News Analysis
BusinessWeek.com
October 2, 2006
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Small Caps: Out in the Cold

While the blue-chip Dow sees record highs, stocks of small companies are singing the blues. Is this the end of the sector's outperformance?

Shed no more tears for the blue chips. Sure, shares of America's largest companies underperformed the broader market for more than six years (see BusinessWeek, 4/17/06, "Blue Chip Blues"). Recently, though, the biggest U.S. stocks have enjoyed a long-awaited rebound. One blue-chip barometer, the Dow Jones industrial average, bobbed above its all-time closing high in intraday trading on Sept. 28 and 29.

HOW LONG A SLUMP?  These days it's the small companies singing the blues. The Dow has edged up 0.3% since hitting its peak for the first half of the year on May 10, while the broader Standard & Poor's 500 index has gained roughly 1%. Over the same period, the small-cap Russell 2000 index has declined 7.2%.

Are small caps just hitting a short-term slump, or has the tide finally turned? Much depends on how long small companies can keep putting up strong earnings numbers. It's also unclear whether the cooling housing market will disrupt the economy's oft-touted "soft landing" (see BusinessWeek, 10/9/06, "U.S.: Consumers Aren't Sweating the Housing Slump Yet"). Nevertheless, slowing economic growth could bode poorly for small-cap stocks, which tend to underperform when times get tough.

If large caps are indeed back in the driver's seat, Wall Street is getting what it has long wanted. Analysts started calling for a blue-chip comeback at least two years ago, but the market has consistently poured cold water on their plans. According to Russell Investment Group, investment managers have picked large-cap growth as their most favored asset class in every quarter since Russell launched its survey in June, 2004.

SMALL CAPS, BIG RISK.  Small caps started to lag at a time when investors faced a dizzying array of risks (see BusinessWeek.com, 6/14/06, "A Summer Slump for Stocks"). The Federal Reserve was hiking interest rates to guard against inflation, while the housing slowdown was beginning to spark recession fears. Oil prices soared above $78 amid violence in the Mideast.

At the same time, investors shifted their assets from aggressive stocks to more defensive, conservative securities. Small-cap stocks typically bear more risk than their larger counterparts, so their prices suffered. But so did emerging-market stocks and other economically sensitive issues.

Many of the worries that prompted this flight to quality have faded in the meantime. While housing remains a huge question mark, crude oil futures have dipped below $63 a barrel, and Mideast tensions appear to have cooled. On Aug. 8, the Fed paused after 17 consecutive rate hikes, and the central bank took another pass at its Sept. 20 meeting. Many analysts are forecasting rate cuts for next year.

TOO PESSIMISTIC?  "Here we are at the cusp of the big fourth-quarter selling season for the holidays, and it looks like things might be much better than this pessimistic view the market took a month prior," says Ryan Crane, chief investment officer at Stephens Investment Management Group and manager of the Stephens Small Cap Growth (STSGX ) and Mid Cap Growth (STMGX ) funds. "If we have this soft landing, then I think small-cap growth is going to be exactly where you want to be when everything rallies."

In addition, small-cap stocks could enjoy surprisingly solid earnings. Small companies will no longer have to absorb the fresh one-time costs of the Sarbanes-Oxley corporate-governance legislation or the new stock-options accounting requirements, which whacked previous quarterly results, says Mary Lisanti, president of AH Lisanti Capital Growth and manager of the Adams Harkness Small Cap Growth fund (ASCGX ). "Small caps usually do not underperform large caps until the earnings growth of large caps starts exceeding small caps," Lisanti says.

Such optimism might be premature, others say. Wall Street is overestimating 2007 earnings growth and revving up for possible rate cuts without first pricing in the risk of a recession, according to Sam Stovall, chief investment strategist for S&P Equity Research. "The market is getting enthusiastic about taking an antidote to a poison it has yet to ingest," Stovall says. "We have to start worrying about a recession before we get excited about getting out of a recession."

EXPECTATIONS STILL HIGH.  Jay Rushin, a portfolio manager at AIG SunAmerica Asset Management (AIG), agrees that the market has yet to price in the possibility of markedly slower economic growth next year. He expects large caps to outperform at least through the end of 2006. "Maybe six months from now when we're closer to a Fed rate cut, then that's going to be a more bullish time for stocks," Rushin says.

While profit expectations have come down for the second half of this year, they may still be too high for 2007, according to Tobias Levkovich, chief U.S. equity strategist at Citigroup (C ). "Small-cap stock prices do not yet fully appear to discount a likely slowdown in earnings growth," Levkovich notes in a Sept. 28 report. He says earnings disappointments are most likely from the capital goods, commercial services and supplies, energy, and materials sectors.

Investors will know soon enough whether small companies' earnings remained strong in the most recent quarter. Third-quarter earnings season kicks off in earnest when Alcoa (AA ) reports Oct. 10. September retail sales figures, due Oct. 13, could shed more light on the situation for small caps.

POSSIBLE GAINS.  In the short run, at least, contrarian indicators suggest small-cap shares could be poised for gains. "Small caps are heavily shorted at the stock level," says Mary Ann Bartels, chief U.S. market analyst at Merrill Lynch (MER ), in a Sept. 25 report. "We look for small-cap stocks to rally further in the short term."

Even if small caps do continue to trail their larger peers, some individual stocks should continue to outperform. Doug Pyle, manager of the Excelsior Small Cap (UMLX ) fund, likes such retail names as Columbia Sportswear (COLM ), Talbots (TLB ), and Cabela's (CAB ), plus tech outfits like Varian Semiconductor (VSEA ) and Cabot Microelectronics (CCMP ). "Having some exposure to the asset class is important," Pyle says.

Indeed, diversification across all asset classes is one of the first rules of savvy investing. Still, while no one knows how much earnings will slow, now may be a good time for investors to tweak their asset allocations to prepare for possible weakness in small caps.