategist, divided the Russell 2000 into five groups, based on various criteria. He found that the 400 biggest stocks within the index climbed 7.7% last quarter, a far cry from the 13.2% gain for the 400 smallest. And while the faction with the best return on equity rallied 7.4%, the stocks with the worst ROE somewhat perversely jumped 10.1%.
In fact, those companies within the Russell 2000 that make no money surged 11.1% last quarter, beating their profitable peers. "Historically, this non-earner rally lasts five to seven months into a recovery, but we're now into the 13th month," DeSanctis says.
Given the parallels between 2009 and 2003 -- both saw double-digit market rebounds that unfurled in March after the government slashed rates -- many thought 2010 might follow 2004's script. Back then, an improving economy and prospective rate hikes persuaded traders to begin steering toward quality by the first quarter of 2004, and within the Russell, the larger, more profitable stocks began to outperform. That hasn't happened so far in 2010, "but we continue to think change is coming," DeSanctis says....MORE