Monday, February 12, 2007

Can Small Caps Keep Up Big Gains?

News Analysis
February 12, 2007

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Can Small Caps Keep Up Big Gains?

The durability of the sector's multiyear advance has proved detractors wrong again and again. They might not be done yet

Small-cap stocks continue to defy the skeptics. Despite some market soothsayers' annual predictions of large-cap supremacy, shares of small companies have piled up an impressive seven-year run (see, 1/3/07, "Style Wars: Growth or Value in '07?"). How much longer can they keep it up?

Small caps—broadly defined as those issues with a market capitalization below $1 billion—did briefly lag the broader indexes during 2006's postsummer rally, but they've since regained their winning ways (see, 10/2/06, "Small Caps: Out in the Cold"). On Feb. 8, the small-cap Russell 2000 index finished at 816.39, a new all-time closing high, up 35% from its 2000 peak. The broader New York Stock Exchange composite index also reached a new all-time high, while the Standard & Poor's 500-stock index still hovered nearly 6% below its seven-year-old record high.

New Record Highs Possible

Investors poured assets into small caps to end 2006. Small-cap exchange-traded funds received three times as much inflows as large-cap ETFs in December, according to data from Barclays Global Investors (BCS). The iShares Russell 2000 (IWM) ETF led in popularity, with $2.6 billion in inflows.

Unexpectedly upbeat economic data and positive technical factors could help keep small caps—and the overall market—going full steam ahead, some analysts say. Others expect bigger-cap names to weather slowing earnings growth and possible rate hikes better than their small-cap peers. In the short term, anyway, the Russell 2000 may continue to set new highs.

Recent economic reports have surprised to the upside, which tends to bode well for riskier assets, including small caps. On Jan. 31, the Commerce Dept. said fourth-quarter gross domestic product surged at a greater-than-expected 3.5% annual clip. On Feb. 7, another government report showed an unexpectedly strong 3% rise in fourth-quarter nonfarm productivity (see, 2/8/07, "A Welcome Pop in Productivity").

Positive Outlook

"Small caps are going to outperform again this year," says Alec Young, equity market strategist at S&P Equity Research Services (MHP). "What it's about is confidence in the economy, confidence that growth is going to continue to be O.K. The macroeconomic backdrop is very healthy."

While Young expects small caps to keep up their recent strength, he expects midcaps—companies with between $1 billion and $4.5 billion in market capitalization—to perform even better. The reason: Midcap stocks look cheaper than large caps or small caps based on their price-to-earnings growth ratio (see, 8/17/06, "A Small PEG to Hang Your Hat On").

From a technical perspective, small caps still look well situated, some market pros say. "The 800 level had been holding the Russell 2000 back," says Chris Johnson, chief executive and chief investment strategist of Johnson Research Group. "Now it's broken above that psychologically important level. The technical environment for the Russell 2000 has resolved itself to the upside."

Slowed Growth Poses Risks

However, small caps still face plenty of hurdles. Slowing earnings growth and the risk that the yield on the 10-year Treasury note will rise above 5% could give an advantage to large caps, which are expected to weather such troubles better, others say. "On a stock-specific basis, small and midcaps can do well, but as an overall group I think they may find it a little bit hard to maintain their reign," says Quincy Krosby, chief investment strategist at The Hartford (HIG).

The earnings slowdown may have a disproportionately severe impact on small caps, some analysts say. Sell-side forecasts for a small-cap earnings growth rebound in the second half of 2007 may prove overly aggressive, according to Tobias Levkovich, chief U.S. equity strategist at Citigroup (C). "Small-cap stocks are more likely to miss earnings estimates than large-caps, in our opinion," Levkovich writes in a Jan. 26 report.

Still, the recent boom in mergers-and-acquisition activity could help cushion the blow for some small-cap issues. Financial-services sector consolidation has been strong, with deals brewing among banks and real estate investment trusts (see, 12/21/06, "Real Estate M&A Roars Ahead"). With 106 deals last year, financials passed technology as the sector with the most smaller cap M&A, notes Denise Saunders, small-cap strategist at Merrill Lynch (MER), in a Feb. 8 report.

Proceed with Caution

Are small-cap bulls enjoying a false sense of security? Volatility indicators don't rule out the possibility investors may be getting complacent. Merrill's MOVE index, which measures volatility in U.S. Treasuries, fell to a record low on Feb. 5. The VIX, a gauge of worry about stocks, remains near a 13-year low set in January.

Brian Gendreau, an investment strategist at ING Investment Management (ING), suspects stocks—particularly small caps—may get hurt in the event of unpleasant surprises, such as interest-rate hikes. "Valuations on small caps have become stretched," Gendreau says. "They don't look cheap, and they look vulnerable to any disruption in the market." The length of the small caps' run may depend on how long investors can expect to keep avoiding the unexpected.

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